Uptick Redux

Industry Braces for Intrusive Short-Sale Regulation

Something needs to be done.

That’s the sentiment these days in Washington and on Wall Street when it comes to short selling. Last year’s market rout scared the bejesus out of hardened traders and politicians alike.

Most accept that the plunge wasn’t caused by conniving short sellers, but they still suspect piling on. They want the Securities and Exchange Commission to apply the brakes. The pols want the SEC to bring back the uptick rule. The traders would prefer a circuit breaker.

It’s the politicians who are in the lead. Several legislators introduced bills this year to force the SEC to bring back the uptick rule it rescinded in 2007.

The politicians cited the need to “restore confidence in America’s financial markets.” Those are the words of Sen. Ted Kaufman, D-Del., who together with Sen. Johnny Isakson, R-Ga., introduced a bill in March to force the SEC to bring back the rule.

The Kaufman/ Isakson bill follows a similar one introduced by Gary Ackerman, a New York congressman and a senior member of the House Financial Services Committee, in January. Ackerman, a Democrat, hounded the SEC chairman at the time, Christopher Cox, for months last year to bring back the rule, claiming it had been discarded out of “deregulatory zeal.”



In the wake of the elimination of the uptick rule,” Ackerman said in a statement, “the value of many volatile stocks has plummeted due to an onslaught of manipulative short-sale practices. Reinstatement of the uptick rule is essential to rein in these abuses and restore much-needed stability and confidence to our financial markets.”

The SEC’s economists say that isn’t true, but the SEC’s commissioners contend that they must deal with political reality. Last month, the commissioners issued a proposal to amend Regulation SHO, the set of rules that govern short selling, to include new restrictions on the practice. “Due to the extreme market conditions that we are currently facing and the resulting deterioration in investor confidence, we believe it is appropriate at this time to re-examine and seek comment on whether to restore restrictions with respect to short selling,” the SEC stated in its massive, 273-page proposal.

The move is the latest in the SEC’s recent initiatives to rein in short sellers. Last year it banned short selling for three weeks in nearly 1,000 mostly financial stocks during the turbulent market conditions of the early fall.

It also enacted a tough new rule aimed at thwarting “naked” short selling. Cox said the decision to ban shorting was made under duress and called it “the biggest mistake” of his tenure in an interview with The Washington Post. He made the statement after reading a report from SEC economists in the Office of Economic Analysis who found that short selling had played no role in the plunging prices prior to the September ban.


Regardless, many saw a clear tie between the rescission of the nearly 70-year-old uptick rule in July 2007 and the market collapse of 2008. The SEC’s Rule 10a-1 held that if the most recent sale price was above the last different sale price, then a trader could sell short at or above the most recent sale price. If the most recent sale price was below the last different sale price, then the trader could only sell short at a price above the most recent sale price.

The SEC included the old uptick rule in its April proposal, but made it clear it did not think it workable in the modern trading environment. It favors a “modified” uptick rule based on the consolidated best bid.

Both would be in effect for all securities (except OTC stocks) throughout the trading day. The SEC also threw in three “circuit breaker” proposals that call for restrictions on individual securities if their prices drop by a certain percentage.

The magnitude and contentiousness of the issue promises a lengthy debate, industry sources say. There are already plans for a roundtable discussion and calls for pilot studies.

“I predict this will get very complicated,” said Peter Chepucavage, general counsel for Plexus Consulting Group and a former SEC official who took part in the drafting of Regulation SHO. “It will get delayed. I wouldn’t hold my breath for a bid or a tick test in the next year.”

Two-Year Study

The passing of Rule 10a-1 certainly wasn’t a snap decision. The process began in 1999, when the SEC put out a Concept Release, asking interested parties to comment on the rule’s usefulness.

In October 2003, as part of Reg SHO, the SEC proposed replacing the uptick rule with a bid test. The agency said the old rule was no longer effective, but it wasn’t ready to jettison price tests altogether.

The regulator changed its mind in late 2006. After a two-year study and much input from the industry, academics and the American public, the SEC concluded that price tests in general had no value. It proposed repealing the price-test rules.

The uptick rule went on the books in 1938 because the SEC believed it would act to decelerate a declining market. The goal was to prevent bears from pounding stocks faster than necessary-the rule made them wait before they could act. Rule 10a-1 was merely a speed bump, but with a tick of 12.5 cents, it was a substantial bump.

But 70 years later, the trading environment was fragmented, fast-paced and based on 1-cent increments. The rule was obsolete, opponents argued. Trade reports came out of sequence. Upticks were plentiful. Hundreds of trades were done in a second.

