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Opinion: We Need the Plus-Tick Rule, Part II

The success of index investing spawned lots of index investing, and in turn, index-based ETFs, and now levered index-based ETFs. You can buy a 3x index ETF using Reg T margin now -- so you get what, 6x leverage on your dollar? Let's leave aside whether it's a good idea to let anyone with a dollar use that much leverage on a product with a theta the size of Montana and an inspiring name. We will just trust that the regulators who restrict individual stock margin accounts to 2x, and who limit naked short option leverage to 3x, have thoroughly investigated the merits of giving cash-account investors the same or more leverage without having to fill out all that silly disclosure paperwork. Instead, consider how many underlying shares of stock are affected whenever one of these things get traded.

A Check on Undue Leverage

The plus-tick rule, of course, throws a monkey wrench into the works, as the ability to sell short instantly is complicated by the necessity of waiting for someone to come along and buy the stock from you.

This is not the only hindrance created for basket players by the rule. Think for a moment what might happen when a basket order is entered near the close, and only 85% of the stocks in it get executed. Which is better, taking the overnight risk, or executing the rest of the stocks in the aftermarket, where there is less liquidity? It all depends on how wedded you are to your basket -- very, if you are an index ETF, of course. If you did well on the first 85% of your positions, how much will you care about the execution levels on the rest, especially when all you have really promised is that you will deliver the basket at the index level, which your trade, of course, will help determine?

The question is whether all the banging and lifting enabled by this basket activity in the absence of the rule is actually bad. I think it is. I've already argued that without the counterweight of a plus-tick rule, there will be more banging than lifting. Even in an imaginary world where there is a natural balance between the two, volatility would be elevated by the execution behavior I just described, and volatility is expensive for the whole global economy.

The absence of the rule enables all kinds of other trading as well. Take the following example, lovingly referred to on many desks as the "Taliban trade" or by Jim Cramer as kesselschlact: You might get short some common stock, then go out and buy credit default swaps, or CDS, on some tranche of the company's debt, boosting the premium so much that people start to wonder whether there's a problem at the company. As the stock falls, you could help it along, if you like, by hitting bids indiscriminately -- there's no plus-tick rule, after all.

One of the powerful things about this trade is all the leverage you might have available to apply to it, not at all limited to that determined by Fed or house margin rules, either.

When you buy CDS, you get not only the normal option leverage but also the de facto leverage that comes from the fact that even though the swaps cover one series of security, the prices of all of the company's securities depend on the company's credit standing. If someone starts to pay a whole lot for protection against the default of one security, the "cockroach theory" would indicate that holders of the company's other securities might wonder about the merits of holding those, too, and start selling, or buying swaps themselves, abetting the cycle of uncertainty.
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