New England Complex Systems Institute
238 Main Street Suite 319, Cambridge, MA 02142
Phone: 617-547-4100 Fax: 617-661-7711
October 17, 2008 -- For seventy years the uptick rule was part of the SEC regulations of trading designed to prevent short sellers from manipulating the market. The rule was implemented in the SEC Act of 1934 in the wake of accusations that short sellers were responsible for the 1929 market crash. This rule was dropped in the summer of 2007 with little resistance based upon the belief that it had become obsolete. The market turmoil in the last year, and particularly in the past weeks, has been blamed on consequences of the loss of value of mortgage backed securities. However, there are a number of individuals who have pointed to the repeal of the uptick rule as contributing to recent market behavior.[2-4] We have performed a preliminary analysis of market behavior that suggests the repeal of the uptick rule makes markets highly vulnerable to manipulation resulting in severe under valuations and market instability.
The uptick rule requires short sellers to sell only on price increases by setting their sell price above the current market price. The sale executes only when the price rises. This limits the rate that rapid short selling would otherwise drive a price down. Rapid sales of shares to manipulate prices are part of some trading strategies that benefit from price changes of related derivatives or the shares themselves, and are not otherwise illegal under SEC regulations.
In recent months many companies have complained or noted short selling manipulations affecting their market value. The SEC, in response to severe price fluctuations, has forbidden short selling on financial companies, but only temporarily, or restricted naked short selling on all companies. The former restriction is generally considered to be overly limiting and has been dropped. The latter may limit the overall volume of short selling, but does not impact on the rate of short selling at a particular time. It is the latter that is particularly important in determining the ability of short sellers to manipulate prices.
Such price manipulations undermine market efficiency and thus the inherent reliability and security of markets for investors. Mortgage backed securities may be the disturbance that is being amplified by an unstable market. A stable market need not have the same response, and could better recover from the disturbance. Thus, while the SEC performed a test of certain securities without the uptick rule prior to repealing the regulation, the instability of the market only becomes apparent when it is subject to a significant perturbation which need not have been present during the test. As noted by others, these effects can be amplified during a "bear" market and not revealed in the "bull" market where the tests took place.
A more complete analysis can reveal the quantitative effects of manipulations, benefits by manipulators that can be gained as well as impacts on market behavior. Such analysis would enable a more careful discussion of how to improve market efficiency through prevention of manipulation. While this can be done, the importance of the uptick rule for the current destabilized market should be recognized. Its restoration is a minimal strategy for risk reduction. Further analysis can be done afterwards.
President, New England Complex Systems Institute