Still, the SEC wanted some proof that eliminating the rules–including Nasdaq’s bid test, which went into effect in 1994–would not harm market quality. It sanctioned a two-year experiment that eliminated short-sale restrictions on 1,000 securities from the Russell 3000 index.


Economists from the OEA and several universities studied the changes in short selling, market liquidity, volatility and quote depth. They concluded that the absence of price tests had led to increased short selling in the 1,000 names (mostly the NYSE-listed, and not the Nasdaq securities) but had not led to a deterioration in the quality of the markets.

That was good enough for the SEC. Despite concerns that the pilot was undertaken during a generally rising market, the regulator rescinded Rule 10a-1 in July 2007 and forbade any self-regulatory organization from instituting a rule of its own.

Price tests were ineffective, the SEC said, and their absence caused no harm. As for bear raids and generally malicious shorting behavior, the SEC cited three broad deterrents.

Bear Raids

First, the markets were more transparent than they were in the 1930s. So-called “bear raids,” where the shorts conspire to drive a stock to zero, were impossible to perpetrate.

Traders today have quick access to information, allowing them to decide if downward pressure on a stock is warranted. Second, there were tough anti-fraud and anti-manipulation rules on the books.

If short sellers were spreading false rumors to aid their cause, they could be prosecuted under these rules. And third, the self-regulatory organizations used sophisticated technology to monitor for abuses.

All the logic that went into the SEC’s decision to repeal the uptick rule was no match, however, for the panic and hysteria that resulted from the crash in financial stocks last year. Chief executives such as John Mack at Morgan Stanley and Dick Fuld at Lehman Brothers claimed abusive short sellers were trashing their stocks. Politicians and other government officials took their side. So now the regulator is back to where it was in October 2003.

Hedge Funds

This time, the industry is likely to be more accommodative to new regulations. There are plenty who will protest any new rules-particularly hedge funds, who would bear the brunt of those rules–but much of the industry appears ready to acquiesce.

Some are merely resigned to change. Others are resolutely in favor of new restrictions, but only as long as the new rules target specific securities, rather than the entire market, and only go into effect in dire circumstances.

“I really believe something has to be done,” Jeff Wecker, chief executive of Lime Brokerage, told Traders Magazine, “but I think any new rules should target the security in question that is overheating.”

Will Sterling, global head of direct execution services at UBS, speculates that the discussion over the next couple of months will probably focus on the details, rather than the concept, of a price test. “We’ve clearly passed the point where people are questioning whether some sort of price test should exist,” he said. “There will probably be very little debate around the structure of the short-sale rule proposal, and a lot of debate about whether the circuit breaker should be 10 percent or 5 percent, or whether there should be no circuit breaker.”

Dave Herron, chief executive of the Chicago Stock Exchange, noted that traders may be inconvenienced by a new rule, but that it’s for the greater good. “If a rule is in place, we will have a healthier market,” he said. “If we have a more stable and healthy marketplace with more public participation, then everyone is better off.”

At the end of the day, the SEC must vote unanimously. At least one commissioner, Kathleen Casey, has indicated she is uneasy about a recall.

“Has the repeal of the uptick rule had anything to do with the economic and market conditions of the past 18 months?” she asked during the SEC’s open meeting that produced the proposals. “From the empirical studies that we have seen to date, I have not yet been persuaded that the answer is yes.”

Battle Lines

Shares sold short account for about 25 percent of all shares sold in the market, according to data provided by the SEC. Market makers and arbitrageurs do the vast majority of those trades, industry experts believe.

Arbitrageurs are mostly hedge funds and brokerage proprietary trading desks. Arbitrage includes statistical (pairs trades), merger, ETF and capital structure (convertible bonds) arbitrage.

The battle lines were being drawn as Traders Magazine went to press. The Security Traders Association issued a white paper calling on the SEC to drop the idea.


The Securities Industry and Financial Markets Association took a neutral stance. The top two exchange operators-NYSE Euronext and Nasdaq OMX-were supportive.

Two smaller market centers, BATS Exchange and Direct Edge, were opposed. Buyside traders surveyed by Traders Magazine had mixed opinions (see Buyside Snapshot on last page).

Hedge fund traders, the main target of any new rules, were opposed. A survey by TABB Group of 62 money managers, broker-dealers and exchanges found that 81 percent believed hedge funds would be the most affected by any short-sale restrictions.

