What is the Uptick Rule?

The Uptick Rule states that you can only short – sell a stock, if it trades higher than its previous transaction price. So if AIG traded at $4 and then at $3.95, you can’t short – sell it. You can only short sell it, if it trades higher than $4. In short, you can short – sell it, only if there is an “Uptick”.

The Uptick Rule was introduced in 1938 in the United States and was eliminated in 2007. There have been calls for re-instating the rule, especially with all the volatility and panic in the markets.

There has been vocal debate on the utility of this rule and whether it serves any purpose at all. There are several factors that you have to keep in mind when looking at the uptick rule.

In the Long Run

The SEC banned any short – selling in financial companies for a brief period between Sep 20 2008 and Oct 2 2008. This was done to reign in price volatility and help the stocks of financial companies.

During that time period Citi moved up from $20.65 to $22.50 and AIG moved down from $4.72 to $4.00. Presently, Citi hovers around 3 bucks and AIG has been reduced to a penny stock.

In the long run, stock prices will reflect the underlying value of the company and nothing else. In the short run, the regulator and market manipulators can influence stock prices, which are distorted and don’t reflect fundamentals.

In the long run we are all dead

John Maynard Keynes famously said – “In the long run we are all dead”. In the context of shares of financial companies like banks – a loss in confidence, however, baseless, can cause a run on the bank that can destroy it. Even if the fundamentals of a bank are strong, if all the depositors decide that they want to take their money out of the bank, only government intervention can save it.

Stock prices of banks and insurance companies play a key role in public confidence in that company. If you see the stock price of your bank getting hammered every day – there is a very high chance that you will take your money out of it. Once that vicious cycle starts, even if the fundamentals of the banks are healthy, nothing can stop its eventual demise.

To that extent, while a cement manufacturer may survive a depressed stock price for months, a bank may not be able to do the same.

So even though in the long term the Uptick Rule may have no impact on stock prices at all — that is not reason enough to leave it alone.

Why worry about the Uptick Rule in 2008 and not 2007?

The Uptick Rule has come into limelight about one year after it was repealed. Had the Uptick Rule been the sole contributor of the current downturn — the downturn would have really started in 2007, and not 2008. That alone should prove that the Uptick Rule is not the sole reason or even a big contributing factor of the crash.

Volatility

That doesn’t mean the Uptick Rule didn’t contribute to volatility, when the crash did come in 2008. It is argued that stocks wouldn’t have fallen as sharply as they did, if the Uptick Rule was still in place. Since this is a rule that discourages naked short – selling, it does provide a cushion against rapid decline in stock prices. By how much and to what degree is anybody’s guess.

Does the Uptick Rule Distort Efficient Discovery of Prices?

Since there is no “Downtick Rule”, I’d say that having an Uptick Rule distorts the efficient discovery of prices. However, when you say something distorts price discovery — it conveys a certain sense of unfairness. I think this sense of unfairness is misplaced because an artificially depressed stock price is far more unfair to the future of a business, its employees, customers, counter – parties etc. than an artificially inflated price is to investors.

Conclusion

There is only anecdotal evidence that repealing the Uptick Rule contributed to the volatility in the recent downturn, but the rule did exist and worked fine for close to quarter of a century.

In fact, after the Asian crisis — Hong – Kong adopted the Uptick Rule.  Even when the arguments for or against the Uptick Rule are not really clear, history shows that its existed for a fairly long period of time and in that time there was no compelling reason to get rid of it.