06.11.09
My comments to the SEC regarding the uptick rule
The following are the comments that I submitted to the SEC.
I recently had the pleasure of reviewing substantially all the research by academics and by SEC staff on the effects of the uptick rule, including the transcripts of the Reg SHO roundtable and the recent roundtable discussions on the uptick rule. I urge the commissioners to pay attention to the conclusions of that research. I summarize it here and add a few of my thoughts as a stock trader.
None of the data from any of the research support the view that the uptick rule prevents so-called ‘bear raids’. In fact, I could find evidence of only one proven instance in modern US stock market history of illegal and manipulative short selling, that being the case of Robert Todd Beardsley and George Lindenberg (who were prosecuted by the SEC see litigation release 21032 for the most recent update on their case) the defining fact about that case is that their manipulation was possible only because of the uptick rule Other cases the SEC has prosecuted involving illegal acts by short sellers involved either insider trading (such was the case of Anthony Elgindy) or publishing false information (such was the case of Mark Jakob). Simply put, there is no evidence that any market manipulation happens that would be prevented by reinstating the uptick rule.
While there was no evidence that the uptick rule was effective in preventing manipulative or harmful short selling, there was clear evidence that the uptick rule made all short selling more difficult. Academic research has consistently shown that short selling helps price discovery (and the SEC commissioners have agreed with that statement) the SEC should thus only hinder short selling if it is clear that doing so will clearly prevent harm to the markets.
There is no evidence that the uptick rule prevents market manipulation while there is clear evidence that it restricts shorts sellers, reducing market efficiency. Some have argued that the SEC should reinstate the uptick rule to increase investor morale. This would be foolish and ultimately counter-productive. The SEC should instead focus on regulations that could clearly benefit the markets rather than wasting time trying to make people feel good.
For example, I believe the SEC could better spend its time changing rules to make pump and dump stock manipulation more difficult. One way to do this would be to change margin rules to make it easier for short sellers to sell short low-priced stocks. Specifically, I recommend that the SEC force the NYSE to change rule 431(c)2, which requires that short sellers have $2.50 in cash to short sell one share of stock priced under $5, no matter how low-priced the stock is. I believe this rule explains why most pump and dumps are perpetrated upon penny stocks. One recent example, Uomo Media (OTC: UOMO), saw multiple stock touts drive the price up from 20 cents to $1.00. Over $30m in trades took place at elevated prices. Restricting such manipulation would yield clear benefits, unlike reinstating the uptick rule.
All comments regarding the uptick rule
Submit a comment to the SEC regarding the uptick rule
Proposed uptick rule (pdf)
How the uptick rule abetted bear raids
The trader’s guide to the uptick rule
Disclosure: No positions.
Yngvai said,
June 11, 2009 at 6:51 pm
Great letter
Tastylunch said,
June 11, 2009 at 11:06 pm
I agree with Yngvai.
succinct, informative yet readily understandable, clear and firm without being condescending. Great letter., hope it gets read.
I wish the SEC understood that shorts are as a important to the reliable market efficiency as predators are to an ecosystem’s herbivore population stability. I suppose I shouldn’t be surprised since we are the same people that hunted many of North America’s large predators into near extinction.
The more the SEC makes it tough/expensive for shorts, the less meaningful price discovery there is going to be and the more excessive volatility there could be.
Dragontoad said,
June 12, 2009 at 9:10 pm
I found this article by George Soros informative regarding how abolition of the uptick rule could have factored into the financial crisis…
http://online.wsj.com/article/SB123785310594719693.html
I have no idea if his version of the events is true or not, but I do generally agree with his theory of “reflexivity”, and what he is saying makes sense to me in that regard.
Michael Goode said,
June 12, 2009 at 9:16 pm
Soros’ argument in that op-ed is primarily against credit default swaps. There is no evidence that the selling of Lehman and Bears Stearns’ stock prior to each firm’s failure was primarily short selling as opposed to the selling by owners of the stock. The CDS are the primary culprit in Soros’ conception of events; increased CDS prices led to selling of the stock (primarily longs selling because the same selling was evident in the financials such as WaMu during the financial short ban).
Dragontoad said,
June 12, 2009 at 9:35 pm
From the article:
“Taking these three considerations together, it’s clear that AIG, Bear Stearns, Lehman Brothers and others were destroyed by bear raids in which the shorting of stocks and buying CDS mutually amplified and reinforced each other. The unlimited shorting of stocks was made possible by the abolition of the uptick rule, which would have hindered bear raids by allowing short selling only when prices were rising.”