“People are blaming the messenger,” said Jeffrey Benton, a former NYSE specialist who runs a hedge fund in New Jersey. “These companies were broken by poor management, not by short sellers. The fact that short sellers let them know it is an efficient part of the market. I don’t think that anything that makes the market less efficient is a good thing.”

Restrictions on short selling will also serve to remove liquidity from the marketplace, Benton added. “The amount of money in long/short hedge funds is astronomical,” he said. “These funds buy stocks their models tell them are too undervalued and sell stocks they believe are overvalued. They’re trying to keep their risk neutral. When you take short selling out of their hands, they don’t buy because they can’t hedge their risk anymore.”

The Security Traders Association is also opposed to new rules. It would rather see the SEC more vigorously enforce existing rules. The STA is “very concerned that regulatory action is admittedly being initiated on the short-sale issue because of popular, if uninformed, concerns on the issue and for political expediency,” it told the SEC in March.

By contrast, Jim Angel, a professor at Georgetown University who specializes in short selling, sees a need for some form of restraint. “When the market is in a nervous spot, we want to put some sort of break on short selling,” he said. “Slow it down just enough so that the market mechanism can do a good job of price discovery.”

Of the two price-test rules the SEC has put out for comment, the SEC contends that the bid-test rule is superior. Most industry sources agree.

The consolidated best bid is considered a more reliable indicator of the direction of a stock than the last sale. It also doesn’t change as much, making a rule based on it easier to comply with.

Flickering Quotes

Using the last sale as a reference price is unworkable, trading executives say. “The problem is the flicker,” said Michael Rosen, senior vice president of product management at agency brokerage UNX. “A stock can fluctuate 1 to 2 cents all day long, and the stock doesn’t move. The last sale can just be the bid and the ask, back and forth.”

The old uptick rule required exchanges and brokers to constantly monitor the last sale to make sure the shorts were going off at the appropriate price. That is too difficult in a marketplace that trades across multiple venues at subsecond speeds.

“How do you police it?” asked the CHX’s Herron. “Which tick do you use? Sometimes you can get 1,000 quote changes in a second. How can you surveil for it?”


Credit Suisse, in a letter to the SEC, argued that no price-test rule is workable in the modern marketplace-tick or bid. That’s because some broker-dealers get their market data faster than others, often by locating their servers next to exchange servers.

“True tick sequence simply no longer exists,” Credit Suisse executive Dan Mathisson wrote. “Each firm receives quotes and ticks in a different order, based on its location relative to each exchange, line bandwidth, network speed, etc.”

Lime Brokerage’s Wecker agreed: “The synchronization of data that comes through different firms at various latencies may mean that one firm’s image of what is really happening in the market is very different from another’s,” he said.

Under the SEC’s bid-test proposal, if the most recent best bid is equal to or higher than the last different best bid, then a trader can sell short at a price equal to or above the most recent best bid. If the most recent best bid is lower than the last different best bid, then the trader can only sell short at a price higher than the most recent best bid. (He could do that by posting an offer or waiting for an upbid to hit.)

This “modified uptick rule,” as the SEC calls it, is the same as the old uptick rule except that it uses the best bid as a reference price instead of the last sale. It is similar to at least three other proposals that have come down the pike in recent years, but most closely resembles the old NASD Rule 3350 bid test.

Under that rule, a trader could short at any price-not just above or more than the bid–if the most recent best bid was above the preceding best bid. The SEC was uncomfortable with this. As with the SEC’s new bid-test proposal, if the most recent bid was below the previous best bid, a trader could only sell short at a price above the most recent best bid. (He could do that by posting an offer or waiting for an upbid to hit.)

In opting for this modified uptick rule, the SEC chose not to go with the rule it proposed in October 2003. That rule was also the same rule that a group of exchanges proposed in March. It held that a trader could only short at a price above the best bid, regardless of its relationship to any previous bids.


In 2003, the SEC heralded this “uniform bid test” as superior to the uptick rule partly because it did not require traders and regulators to monitor every tick to determine whether the most recent sale price was equal to, higher than or lower than the preceding sale. The turnabout last month in the SEC’s thinking could require a substantial investment in time and money by the industry for compliance.

Credit Suisse told the SEC: “Broker-dealers would need to track upticks or upbids in their smart order routers … and then preserve this tick history so that regulators can audit it. Building such systems would likely be as expensive and challenging as Reg NMS implementation was from 2005 to 2007, and would likely take more than a year to implement.”

Traders’ major criticism of the SEC’s 2003 proposal was that it would unnecessarily hamper short selling in an advancing market. That’s because a short seller would always have to sell short at one increment above the best bid, regardless of the direction of the bid.

