During a conversation with a friend at a cocktail party last November, I was reminded of the disparity between the importance of the uptick rule and the awareness of its importance. My friend has an investment banking background and is a senior executive at a major financial institution. He is also a well-established supporter of one of the nation's two political parties -- while he is intelligent, pragmatic and extremely successful, he is also an idealist.
We were talking about credit default swaps, systemic leverage and so on, and I lamented how the elimination of the uptick rule was such a causative and exacerbating factor in the extreme market behavior we that last November. His eyes glazed over and I realized that while he was familiar with the rule, his career path -- like that of most people even in our industry -- had never passed close to it, in contrast to those on the dealer side.
However, his interest grew during our conversation, and he exhorted me to write an op-ed regarding what I explained to him. His experience in politics had taught him that most people may believe strongly in something but rarely express their views until they feel compelled to do so -- which is often much later than the best time to do so.
The uptick rule has been a far more vital and essential element in the functioning of capital markets than many investors were ever aware. On the surface, it may seem arcane and of little interest to most people, whether they are investors or not.
While we have delivered powerful
demonstrating the overall importance of the uptick rule and the urgency for its reinstatement, it feels as if I have not yet heard any well-developed arguments for its continued suspension.
However, as we prepare to deliver a petition letter signed by thousands of citizens who have either taken the time to understand a complicated issue or who have lived with it professionally, we should examine objections and obstacles that may be presented on the road to reinstatement -- which in turn will demonstrate the good logic of bringing it back.
Some potential obstacles to reinstatement include:
- Fear of recrimination, retribution or other criticism or embarrassment on admitting that elimination was a mistake on the part of the officials responsible for eliminating the rule.
- The presumed difficulty of monitoring each market -- whether exchange, electronic crossing network (ECN) or other in a penny-spread world full of "dark pools," derivatives and swaps and other synthetics -- to ensure participants are always aware of the state of the market with respect to the last price and whether that price represented a plus, zero-plus or minus tick.
- The potential for an unfair burden placed on facilitating market makers, especially options market makers and dealers.
- The potential burden on sponsors trying to accommodate investors in exchange-traded trusts and funds.
- Free-market theories advanced by nuts and crazies. (Just kidding -- I grew up in New Hampshire, where the license plates say "Live Free or Die" and half the class was absent from school on opening day of deer season and the start of the smelt run.)
I will thus write a column examining each issue, starting with the fear of recrimination. There may be officials, either appointed or elected, who are concerned that reinstatement might present an admission of error, which would carry consequences presumably ranging from simple embarrassment and career derailment to lawsuits that might successfully argue for specific damages sustained by parties harmed by the suspension of the rule.
That pride might stand in the way of good policy is preposterous, but in terms of damage done for stupid reasons, pride has few equals. There's a reason many cultures consider it the greatest of sins. It seems difficult to imagine that anyone with influence over the decision to reinstate the rule would let pride -- whether his or her own or anyone else's -- affect his or her decision, but there is a great deal at stake and enough interests at work so that it will be hard enough as is without emotions clogging the process.
Economic consequences are always possible, but they seem an unlikely outcome, although I am not a lawyer. They are perhaps more probable in cases where the decision resulting in harm was more specifically applicable. In such a case, the "government" would be the defendant, deflecting the actual economic consequence away from the individual, although years of giving depositions might be a fate to avoid.
This potential cost is likely to be zero anyway; even if any lawsuits to arise, the benefits of having the rule reinstated will accrue to the taxpayer, the same party who might end up footing the bill for any successful claims brought against the government.
There is no reason to recriminate against those who might have supported or caused the elimination of the rule. In fact, while the economic burden has been large, it may also be viewed as the price of very valuable information, otherwise impossible to obtain.
We now know what happens to the capital markets in this country -- with all of its great disclosure and operating and regulatory infrastructure -- without such a rule helping balance the factors that create the negative skew inherent in all capital markets.
A cynic might view my argument as a little too cute, paraphrasing it: "You who got rid of the rule are forgiven because it's not your fault that you were too ignorant to be the arbiters of the decision in the first place." This is false; I'm not being disingenuous at all.
The authors of the pilot study commissioned by the
prior to the elimination were clear in describing the limitations of the study: "While the Pilot study was designed to facilitate a natural experiment in a controlled environment, the results might not be entirely representative of removing the rule permanently for all stocks."
The lack of a good control population fatally flawed any influence that the study might have had over the final decision. There was simply no way to extrapolate results from the world where most stocks were subject to the rule to the world where there were none.
"No way of knowing," however, does not mean necessarily that anyone could have assumed correctly that the results would be as bad as they turned out. They might have been different -- even positive. So as much as anyone might have doubted that outcome for other reasons, those reasons could only be based on logic and anecdote rather than empirical data subjected to rigorous and correctly administered scientific analyses.
There were reasonable and well-mounted arguments for trying out suspension of the rule advanced by a vocal constituency that spent a great deal of effort promoting the cause. Those who might have objected argued less for their position.
In a situation where the outcome of regulatory change might be better judged, the officials responsible for the decision could be expected to have no compunction about making the decision based on their own analyses. In this case, while they made efforts to compensate by showing they recognized the flaw in their study, there wasn't a lot they could do about it.
They even might have decided differently if the study turned up some extreme and significant information, but it did not -- just a few small tendencies toward what was to come. Therefore, it made some sense to give more weight to others' arguments.
This is a democracy and, further, a democracy of free people that believe overall in free market ideals. There are always exceptions, including many that actually engender more freedoms for larger proportions of the overall population such as the uptick rule.
However, experience teaches us that exceptions, in all manners of human relations and endeavors, are not to be taken lightly. Under the circumstances in 2006-2007, it was reasonable for the SEC to have made the decision it did, and recriminations are as much a waste of time as are fears of them.
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At the time of publication, Furber had no positions in the stocks mentioned.
William Furber is the founder of High Street Advisors in Manchester, Mass.