Crying About The Uptick Rule? How About A Downtick Rule?

Last July, the SEC retired the Uptick Rule. The rule was promulgated in the aftermath of the Great Crash of 1929 and requires that a short position in a stock may not be established unless the stock has most recently ticked up in price. People in general do not understand what shorting is (I still cannot get my mother to understand it) and they tend to believe that someone who would short a stock is a bad person, probably because there is a sense that people who root against others are bad sports and potentially destructive.

Coincidentally, the stock markets started going down not long after the rule was abolished. As people are particularly susceptible to the fallacy known as ‘post hoc ergo propter hoc’ (loosely translated from the latin as “after this therefore because of this”), you have started to hear cries for the SEC to reinstitute the rule.

There are two arguments in favor of the Uptick Rule. There is some small argument in favor of the rule based on the nebulous moral feeling that it is bad to have a motivation against our fellow citizens, to root against them. NYSE floor traders complain that it leads to increased volatility which is somehow bad. The bad outcome can take place, for instance, if, as a result of the stock going down further than is “justified”, a company like Lehman suffers a crisis of confidence that destroys it. This leads to all kinds of discussion about whether there is a “natural” or “real” price for something, whether it isn’t because the company is really a dog, and whether short selling is a cause or a concomitant effect. At the end of the day, if – as a matter of public policy – you are going to mandate an artificial asymmetry like this in the way the market works, I think there needs to be a higher standard of proof to clear than the mere feelings of those on the floor or the fears of those who stand to lose if it is made clear that they, like the emperor, have no clothes. Aside from making it marginally more difficult to program trading systems and generating more paperwork, the benefits claimed by the rule are hard to prove.

And to play devil’s advocate, if you are going to require the asymmetry of an Uptick Rule for Short Sales, why not require a Downtick Rule for Long Sales or purchases of stock? That is, why not require that before you can purchase a stock, it must have ticked down in price beforehand? Think about it for a minute.

Had we had the Downtick rule, and if such a rule were as efficacious as proponents of the Uptick Rule say that rule is, then perhaps we would not have had the massive NASDAQ bubble which ended in tears in 2000-2003. And if we had not had such a bubble in 2000, the Fed would not have moved the Fed Funds target rate to 1% (something like 1.5% negative real rate) and kept it there for a considerable period. And if they had not done that, then perhaps the Housing Bubble would never have happened, the subprime and ensuing credit crisis we are currently suffering would never have happened, the Commodity bubble that is currently crushing consumer spending would have been more moderate, the dollar would not have been crushed and so on.

Basic caution should make one think twice about introducing arbitrary and asymmetric rules into markets. The natural state of things is to have symmetry between the processes of selling and buying. The next time you hear someone moan about how we need the Uptick Rule again, greet it with skepticism or propose that in return we also have a Downtick rule to keep things honest.

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