Tucson CitizenTucson Citizen

Short sale rule change fuels market volatility

The last nine months have been a gut-wrenching period for stock-market investors.

Since mid-2007, the Dow Jones Industrial Average has suffered more than 45 daily drops of at least 100 points. A volatility index tracked by the Chicago Board Options Exchange has been running 50 to more than 100 percent above where it stood early last year.

The nervousness has shown up in plunging consumer confidence and overall anxiety about the economy.

But you have to wonder: How much of all that turmoil was avoidable?

The stock market has lost ground for various reasons. Investors have had to contend with the real estate slump, the credit crunch, a weak dollar, a looming recession, spiking oil prices and surprises like the Bear Stearns debacle.

But the downdrafts likely were magnified by the elimination of a somewhat obscure rule that had prevented bear raids from getting out of hand. Now hedge funds and other big institutional traders have a clear path to bet against stocks by selling them short. And that, critics say, causes more frequent and intense downdrafts.

“Since elimination of this rule, we have witnessed a dramatic increase in short selling and substantial market volatility,” complained Rep. Michael Castle (R-Del.) in a recent letter to the Securities and Exchange Commission. “It is important that we monitor closely any impact of unrestricted short selling.”

Short selling is the opposite of what most people do when they enter the stock market. In a normal or “long” transaction, you buy shares, hope they appreciate, then sell them.

With short selling, you first sell shares you don’t own (borrowed from a broker) in hopes you can buy them for less later, completing the trade.

After years of a Depression-fed bear market, in which many stocks were beaten to a pulp by short sellers, the recently formed SEC devised a way to restrict this activity.

The regulation, adopted in 1938, was called the short-sale “uptick” rule. It didn’t outlaw short selling but slowed it down. Under the rule, short sales essentially were allowed only when the preceding trade was made at a higher price, on an “uptick.” The idea was to prevent cascading downward pressure on stocks that could lead to manipulation.

Yet last the SEC July abolished that restriction. The agency decided the financial markets had evolved sufficiently, with better regulatory oversight and transparency, to render the rule unnecessary.

The SEC cited advancements such as decimal pricing and the spread of fully automated markets as factors that discourage short sellers from trying to manipulate a stock’s price.

The SEC also said eliminating the rule would make for more consistent global regulation and reduce the compliance costs borne by the brokerage industry, by eliminating their need to monitor short sellers.

But the decision was controversial and remains so.

“I thought it was a bad move to eliminate it when they did,” said David Daughtrey of Copperwynd Financial in Scottsdale, Ariz. “Volatility clearly has increased since last summer.”

Rose Papp of L. Roy Papp & Associates in Phoenix doesn’t oppose the SEC’s action, arguing that traders can use options and other means to bet on downdrafts. But she does think the new policy has boosted volatility, at least somewhat.

David Brady of Brady Investment Counsel in suburban Chicago, who last summer warned about the prospect of rising volatility, remains critical of the decision to abolish the rule.

“Absolutely it has contributed to volatility,” he said. “We haven’t seen a period like this with such wild gyrations in quite a while.”

Brady blames hedge funds for most short trades and wonders if regulators fully understand the impact they exert on markets. “I’m not a fan of a bunch of rules to regulate the markets, but we need some framework,” he said.

The SEC hasn’t announced any change to its short-sale uptick policy, and a spokesman said none is in the works.

That’s too bad because repealing the rule, in retrospect, looks like it was a case of fixing something that wasn’t broken – but now apparently is.

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