I think it is clear from that statement that he viewed “unlimited shorting of stocks”, which was “made possible by the abolition of the uptick rule” as an important factor in this interaction… This would have also of course triggered longs to ultimately sell as well in addition to the shorting.
Michael Goode said,
June 12, 2009 at 10:21 pm
What Soros does not explain (and I have not heard anyone else expousing the same views of “the short sellers killed Bear Stearns & Lehman Bros” explain this either), is why does the end of WaMu look so similar to the demise of those iBanks? Its stock fell and its CDS soared and it quickly went bust (in this case it was taken over by the FDIC and sold off quickly). Short sellers could not have knocked its price down because during its last days WaMu was included in the SEC financial short ban list.
http://www.sec.gov/news/press/2008/2008-211.htm
http://www.google.com/finance?chdnp=1&chdd=1&chds=1&chdv=1&chvs=maximized&chdeh=1&chdet=1223064000000&chddm=5233&q=OTC:WAMUQ&ntsp=0
While reflexivity has a nice ring to it, we must not ignore the fundamental fact that every single financial institution that went bust was fundamentally unsound; they suffered huge losses on bad investments and were highly levered. Furthermore, their funding was primarily short-term while their assets were long-term. Bear, Lehman, and WaMu suffered old-fashioned bank runs because there was legitimate fear about their solvency and their liquidity. If the government wishes to prevent such failures in the future it should increase oversight of banks and increase reserve requirements, thus attacking the root cause of the fear surrounding the banks, rather than focus on a few capital market actions that might have somewhat inflamed the fear.
Dragontoad said,
June 13, 2009 at 12:43 am
Ok, let me preface this by saying that you are certainly smarter than me, and know much more than I do about this, but I would like to continue to play devil’s advocate for a bit..
Regarding how WaMu’s demise “looked”:
Couldn’t mini bear runs potentially occur over a period of time as a way of “gaming” the markets for short-term gains? ..in a similar way as futures can be (supposedly?) used to game stock prices? Then, after it falls enough, the fundamentals can deteriorate to the point where it will collapse on its own. As Soros states, regarding the “reflexivity” of the markets:
“Nowhere is this phenomenon more pronounced than in the case of financial institutions, whose ability to do business is so dependent on trust. A decline in their share and bond prices can increase their financing costs. That means that bear raids on financial institutions can be self-validating.”
Here is a picture of WaMu’s CDS vs. share price from approximately the date of the removal of the uptick rule:
http://www.marketoracle.co.uk/images/2008/WaMu-CDS1.png
By the time the ban on short selling was imposed (September 19, 2008), it was probably too late for something like that to work anyway.. fear had long ago set in, especially with what had happened to Bear and Lehman. Furthermore, the need to impose such a ban could signal a lack of confidence to longs, causing them to panic and sell while they still had a chance. Therefore, even if this may have helped if enacted quickly, by that point it was probably too late anyway.
I certainly agree with you that these institutions were unsound, and it was likely just a matter of time before something like this happened, and there are probably a slew of more important measures which should be made to strengthen the system.. Nonetheless, couldn’t reinstatement of the uptick rule (in some form) could be part of a package to achieve this goal?
Even Warren Buffet says that “on balance” we should probably reinstate it:
http://everythingwarrenbuffett.blogspot.com/2009/03/full-cnbc-squawk-box-transcript-video.html
“BECKY: All right, you counted on–you commented on mark-to-market. What about the uptick rule? We’ve had several people who’ve written in about that.
BUFFETT: Yeah. Yeah, I–there’s no–there’s no question that it–there’s something wrong with people buying stocks and saying untrue things, and there’s something wrong with people shorting stocks and saying untrue things. And sometimes it seems like the shorts are a little more eager to spread negative stories than the longs. But I’ve seen a lot of people on the long side do a lot of things they shouldn’t have done, too. I think–I think probably the uptick rule is a good idea. I mean, we had it for decades and the–it–on balance, I probably would have it in. I don’t think it’s the key to things at all. I mean, I think that–I mean, you can–you can do bear raids of a sort through credit defaults, swaps and all that sort of thing now, and there’ll always be people trying to push the bear case. There are people trying to push the bull case all the time. In the end, if you don’t owe money on stocks and you own a good business, a good business will not be ruined by somebody selling stock short on an uptick or otherwise. I welcome people shorting Berkshire. I mean, you know what I mean? They’re the–they’re the sure buyers later on. They have to buy someday, right?”
…So Buffett essentially seems to think that it provides more value to the markets than it takes away, while stating that a “good business” will not be ruined by short selling… Going back to the Soros piece, however, for financial institutions, unlike other businesses, there exists the possibility for declining share prices to actually affect their fundamentals, thus (potentially) even turning a “good business” bad.