Restore the uptick rule
Should you be allowed to bet against something you don’t own? If you make such a bet, should an army of your friends be allowed to pile on and make the same ghoulish bet?
We bet your stock is going to fall!
Might such a stampede of necromancers have contributed to the meltdown of financial stocks like Bear Stearns, AIG and others, that contributed to our current global crisis? That’s the thesis tested, at least statistically, in this data-driven report and Op-Ed from The Wall Street Journal:
There’s a
The SEC should restore the uptick rule.
By ROBERT C. POZEN and YANEER BAR-YAM
When
What’s a theoretical mathematician doing commenting on stock trades? That’s Yaneer, whom I met on a little American Eagle flight to
Delighting in complexity: Yaneer Bar-yam
These measures proved ineffective. Even during the three-week ban starting on Sept. 22, financial stocks fell along with the market, after outperforming the market prior to the ban. Moreover, the liquidity of these financial stocks decreased, and the cost of trading them increased, as bid-ask spreads widened.
Pozen the question: should we allow naked shorts?
Yaneer runs New England Complex Systems Institute (NECSI) which focuses on complex systems:
Complex systems science is a new field of science studying how parts of a system give rise to its collective behaviors, as well as how the system interacts with its environment. Social systems formed by people, the brain formed by neurons, molecules formed by atoms, the weather formed by air flows— these are all examples of complex systems. By using mathematics to focus on pattern formation, and the question of parts, wholes and relationships, the field of complex systems cuts across all the disciplines of science, as well as engineering, management, and medicine.
A complex system modifies itself
Such thinking figures heavily in our view of affordable housing finance as an ecosystem, a metaphor Yaneer picks up when commenting on the financial environment. Shortly after meeting Yaneer, I took his two-day introductory course on complex systems – highly recommended! – and since then have studied self-organizing networks as a critical element in our thinking about affordable housing finance. When I saw he’d written an Op-Ed, I took notice.
We’ve already seen, in Unlicensed Insurance (Part 1, Part 2, and Part 3), that Collateral Default Swaps (CDSs) are like double-indemnity insurance, or side bets on a football game: you and I speculate on a third party’s fortunes, with me hoping they’ll lose. If such a bet took place only in a financial private club, that would be one thing, but much like the Double Indemnity situation, a massive amount of short selling can destabilize the stock price.
That’s what happens with too much short selling
Given the continued turmoil in the financial markets, the SEC should reinstate the “uptick” rule, which helped limit downward spirals by allowing a stock to be sold short only after a rise (an “uptick”) from its immediately prior price.
Limiting short selling to situations after an uptick is like putting pawls on the gears – it would prevent runaway shorting.
Keeps the price from unwinding
I dug out the NESCI report (link in .pdf). Here’s what they had to say:
Taken together, this information strongly implicates the uptick rule repeal as a major contributor to, if not the outright cause, the current severe financial crisis – a crisis that is greater than any since the crash of 1929 and the subsequent turmoil of the early 1930s. The prevention of such conditions was the original motivation for the uptick rule.
That’s quite striking: the rule in question was instituted a few years after the 1929 crash. Do you think its repeal might have something to do with the current difficulties?
Adopted in 1938, the uptick rule was repealed by the SEC on July 3, 2007, primarily on the basis of a pilot program conducted in 2005. In the pilot program the agency compared 943 randomly selected stocks from the Russell 3000 not subject to the uptick rule to the remaining stocks in the Russell 3000 (a broad-based index of U.S. stocks of all sizes) still subject to this rule.
Science is based on replicability and materiality. Statistical science needs paired comparisons — which we have here – and enough data, which we also have here.
During these six months, the SEC found that the stocks not subject to the uptick rule had 2% lower returns than those still subject to the rule. This difference implies that removing the uptick rule goes farther than the SEC’s apparent goal of attaining a neutral environment for stocks.
As explained by a research analyst at University of Tennessee, Min Zhao, the SEC’s lifting of the uptick rule for large stocks in the pilot “is associated with undervaluation . . . [and makes it easier] for ‘predatory’ short sellers to aggressively submit short orders and to manipulate stock price downward.”
And the consequences: depressing returns for stocks not subject to the uptick rule
The SEC dismissed this 2% difference as statistically insignificant relative to the standard deviation of the Russell 3000 during the pilot period. However [snip], return differences of 2% within six months are economically important, because annual returns in the
In other words, the difference equaled as much as two-thirds of the return for the one-half-year period in question. That’s a big difference. It’s also visible:
The SEC was warned by two commentators not to repeal the uptick rule since it limited “bear raids” — when short sellers drive down a stock’s price in the hopes of scaring other investors into dumping the stock or triggering margin calls to force liquidations. In response, the agency approvingly summarized the views of three other commentators — that bear raids “are highly unlikely to occur in today’s markets, which are characterized by much smaller spreads, higher liquidity, and greater transparency than when the rule was adopted 70 years ago.”
Glad to hear it
In other words, there was nothing to worry about, because we had new and improved technology. Similar arguments, we recall, were proffered as to why securitization would allow buckets of C-rated assets to be pureed into a Triple-A milkshake.
This summary did not take into account another factor — the advent of over $1 trillion managed by hedge funds with the ability to short stocks.
Who you calling a hedge fund?
Did the bears rouse themselves? They did.
In fact, after the repeal of the uptick rule, there was a marked increase in the number of NYSE-listed stocks with price drops of over 40% in a day — a rough proxy for a bear raid. In the 12 months following Sept. 30, 2007, the number of such huge drops doubled as compared to a prior period with similar market declines and high volatility — the 12 months following March 31, 2000.
In the formal report, the authors are even clearer:
In this report we show that during the pilot, unregulated stocks had statistically and economically significantly lower returns.
This provides evidence for increasing numbers of ‘bear raids’ – when short sellers rapidly sell stock in the hope of triggering margin calls or driving other investors to sell due to fear of losses. Preventing such manipulation was a key motivation for implementing the uptick rule in 1938. Our findings suggest that the uptick rule has been key to the historical stability of markets and should be reinstated.
We found that the removal of outliers with over 100% return, or an analysis that combines both the NYSE and NASDAQ data reveals statistically significant lower returns for the unregulated stocks.
That’s statistics-speak for ‘moral certainty’
Guaranteed to be the reason
Our analysis shows a dramatic, statistically significant, increase in the number of stocks with drops of over 40% of their value in one day (see Table 3) between 2 pre-selected periods: 12 months following March 31, 2000 (pre-repeal), and 12 months following Sept. 30, 2007 (post-repeal).
The longer the period the uptick rule was repealed, the worse the repealed stocks performed:
Who are you going to believe, the SEC or your own eyes?
The passage of the Economic Stabilization Act of 2008 has not stopped bear raids, so the SEC is reviewing its tool kit on short selling. Instead of another blunt tool like a temporary ban, the SEC should promptly bring back the uptick rule.
I’m persuaded. Are you?
Whattaya think, punk?
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