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This is the final part of a three-part series on why the "plus-tick" rule should be reinstated. This rule, also known as the uptick rule, requires that any person selling a stock short must do so only at the price which is the higher of the last two discrete transactions.
looked at how the rule serves a vital function in the market by addressing imbalances.
, we discussed certain obscure but significant risks built into certain market practices such as basket trading and the use of leverage, and we examined some of the unintended consequences of having eliminated the rule to the detriment of the original purpose of capital markets.
Today, in Part III, we will describe how the rule has been strengthened and weakened at different times over the past two decades, show how the market acted during those times, and describe the process whereby the rule was eliminated in July of 2007.
The existence of the plus-tick rule presents a classic conundrum: the tradeoff between short-term hoarding and long-term benefits.
The rule impedes a certain type of transactions, but not others. In a competitive, commission-based world, not being able to access those prohibited transactions would be frustrating enough, but as we discussed in Part II, the development of index ETFs has added a way to access revenue that's not typically associated with transactions but rather with asset levels.
The ETF sponsors' only mandate is to match the price level prevailing when their investors' capital is committed. Even if their capital -- or levered capital promised on it -- is so great that they end up moving the market, they fulfill their promise by getting the money invested, regardless of price. How frustrating, then, to have a rule that impedes their ability to make transactions happen, and so to generate more fees.
ETF sponsors, of course, are only responding to demand. (I wonder if the old study still holds true, that most active managers underperform the indices.)
Rules and Choices
There is no need to compare the arguments for grabbing income right now vs. acting in a way that pays income, and probably a lot more income, periodically over time. There are good, rational reasons to argue for each. Rather, we have to consider whether we want so many golden eggs right now that we are willing to run the risk that we'll kill the goose when we jam her full of amphetamines. There is a limit to the immediate capacity of almost everything.
This is why even the freest of markets need regulations. We need to be free to make choices in the world of finance, and that means we need functioning and at least occasionally discriminate markets. No markets, no way to choose. Markets require capital, and capital requires a level playing field. The last 12 months have shown us what happens when capital decides it's not worth it to be in the markets. Money market levels are at all-time highs, as capital is pulled to the sidelines.
Securities and Exchange Commission
eliminated the plus-tick rule because people and organizations with an interest in seeing it gone asked them to, and while there were others who disagreed, the SEC chose to get rid of it. Before doing so, the agency's Office of Economic Analysis studied the issue over a period of about 18 months, beginning in May 2005. (Interestingly, although the pilot period was extended until August 2007, the SEC did not wait until the pilot was complete before eliminating the rule.)
The report reflects both the authors' efforts to be thorough and their reservations about the limitations of the study. Unfortunately, however, the validity of the report was doomed from the start -- they had no way to properly apply the scientific method, for they had no way of creating a valid control group. They eliminated the plus-tick requirement on about a third of the stocks in the Russell 3000, starting in May 2005, and compared the price action of those stocks with the price action of the rest of the stocks in the same index, which remained subject to the rule, as did all others that were not in the index. Within this context, the statisticians were of course careful in their selection and overall methodology, but remember the three people stuck on a desert island with a case of canned beans and no way open them? The economist says, "Assume we have a can opener..."
There was simply no way to study the effects on those individual securities of a market in which all of the other securities traded were not themselves subject to the rule. In other words, the rule was designed to address negative emotional behavior, and emotional behavior might be reasonably considered to be affected by the price behavior of the majority of stocks in the market that were not included in the study, of course. For the study group to effectively test for the outcome they sought would be so cumbersome, if even possible, that they really had no choice but to assume it away. Their only other choice was not to do the study at all, and that may not have been their best option under the circumstances.
How the Change Went Through
It is not really fair to lay all of the blame at the door of those running the SEC, however. They did solicit opinions from all of us at the time. Although they might have stepped back and decided at any moment that the combination of faulty methodology and the possibility of bias in the motivations of those arguing the loudest for the rule's elimination made it a risk not worth taking, the blame also lies with traders, especially professionals. Many of us who did not comment might have thought how obtuse the whole notion was of doing away with the rule really, yet we did little to argue the point with the people who would ultimately make the decision. I know I did, and didn't.
