The uptick rule, the credit default swap (CDS) market and short/leveraged ETFs have become lightning rod issues for market participants who see how poor regulation of, or a complete failure to regulate, the financial markets resulted in an untenable investment environment.
By now, legislators on Capitol Hill have latched onto these lightning rods in an attempt to seek a Congressional cure, so the writing is on the wall. In fact,
, the biggest purveyor of ETFs, announced that the company is in talks to sell its iShares ETF unit. The company cited the need to raise capital, but perhaps Barclays really considered the possible regulation of ETFs as a signal of a topping out in the ETF market.
Simply reinstating the uptick rule, regulating CDS and eliminating short and leveraged ETFs will not be cure-alls to all that ails the markets. For generations, creative Wall Street traders have figured out ways to legally weave their way around regulations to obtain a stated goal -- namely, to make money. Count me as one of those creative individuals. As sure as the sun rises in the east and sets in the west, if we continue on the current legislative track, my guess is that the uptick rule will be reinstated with exceptive relief, CDS will be loosely regulated and ETFs will be subjected to more scrutiny but remain as neither fish nor fowl from a regulatory perspective. Whether that is the manner in which regulatory changes unfold is not certain. I will guarantee, however, that new regulations will be lacking in scope and impact. In other words, we will have more opportunities to create structures to get around a new set of half-baked rules. I might as well dust off my résumé and shop it around now.
You see, what will happen is that that cures will be applied as bandages on some very visible problems, but that will still leave a whole host of viruses swarming throughout the financial system. Any half-hearted attempt to create legislation will be impotent. A full range of regulatory and banking changes need to be enacted to make sure that we have a symmetrical marketplace where the individual investor can make a transaction without the fear of being manipulated by hedge funds or quant traders gone wild. Hence, I want to suggest some other changes or areas of regulation that need to be addressed in concert with the uptick rule, CDS and short/leveraged ETFs.
Let's start by revisiting
(Reg T), one of the most antiquated banking regulations still in existence. Reg T is a one-factor model that bases the extension of credit on the type of security upon which a loan is made. For example, when buying stocks, 50% of the purchase price must be made in cash with the other 50% being extended as credit. Ask yourself this question: Would you be willing to lend 50% on just any stock, or would you rather lend more against a less risky stock and lend less on a more risky stock? Furthermore, would you be willing to lend 50% to any investor, or would you rather perform a credit check first and extend more credit to a more creditworthy customer and less to a bigger credit risk? Reg T needs to be transformed into a two-factor risk model, as I
article published way back on Aug. 20, 2002.
Next, let's have a look at
married put stock manipulation
. A married put is the purchase of stock in combination with the purchase of puts on that underlying stock. If one enters into a married put position to manipulate the price of a stock, however, then the
considers that to be an
. Furthermore, if sham married puts are used as part of a fraudulent or manipulative scheme, the conduct may also violate the Commission's anti-fraud and anti-manipulation provisions. As I had pointed out in an article originally published on
in 2004, followed by a discussion on the old "Kudlow & Cramer" show, and then reiterated on July 30, 2007, while filling in for Doug Kass on his
trading diary, The Edge, one can enter into "
" trades by using single stock puts tied to ETFs or swaps to manipulate individual stock prices. This is not considered by the SEC in its interpretive release on married puts but has been a commonplace practice and made more pervasive by the advent of leveraged and short ETFs and the lack of an uptick rule.
Moving on to
, while the noise is being made over CDS, the entire swap market flies 30,000 feet above regulation. In fact, swaps are exempted from regulation under "Part 35" by the Commodity Futures Trading Commission (CFTC). The entire swap market, which includes the underlying transaction for leveraged ETFs, is totally unregulated. Swaps need to be looked at in their entirety and not just from the perspective of the subset referred to as CDS. Furthermore, swaps are exempt from Reg T, and credit is extended on a case-by-case basis.
Leverage from swaps has gotten us into trouble before. If you don't believe me, I suggest you read up on what happened in the wake of Long-Term Capital Management's (LTCM) failure.
by Roger Lowenstein is a great account of that period of time for our financial markets when we last faced systemic failure. Not only is that book required reading for my students at the
but I am an unnamed participant as a swap provider to LTCM in the book. By the way, I had the foresight to stop doing business months before LTCM went bust despite pressure being applied from higher up the management chart.
