Did repeal of the uptick rule unleash market havoc?

Sep 10, 2007 @ 9:21 am

By Jeff Benjamin

The sudden burst of stock market volatility this summer has sparked a finger-pointing exercise that assigns much of the blame to an obscure rule change that makes it easier for traders to sell stocks short.

The ultimate losers, according to some critics, are retail-class investors who still are being told to buy and hold for the long term.

In an increasingly heated debate, the rising number of short sales and growing market volatility since July are being cited as evidence that institutional traders, such as hedge fund managers, are fueling the choppy markets, according to some industry professionals.

“The rule changed eight weeks ago, and market volatility has increased substantially,” said Patrick Becker, president of Becker Capital Management Inc. of Portland, Ore.

The so-called uptick rule, established in 1938 but repealed by the Securities and Exchange Commission on July 6, had required traders to wait for a stock’s price to make an upward move before it could be sold short.

Short selling is a trading strategy designed to profit from a stock’s downward movement. It involves borrowing shares from a brokerage firm, then immediately selling them and waiting for the stock price to decline before buying the shares back at a lower price and returning them to the brokerage lender.

Advantage Hedge funds

“I don’t think anyone would disagree that removing the uptick rule is a benefit to short sellers — and they are mostly hedge funds,” said Peter Chepucavage, general counsel at Plexus Consulting Group LLC in Washington.

Mr. Chepucavage, an SEC lawyer from 2001 through 2005, worked on a pilot program to study the potential effect of repealing the uptick rule. He does not believe the rule change alone drove the recent market volatility.

“A number of highly experienced people have suggested the rule change is having a major impact on the stock market, but I think there’s a combination of factors, including the subprime-mortgage crisis,” he added. “This summer was a bit of a perfect storm that included the first rewrite of the short-sale rules in 60 years.”

The uptick rule originally was designed to prevent the kinds of bear raids on stocks that occurred during the 1929 stock market crash. But an SEC evaluation of the rule found that the uptick requirement was antiquated and had minimal effect on modern financial markets.

In a June 28 statement, the SEC said: “We note that while we believe that current price-test restrictions are no longer effective or necessary, we intend to closely monitor for potentially abusive trading activities.” SEC spokesman John Heine would not elaborate on what drove the repeal of a rule that the SEC had described as essentially benign.

Some critics theorize that the change was driven by hedge funds and stock exchanges likely to benefit from the increased trading volume and market volatility.

“The power of the short sellers — or you could call them hedge funds — has grown significantly in stature,” said Andy Brooks, head of equity trading at T. Rowe Price Group Inc. in Baltimore.

“We’re in the thick of it, and I think [eliminating] the uptick rule is a major contributor to what’s happening in the stock market,” he added. “I’m not saying the markets wouldn’t have gone down, but they would have gone down in a more orderly fashion.”

The lack of order in the stock market is illustrated in the recent volatility of the Standard & Poor’s 500 stock index, as measured by the Chicago Board Options Exchange’s volatility index, or VIX. Since 1990, the average daily volatility of the S&P was 18.9. But from July 26 through the end of August, it never dropped below 20, and spiked above 30 on two occasions.

During the same period last year, the VIX hovered between 11.6 and 15.2. In sync with the increased volatility was an increase in short sales, according to the New York Stock Exchange Group Inc.’s monthly short-interest reports.

Short interest totaled 12.5 billion positions in August, 12.95 billion in July and 12.47 billion in June. Last year, by comparison, there were 9.63 billion short positions in August, 9.3 billion in July and 9.1 billion in June.

A number of academics have sided with the SEC by suggesting the uptick rule did little to help stabilize the financial markets. “We found very little changes when the uptick rule was suspended in pilot programs, and it’s unlikely the current volatility is a result of that change,” said Karl Diether, an assistant professor of finance at Ohio State University in Columbus.

But Mr. Brooks and others charge that the pilot tests were not done under a full range of market conditions that might have produced results similar to the current market volatility.

“I think they’re not doing nearly enough academic work to fully evaluate this,” he said.

Unbridled tactics

Without the uptick rule, hedge funds are unrestrained in their aggressive short-selling tactics, which could be characterized as price manipulation, Mr. Brooks added. “They short sell it and drive the price down, and then they turn around at the end of the day and buy it back at a profit,” he said. “It’s just another example of the market structure enabling people with a very short time horizon to disadvantage those people on the other side with a longer time horizon.”

Meanwhile, proponents of the rule change suggest the critics might be clinging to a fallacy with regard to the benefits of the uptick rule.

“The uptick rule was really just a trap for the unwary, and I don’t think it has contributed to the recent market volatility,” said Charles Crow, partner at the Princeton, N.J., law firm of Crow & Associates Inc.

“Taking a position that a stock will go down is just as valid a position as one that a stock will go up,” he added. “Stocks that need to go down should go down, and if this rule change facilitates that, I applaud its departure.”

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