Uptick Rule: Do Exchanges Have Better Alternative?
March 30, 2009
As pressure builds in Washington to reinstate the uptick rule for short selling, the Securities and Exchange Commission is considering several options, including a proposal from three exchanges that could generate fewer operational difficulties than the alternatives.
The SEC in July 2007 eliminated the uptick rule, which required that short-sale bids be higher than that of the prior trade. But with many blaming short sellers for exacerbating the market's decline there has been a call for new restrictions. The SEC plans to discuss various alternatives next week and may issue a short-selling proposal later in the month.
One possibility was unveiled on March 16, when Sens. Johnny Isakson, R-Ga., and Ted Kaufman, D-Del., introduced a bill that would prohibit shorting the stock of a financial institution unless the price is 5 cents higher than in the previous transaction. Other potential solutions include a reinstatement of the Nasdaq Stock Market's bid test or extending the concept of circuit breakers to individual stocks.
Last week the New York Stock Exchange, Nasdaq and BATS Exchange submitted a letter to the SEC that introduces another option. Their proposal would also apply circuit breakers to a security after its price falls by a certain percentage--the exchanges suggest 10 percent--but rather than halting trading, successive short sales would have to be above the national best bid.
"You can't hit the best bid any longer with a short sale," explained Chris Isaacson, chief operating officer of BATS. "You have to be selling long to hit the bid." If the best bid is 11 cents when the circuit breaker is triggered, a short seller would have to post an order at 12 cents and wait for a buyer, "relieving some downward pressure," said Isaacson.
The uptick rule and the bid test are also designed to slow downward momentum without stopping shorts altogether. After analyzing the results of a pilot that ran from 2004 to 2005, the SEC determined that the tests did little to curtail excessive shorting and eventually eliminated both. However, critics pointed out that the pilot was conducted during a low-volatility period when the market was trending upward.
Penny Quoting
With the advent of penny quoting in 2001, the 12.5-cent uptick required to short stocks fell to 1 cent, providing less of a deterrent. While the 5-cent movement proposed by Isakson and Kaufman would be more effective, it could represent a significant operational burden for broker-dealers.
Reinstating a 1-cent test would be relatively simple, said Randy Frederick, director of trading and derivatives at Charles Schwab Corp. When the rule was revoked, brokerages typically programmed their systems to skip over that functionality, or they still have the software that performs the job stored in older databases. However, a 5-cent move could take multiple trades to accomplish in a penny-quote environment, and brokerages would have to write software to track those moves and determine when the 5-cent tick was achieved. "The SEC would have to be very specific about what's done and how it's done," said Frederick.
And the multitude of trading venues presents additional obstacles. "From which venue will you gauge your tick?" said Josh Galper, managing principal of New York-based consultancy Finadium. "There could be an uptick in one and a downtick in the other, and it's not viable to say there has to be an uptick in every market." Galper said he prefers the circuit breaker approach. "It slows things down but only after a certain threshold is reached," he said. "The uptick test would directly impact market liquidity on every single short sale."
