Short-selling and the uptick rule

The SEC has been holding hearings about reinstating the “uptick rule” for short-selling in the US market, and has come up with a new rule.  The rule-making comes as a reaction to assertions that the Wall Street decline in late 2008 was made worse by speculative short sellers taking advantage of the removal of the uptick rule in 2007.  What are the issues?


A short seller borrows stock from an owner, promising to return it on demand, and  promptly sells it.  The debt to the owner is expressed, not in dollars, but in a specific number of shares of a certain stock.  So at some point, the short seller must buy the stock back in the market and return it.  This can happen because the short seller decides his investment idea has outlived its usefulness, or because the original owner “calls” the stock back to him.

why sell short?

The short seller may think the stock in question will go down, so that he can make money by buying it back at a lower price and then returning it to the original owner.

Or he may have a hedging strategy in mind (this was the original “hedge fund” idea).  If so, he will reinvest the sale proceeds in something else he thinks will do better than the stock he sold short.  He might, for example, short Toyota and go long (i.e., buy) Ford.  In this case, he will make money if Ford goes up more, or down less, than Toyota.  He doesn’t need the stock he’s betting against to be an absolute loser, just a relative one.

Short selling is highly institutionalized on Wall Street.  Many financial firms and most large institutional investors have stock lending departments, which deal with each other to facilitate short selling by locating and arranging for stock to be borrowed and arranging for collateral to be provided.  (As a portfolio manager, I understood why my firm would do stock lending.  It didn’t thrill me, though.  It always irked me on those occasions when, despite their promises to the contrary, the borrower refused to return a stock I wanted to sell.)

Then, of course, there was the incredible disaster at AIG–and apparently other middlemen as well–where that company took the collateral it was holding, typically Treasury bonds, sold it and replaced it with sub-prime mortgage securities so it could earn higher interest income.  After sub-prime mortgage securities tanked, short sellers couldn’t close out their positions because AIG couldn’t give them back their collateral.  AIG needed another $40 billion+ from the government to clean up this mess.  But that’s another story.

the uptick rule

The uptick rule was instituted for exchange-traded stocks by the SEC in 1938, in response to a market swoon in 1937.  The SEC believed the market’s fall was caused, or at least made considerably worse, by rampant speculative short selling.  In response to brokerage industry lobbying, the rule was rescinded in July 2007–just at the beginning of a sharp market contraction made considerably worse, in the view of many, by rampant speculative short selling.

The rule was that you could only sell a stock short on an uptick.  That is to say, you could only sell a stock short either:

–at a price higher than the immediately previous trade, or

–at the same price as the previous trade, if the last price that was different from the previous trade was a lower price.

Put in less precise terms, the rule says that if a stock is declining you can’t hold it down or push the price even lower  by selling it short.  You can only sell short into a rebound (and thereby prevent that rebound from advancing), but if the stock turns lower again, you have to stop selling it short.

Remember, none of this prevents a “natural” seller (someone who owns the stock) from selling.  The uptick rule only applies to short sellers.

the new rule

The SEC has just instituted a new, limited anti-short selling rule.  It applies only to stocks which have fallen by 10% in price during a trading day, and applies only to the remainder of that trading day and the following trading day.

During that time, a stock may only be sold short if the sale price is higher than the highest bid price maintained by any market maker in the stock.  In other words, the short sale trade has to establish an uptick.

The main untested feature of the new rule is that it only kicks in after a stock has fallen by 10%  Before that, it’s a free-for-all.  It may well happen that market makers decide to move the market in a stock that’s being sold short down as fast as possible to the 10% mark, where they receive temporary protection against short sellers.  In my experience, that’s what happens in foreign markets when market makers encounter any sort of concerted selling.

“naked” shorts are much more important, I think

I don’t find anything particularly wrong with short selling–I should mention, though, that I worked on, and later ran, a (very successful) short portfolio in the early Eighties.  I’m also not sure that the uptick rule is a significant issue.

If anything, there may be unintended negative consequences.  My experience outside the US with markets that put arbitrary, or commodity market-like, restrictions on selling is that they end up with declines that are longer in time and deeper in extent than similar markets that don’t have such restrictions.

I think that colorfully named “naked” shorts are a much more significant concern.  More on that topic in my next post.