By Guest Author Tim Smith
[More than 5,000 people signed a petition calling for the reinstatement of the uptick rule that was prepared by Jim Cramer, William Furber, Eric Oberg and Scott Rothbort and sent to the SEC earlier this week. In today’s guest post, Tim Smith of SunGard’s Astec Analytics weighs on the effects of the removal of the rule, which forbid short sellers from selling securities before a share price increase, and its possible re-introduction.]
True or false: The removal of the uptick rule helped create the environment of falling stock prices
There has been much debate around the possible re-introduction of a form of the uptick rule that is seen by some as a panacea for all evils that have befallen stock values. Some argue that the removal of the original uptick rule in June 2007 was the catalyst that started, or at least exacerbated, the downward trend in prices and allowed the bears to have their way with what were perceived to be over-valued stocks. It is a generally held belief that the decision to remove the uptick rule had been a relatively quick one, implemented without much planning or aforethought. This, however, was not the case. There had been a lengthy pilot scheme (August 2005 to July 2007) involving about one-third of the Russell 3000 Index being exempt from the rule which showed over that period that those in the pilot and those not in the pilot moved in similar ways, thus proving the point, it was thought, that the uptick rule was no longer relevant.
There are misunderstandings on both sides in the current debate. Firstly, those who argue that this is the answer to all the stock market woes are wrong because the uptick rule, or rather a form of uptick rule (about five methodologies are being considered), is just one element in the array of weaponry that the regulators have to ensure orderly markets. There are also other more mundane controls such as collateral types and margin for securities lending (the thing that takes the “naked’ out of “naked shorting”), the ability to ban short selling in groups or all stocks and the current wide-ranging legislation covering market manipulation, Reg SHO etc. In other words, it is the sum of the whole that may work and not only one of the constituent parts. Secondly, for those arguing vociferously against the re-introduction, we can lay the accusation of being pre-judgmental. There are five different methodologies being looked at and there will be a sufficiently long time to analyze them before any decision is made – and also a sufficiently long time to find ways of coping with any new rule as well. It is only prudent for regulators to analyze every option available to them.
One way of starting to see whether any re-introduction of an uptick rule might have an effect would be to analyze what went on after the last rule was withdrawn. The chart below shows how the pilot securities moved in the securities lending world (the current best proxy for short selling we have) against the non-pilot securities over the period of the test and after the removal. It can be seen that there was an increase in the amount of borrowing activity and thus short selling for the period after the uptick rule was removed. However, there was an increase for those securities that were already free of the rule previously. Consequently, the initial view is that there would appear to be no difference between the groups before and after but the amount of securities being lent did shoot up. This could mean that the removal of the uptick rule provided the environment within which short selling became more acceptable and “standard”, thus pulling everyone up, even those on the pilot scheme. Alternatively, perhaps other market events may have driven the activity; for example, Bear Stearns or Lehman Brothers.
Thus, in the best traditions of viewing statistics and data, it can be argued that the removal of the uptick rule both did and did not affect market activity and stock prices, which implies that it would be the same for any re-introduction. Potentially, there may be same effect as seen when the introduction of a short selling ban and the removal of the same were promulgated; namely, that there might be an initial surge in activity as people seek to secure their supply or position which then eases off to more “normal” levels, whatever they may be, once the full ramifications or lack thereof sink in. In the final analysis, we are drawn back to the inevitable conclusion that it will or may be just one rule that everyone will have to live with; one of many that already exist. It will be coped with just as it was before and it may be withdrawn if implemented at some unknown future date, when the next generation of traders and experts mature into seasoned bankers, analysts, investment managers and regulators. And thus the cycle continues…
Median Change in Share Borrowing per Stock
Before the pilot to just after the pilot
The last months of the pilot to just after the uptick rule was completely eliminated