Finally, we've got the
SEC Form 3
, which must be filed by any beneficial owners of more than 10% of a class of a company's equity securities. Sound goods to me, but I recently
whether short sellers have rights in Columnist Conversation when I wrote the following:
Can someone tell me what rights short sellers have? I have been in this business a long time. I have studied securities law and know it pretty darn well for a non-attorney. Shareholders can vote their proxies, receive dividends, attend shareholder meetings, enter into shareholder derivative lawsuits and file for claims under class action settlements. What rights do shorts have? I am only talking according to securities laws. If you want to get into the moral/public policy issue on short selling, then that is a whole different ballgame and discussion for another time because lack of uptick rules and ultra shorts run afoul of public policy, in my opinion.
Now here is the strange twist. Not only do shorts have no rights but it appears that they have virtually no obligations as well. Shorts should also be required to file with the SEC if they control a significant short position. That short position should be defined as the aggregation of short stock and short equivalents from options, stocks, ETFs or other derivatives. Also,
, while well-intended, is so loosely enforced that the shorts are able to run roughshod over shareholders and their rights.
A few flaws in the current system could fixed by implementing my suggestions. On Feb. 28, 2007, again, while filling in for Doug Kass in The Edge, I
other solutions in a piece titled, "What Must Be Done to Ensure Fair and Orderly Markets." The multitudes of structural problems in our financial markets could fall through the cracks if we as a nation seek to enact some quick-fix solutions to mollify the public perception of Wall Street. A comprehensive and holistic approach to fix the market's problems is necessary, but does Congress have the foresight to act prudently rather than promptly, and can the multitude of regulatory agencies (i.e., the SEC, CFTC, self-regulatory organizations and the
) put aside territorial ambitions for the benefit of the common good?
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Know What You Own: Scott Rothbort mentions the iShares ETFs, and some of these include the iShares Barclays 20+ Year Treasury Bond (TLT) - Get Report, iShares Dow Jones U.S. Index (IYY) - Get Report, iShares FTSE/Xinhua China 25 Index (FXI) - Get Report, iShares NYSE Composite Index (NYC) , iShares Russell 2000 Index (IWM) - Get Report and iShares S&P 500 Index (IVV) - Get Report. For more on the value of knowing what you own, visit
Investing A-to-Z section.
If you would like to read other stories on these issues, please follow these links:
- Furber: " We Need the Plus-Tick Rule, Part I"
- Furber: " We Need the Plus-Tick Rule, Part II"
- Furber: " We Need the Plus-Tick Rule, Part III"
- Oberg: " Why Short Sector ETFs Aren't So Smart -- Part I"
- Oberg: " Why Short Sector ETFs Aren't So Smart -- Part II"
- Oberg: " Looking Deeper Into the Pitfalls of Short Sector ETFs"
- Oberg: " The Perils of the ProShares Ultra Shorts"
- Oberg: " On the UltraShort Treasury ETF"
- Oberg: " UltraShorts and the Fall of the Uptick Rule"
- Oberg: " Uptick: Let's Get It Right"
- Oberg: " Uptick Rule: Form vs. Substance"
- Rothbort: " Market Impact of ETFs and Futures"
- Rothbort: " Inconsistency in ETF Returns"
- Rothbort: " How Leveraged ETFs Flout Margin Requirements"
At the time of publication, Rothbort had no positions in the stocks mentioned, although positions can change at any time.
Scott Rothbort has over 20 years of experience in the financial services industry. In 2002, Rothbort founded LakeView Asset Management, LLC, a registered investment advisor based in Millburn, N.J., which offers customized individually managed separate accounts, including proprietary long/short strategies to its high net worth clientele. He also is the founder and manager of the social networking educational Web site
Immediately prior to that, Rothbort worked at Merrill Lynch for 10 years, where he was instrumental in building the global equity derivative business and managed the global equity swap business from its inception. Rothbort previously held international assignments in Tokyo, Hong Kong and London while working for Morgan Stanley and County NatWest Securities.
Rothbort holds an MBA in finance and international business from the Stern School of Business of New York University and a BS in economics and accounting from the Wharton School of Business of the University of Pennsylvania. He is a Term Professor of Finance and the Chief Market Strategist for the Stillman School of Business of Seton Hall University.
For more information about Scott Rothbort and LakeView Asset Management, LLC, visit the company's Web site at
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