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Uptick Rule: Meaningful or Meaningless?

This article was originally published Feb. 26

Market observers are divided as to whether the elimination of the uptick rule was to blame for the stock market's sharp decline, with one side arguing that short sellers drove share prices lower while the other claims those betting on a decline are the scapegoats.

The uptick rule, instituted by the Securities and Exchange Commission following the Great Depression, said that the short selling of stocks could be done only after the price ticked higher above the prior sale. The rule was designed as a guardrail that slowed down the short-selling process, preventing shorts from driving the price of a stock at a faster clip.

In a short sale, an investor borrows stock from a broker, sells it to other investors, and hopes to buy it back at a lower price later before returning it to the original lender. The difference in the transactions is kept as a profit.

The SEC made the controversial decision to eliminate the uptick rule in June 2007 after its analysis showed it did little to prevent the manipulation of share prices. Of course, many market participants point to the move as the catalyst that helped short sellers thrive in 2008.

Even Federal Reserve Chairman Ben Bernanke, testifying before Congress, said if the rule were still in place it "might have had some benefit" in preventing the market meltdown.

Those in favor of the uptick rule say that its removal created an environment where shorts could accelerate the failures of a number of companies, especially financial names like Bear Stearns and Lehman Brothers and severe pressure on others, such as Citigroup (C - Get Report), Goldman Sachs (GS - Get Report) and Morgan Stanley (MS - Get Report).

"With the market that we currently have, the absence of the uptick rule leads to fairly consistent selling pressure as there's no impediment to shorting," said Thomas Sowanick, chief investment officer at Clearbrook Financial. "It's very evident in the financials."

According to a short selling study conducted for the New York Stock Exchange in October 2008, 85% of the 438 CEOs, CFOs and investor relations executives surveyed favor a reinstitution of the uptick rule "as soon as practical, along with other options designed to place some constraints around short selling." Eighty-two percent think bringing back the rule would help instill confidence in the market.

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