"It's physics; you wouldn't understand."
It brings a smile to my face to recall the tongue-in-cheek response our high school physics teacher told us to give kids that asked what we were doing on the lawn outside the school -- we were completing an angular momentum lab. It was a great deadpan comedic line, giving the geeky physics kids a rebellious retort to the flack we took from others.
Having been one to actually utter that line decades ago, I recognize it now. You see, this is essentially the line we are getting from the quants as the concept of bringing back the uptick rule gains momentum. Only this time it takes the form of "The code in these programs is so embedded, it would be impossible to go back," or "There are so many trades that take place with the push of a button, this would be impracticable," or something to that effect. However, these lines aren't being uttered tongue-in-cheek. The quants are actually trying to get us to believe them.
You mean to tell me that you can create all of these sophisticated macro programs that trade thousands of stocks a second based on complex algorithms, but you cannot figure out how to do so with an uptick rule? That is simply insulting.
The intent of the rule is to provide a circuit-breaker on destructive, rapid-fire short selling. So if the program traders are slowed a bit, doesn't that seem to fit the intent? What am I missing here?
I've got an idea: if you cannot comply with not only the letter but also the intent of the uptick rule, don't trade. My guess is you'll be able to figure it out -- put the Ph.D. in rocket science to work.
The SEC will face the issue of form vs. substance. If we put a rule in place that carves out myriad exemptions, then you know the rule is not one of substance.
Along the same lines, lots of people have asked me about what happens to these levered short side ETFs if the uptick rule comes back. This seems to be the buzz around the chatrooms; the question was even asked last week on a popular trading show and no one seemed to know.
Well, I will hazard a guess -- it isn't simply the uptick rule that should cause the SEC to rereview these but also the margin rules (the very fact that the SEC approved these shows the need for a super-regulator as they seem to fly in the face of reg. T).
The holders of these funds do not need to be concerned that their investments will be wiped out. These are funds with assets and holders are entitled to their pro rata share of the value. So if these get taken off the market, speculators that hold these (I can hardly deem them "investors" or "hedgers" given the longer-term performance) do not need to worry about what happens to their money; the funds will simply unwind.
I do not see how these will be able to remain viable if the uptick rule is to have any credibility. While in the past there may have been a "diversification exemption," I cannot see how that would apply specifically in the case of these narrow sector ETFs -- we have just witnessed how high correlation can be within a sector. And forget about the argument that these were spared during the short-sale ban last fall -- that was hardly a considered action, as the former SEC chair admitted.
More important is the structure of exchange-traded funds. ETFs were created as a means to avoid socialization of gains and losses that occur in mutual funds. This is done through an in-kind "create and redeem" process where the buyer contributes a pro rata share of the portfolio in return for a share of the ETF. This allows investors to only be taxed on their own actions. When they sell, they get back their pro rata share of the portfolio and their capital gain/loss is figured out based on their own disposal of the assets.
With these levered short portfolios, they are in theory shorting the shares of the underlying portfolio. They would need to wait for an uptick on each share, which would be incredibly unwieldy. In reality, these funds hold swaps as their assets rather than maintain a series of individual stock shorts (although somewhere the swap counterparty is holding short positions and the market makers will hedge their positions by establishing shorts). So this is where we get into "form vs. substance."
If the SEC is just trying to put out a toothless rule to appease the politicians and the public, they may well exempt these ETFs from the uptick rule because of the "form" of shorts being established. In that case, everyone will just use these ETFs to front for their avoidance of the rule. But if the SEC is actually behind the intent and spirit of the rule and cares about "substance" rather than form, these vehicles will not be exempted and their viability will be in question. Expect a major lobbying effort here -- the dollars are too large for the purveyors of these products.
If these vehicles are no longer viable, expect a wind-down, maybe all in one day or maybe over a few days or weeks, and holders will get the proceeds. For a holder, this may effect your capital gain/loss position based on your holding period and entry point. Yes, this mucks up the tax efficiency a little bit, but remember many of these funds paid out huge capital gains late last year -- unexpected for many investors and not based on their own actions. So I guess these didn't quite act like a traditional ETF anyways.
My guess is you will see some of the bearish money redirected to the options market and traditional forms of shorting, forms that comply with the margin rules. Some of the "pile on" shorts will simply go away, lending credence to the "easier margin terms will bring in more uninformed traders" theory. (Taking a glance at the message boards for some of these products, you realize how many folks do not understand how they work.... Hmm, not understanding the levered derivative product that one purchases -- does that sound at all familiar to anyone?)
There are similar questions about married puts, deep -in-the-money options, dark pools and trading across various platforms away from the exchanges. I won't get into those now, but it just shows the degree of comprehensiveness that needs to take place -- it isn't as simple as just passing a rule. Please see my earlier article on
the merits of adopting a principles based system, or at least placing broad antifraud provisions around the rule.
This whole thing boils down to form vs. substance. Do we want a rule that may actually do something to protect capital formation, or do we just want the appearance of doing something? Do we want the decision to be made based on a considered opinion or who spends the most lobbying dollars?
We will learn a lot about the future of capitalism as this debate takes place. The public comment period will likely open soon. You can bet that those that are currently reaping the benefits of this
system will be vocal in their opposition of the uptick rule.
If you care about the integrity of the markets, if you care about investment and capital formation, I urge you to participate in the process. Let the regulators and policymakers know that you are behind the intent and reinstatement of the uptick rule. Tell them you care about substance over form, that you realize it's not physics and you do understand.
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At the time of publication, Oberg had no positions in the stocks mentioned.
Eric Oberg worked in fixed income, currencies and commodities for Goldman Sachs for 17 years before retiring as a managing director.