That would prevent them from hitting the bid to short. It would relegate them to posting an offer. That could slow the process down or even preclude shorting altogether. It would also entail “signaling” risk, or alerting other traders of one’s intentions.

At the time, Nasdaq noted that the rule would reduce “short sellers’ willingness to enter limit orders, thereby increasing the price paid by buyers and hindering the execution of displayed limit bids.” Knight Capital Group argued that traders would “have to use limit orders at a penny above the offer with no assurance that a buyer will be willing to pay more.”


The Managed Funds Association, which represents hedge funds, told the SEC the rule “would impede trading and distort market pricing by preventing short sellers from hitting the best bid.”

The NASD bid test, which was preferred by many traders over the SEC’s 2003 proposal, allowed unrestricted shorting in rising markets. So did the old uptick rule.

In crafting its recent proposal, the SEC heeded those complaints. It noted that its modified uptick rule was “designed to preserve instant execution and liquidity by allowing relatively unrestricted short selling in an advancing market.” However, Commissioner Casey told Reuters she was worried that each of the five proposals could have unintended consequences, such as a negative impact in an advancing market.

No price test is perfect, industry sources say. A rule that is compliance- and operations-friendly may constrain trading options.

It doesn’t involve keeping track of prices, but it makes it harder to short in an advancing market. Trader-friendly rules can be more cumbersome from an operational and compliance standpoint.

Circuit Breaker

The solution to this paradox in the eyes of many industry executives is the circuit breaker. If there has to be a price-test rule, then it should only go into effect when stock prices are crashing.

That’s what four market centers proposed in March. They offered a bid-test rule that was operations-friendly but trader-unfriendly, but they neutralized the impact on traders by proposing that the rule only go into effect if a given stock had dropped by 10 percent from the previous day’s close. They called it a “circuit breaker.”

“A circuit breaker permits normal market activity while a stock is trading in a natural range and short selling is more likely to benefit the market,” the exchanges told the SEC. “Conversely, a circuit breaker will restrict short selling when prices begin to decline substantially and short selling becomes more likely to be abusive and harmful.”

The SEC got the message. Three of its five proposals include a circuit breaker.

If a given stock falls by a certain percentage, then a rule kicks in. One would ban all short selling. A second would trigger the old uptick rule. The third proposal would trigger the SEC’s bid-test rule.

Of all five proposals, the industry appears to favor some sort of circuit-breaker approach. Proponents of circuit breakers argue their use is more consistent with the SEC’s philosophy that rules are necessary to prevent short sellers from driving share prices into oblivion. The rules are not meant to hamper traders in stable or rising markets.

For instance, Josh Galper, principal at consultancy Finadium and a specialist in short selling, believes that a security-specific rule is superior to a marketwide rule. Of the SEC’s three circuit-breaker proposals, he prefers the circuit breaker/bid test. He finds the circuit breaker/total ban proposal “too extreme” and the circuit breaker/uptick rule “difficult to implement.”

Credit Suisse’s Mathisson, on the other hand, prefers a circuit breaker with a ban. “If a stock drops more than 10 percent in a single day, or if it drops more than 20 percent over three days, shorting in that stock would be immediately banned for the rest of the day, and for the subsequent four trading days,” he told the SEC.

Lime Brokerage’s Wecker agreed. “If the market moves down by more than a certain amount, you have a cooling-off period,” he said. “If the market continues to move down, then you shut down trading for the rest of the day or even longer. Those are the kinds of controls that allow information to catch up with the marketplace.”

SIDEBAR: No Exceptions for Market Makers

Market makers don’t get a break in the Securities and Exchange Commission’s new short-sale rule proposal. Excluded from the proposed uptick and “modified” uptick rule proposals are exemptions for “bona fide market making.”

The term has a relatively strict definition and was exempted under previous short-sale price-test rules. Market makers have always maintained that they need to be able to sell short to accommodate incoming customer buy orders, build up short positions in advance of future buy orders and accommodate price guarantees.

This time, the SEC has decided there is no need. The SEC states an exception would “undermine the goals of our proposed short-sale price-tests restrictions at this time.”

Market makers–who can include the registered variety and, some maintain, the unregistered liquidity providers–don’t agree. “It is very important to allow market makers to continue to have the bona fide exemption when handling their orders; otherwise, there will be a fair amount of liquidity taken completely out of the marketplace for no beneficial purpose,” said Len Amoruso,general counsel at Knight Capital Group.


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