Published: March 29, 2008 11:20 pm      

Short selling rule change hurts market

EDMOND — Does it seem like the stock market has gotten more volatile than usual in the past year? It may not be your imagination. There was an important rule change last summer that you and most others probably never even noticed. But the result certainly has been noticed. On July 6, the SEC repealed the “uptick rule.” You probably never heard of this rule and don’t care. But you should care because you just got cheated by the big guys once again.

Short sellers bet a stock is overvalued and that its price is likely to fall. They borrow shares, sell them and then wait for the stock to fall so they can repurchase the shares at a lower price, return them to the lender and pocket the difference. Done correctly, this is a perfectly legitimate activity.

Back in the roaring 20s and Depression-era 30s, there were a number of wealthy investors who played all types of “games” to manipulate the stock market. One of these manipulations was where a number of large investors simultaneously would sell a stock short in an attempt to drive the price down. They often were successful. Of course, all the people who owned the stock suffered great losses.

Under the Securities Exchange Act of 1934, one of the new rules was designed to eliminate this sort of illegal activity. It was called the “uptick rule.” What this rule basically said was that before your order to sell short was executed, the last trade had to be an uptick, i.e. a price higher than the last one. That meant in order to sell short, a stock had to go up before it could be brought down. This prevented short sellers from selling in massive quantities to drive the price down.

Of course, this didn’t completely solve the problem. A common practice for “big money” on Wall Street was to craftily put in a significant amount of buy orders to move a stock to an uptick before then placing their real short sale order. But now that the SEC has eliminated the uptick rule, short selling is now more efficient for these institutions and funds.

Although not perfect, for 73 years this rule worked pretty well and kept the raiders somewhat at bay. For reasons that nobody seems to be able to explain, this rule was quietly repealed last summer because the SEC said it was no longer needed. Hedge funds lobbied heavily for its repeal and the SEC caved in. Since the rule was repealed, downside trades have proliferated and volatility has become increasingly prevalent in the stock market. Short interest is at a record high on both the NYSE and the Nasdaq.

Before revoking the rule, the SEC began a pilot program in 2005 to suspend the uptick for a group of 1,000 stocks. Ingrid Werner and two colleagues from Ohio State published a study examining the program and they found that short selling did increase and that the pilot stocks did experience higher short-term volatility immediately after the suspension. But the study also found that returns from the stocks and daily volatility were unaffected.

Of course, those tests were conducted in an up market where a bear raid was unlikely to happen. That’s certainly not the type of market that we’re living with now. It’s no coincidence that since then the size and severity of market declines is unprecedented. It was a hedge fund traders dream come true. When a group of hedge funds gang up and sell billions in what is called a “bear raid,” they can drive any stock down and you and I are left as innocent bystanders. Without the uptick rule, they can put anyone out of business.

What can we do about it? Write the SEC and write Congresswoman Mary Fallin and senators Jim Inhofe and Tom Coburn. Tell them you want the uptick rule reinstated. Tell them that greed has taken over again and the inmates have taken over the asylum. Investing is tough enough with a level playing field. This is criminal. Thanks for reading.



NICK MASSEY is a financial adviser and owner of Householder Group Estate & Retirement Specialists in Edmond. He also is a frequent guest analyst on CNBC and Bloomberg.