The effectiveness of the rule began to be undermined as far back as the late 1980s, as the equity options market developed. Buying a put and selling a call is the equivalent of being short the underlying stock, and it seems reasonable to argue that as more investors became experienced in option trading, they would be able to circumvent the rule if they wished to do so.
The financial engineering which brought about even the first ETFs resulted in actions that further diminished the power of the rule. In 1993, the
S&P Depositary Receipts
, or SPY, was granted a diversification exemption. Others followed for the mid-cap Spyders, the
(now known as the QQQQ) and sector ETFs. By late 2002, we had plenty of exceptions, from ETFs to options bullets.
Interestingly, and shortly prior to announcing the pilot to study the elimination of the rule, the SEC actually moved to strengthen the rule significantly. In November 2003, it issued an interpretive release clarifying, effectively, that "married put" or bullet transactions were also subject to the rule. Note the action of the VIX and VXO volatility indices between mid-2003 and mid-2007, when the rule was repealed. Not bad, as smoking guns go.
I would note that although the release's effective date was not until Nov. 21, 2003, the SEC had apparently begun gathering information and making market participants aware of their consideration with respect to issuing the guidance much earlier in the year. It is certainly possible that knowing that the SEC might determine that a common practice violated a long-standing law still in existence could dampen enthusiasm for that activity. This might account for the way volatility came down sharply several months earlier than the release date.
It is also important to note that prior to the release of the interpretation, it might have been very reasonable to assume that the practice was permissible because the rule did not actually apply to the practice -- hence the need for the clarification provided by the release. What is important to my argument is that for the first time in years, the rule had teeth, and the effect on volatility appears to have been remarkable.
It is certainly possible that I am "curve-fitting" here, that there are other reasons for the exceptional changes in both level and shape, for the period shown. Extending the chart of volatility to the right will not, however, argue against my case -- the rise in volatility following mid-2008 is huge. It appears that there was a general upward trend in volatility as the exceptions to the various ETFs were being granted from the mid-1990s on, but I have not yet dug in to that data. I am rather trying to make the point that, in light of the points raised in the first two parts of this article, it is worth looking again at whether the decision to eliminate the rule has proven useful to the broadest population of market participants. I believe it has not, and I believe that the rule should be reinstated.
I don't believe the rule will keep the stocks of bad companies up, nor will it protect against excessively high valuations; markets will still go up and down after it is reinstated. The ability to profit by correctly taking a negative view of a company's, prospects -- or the market's, for that matter -- by shorting securities will not only remain, but be improved as investors again discriminate between individual companies. The rule is simply one tool, similar to regulating the extension of credit or the dissemination of material nonpublic information, which should be wielded for the "greater good" of continuously functioning capital markets.
The rule will provide a balancing force, a counterweight, to factors that might otherwise grow to permanently impair the effectiveness of our capital markets. In its absence, the possibility is very real that the markets may soon suffer damage from which recovery over any practical horizon becomes unlikely; there is no reason as compelling to have eliminated it.
I think everyone has noticed that things in the capital markets haven't been working out all that well since the rule was eliminated. Considered next to TARP, TALF and stimulus plans, reinstating the rule looks cheap -- and given the certainty surrounding the implementation of those other remedies, it's easily worth the shot of risking the possibility that it won't work. The rule should be reinstated.
Know What You Own:
Other ProShares funds include the
ProShares Ultra Real Estate ETF
ProShares UltraShort Real Estate ETF
ProShares Ultra Financial ETF
ProShares UltraShort FTSE/Xinhua China 25
ProShares UltraShort QQQ
ProShares UltraShort Oil & Gas
ProShares UltraShort Industrials
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At the time of publication, Furber had no positions in stocks mentioned.
William Furber is the founder of High Street Advisors in Manchester, Mass.