Planks in the new regulatory platform: Part 1, the uptick rule
Because new technology always outruns safety warnings, we discover the necessary improvements in regulatory structures only after the financial catastrophe – or, said more optimistically, now that we’ve lost all this money, shouldn’t we at least use the knowledge to build a new regulatory platform?
When designing new regulatory structures, wear a hard hat and a thick skin
Regulation is a framework, an interlocking ecosystem of rules and requirements, and over the last few weeks two planks have been laid down, or in any event proposed to be laid down.
1. Restoring the uptick rule
As reported in the New York Times (verdana font), and as we recommended last December, the SEC is proposing to restore the uptick rule:
April 9, 2009
SEC Airs Proposals to Restrict Short-Selling
Seeking to restore investor confidence in the markets, securities regulators made several proposals on Wednesday that would restrict investors from betting on a stock’s decline at specific times.
The proposed rules are meant to curb potentially abusive trading activity and have been supported by financial institutions and other companies, which have experienced sharp declines in their shares.
Markets work best when rules are clear, information is transparent (and real-time), and bets are collateralized. But with naked short-selling – shorting a stock you do not own – they are not, which means naked shorts create extreme leverage:
Now pay attention
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
As we’ve seen in numerous posts, the causes of our capital markets global de-leveraging are myriad, so it’s unrealistic to think any single change will be the magic bullet that solves the problems with one shot.
Nice shot, but are our problems are more complex than crayons
The Securities and Exchange Commission announced five proposals to curb the practice of short-selling, including a modified version of a Depression-era rule that prevents investors from shorting a stock when its price is already declining. That restriction, known as the uptick rule, was repealed in 2007 after regulators determined that it was not effective at stopping abusive trading.
Argh – the Times’s description of the SEC’s finding is wrong. The SEC said nothing about whether the uptick rule affected abusive trading; rather, the SEC found (incorrectly, as Yaneer Bar-Yam’s analysis showed) that repealing the uptick rule didn’t artificially depress prices of the affected stocks:
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.”
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:
Now that the immediacy is behind us, the SEC is moving deliberately:
In an open meeting of the SEC on Wednesday, several commissioners said they were not convinced that the repeal of the old uptick rule had anything to do with the current volatility in the market.
Some people need more evidence than others.
“Whhoa re you going to believe, me or your lying eyes?”
The commissioners will seek comments from the public over the next 60 days [through June 1, 2009 – Ed.].
Reinstatement of the previous uptick rule “is only a partial solution” to abusive short-selling because it does not cover equity swaps and other financial derivatives that provide the same economic benefit as short-selling, said Luis A. Aguilar, a commissioner.
Aguilar wants a fuller solution
Of course he’s utterly right. Subjecting all of the side bets to similar transparency and collateralization rules is both consistent and necessary:
He called for Congress to give the commission power to oversee such derivatives.
I’ve already recommended that.
Plank by plank, we make it seaworthy
The second plank is equally welcome.
Still trying to make sense of it …
[Continued tomorrow in Part 2.]
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