UltraShorts and the Fall of the Uptick Rule

Editor's note: This was originally published on RealMoney. It is being republished as a bonus for TheStreet.com readers. To subscribe to RealMoney, click here.

I had mentioned in one of my early articles on levered short-side ETFs that I thought it would be tough to reinstate the uptick rule with these products outstanding. I never really thought much more about it beyond that one fleeting sentence. Revisiting the thought now, though, I wonder if the massive proliferation of these vehicles would have ever been possible had the uptick rule not been eliminated to begin with. (Don't miss " Uptick Rule: Meaningful or Meaningless?")

This week Feb. 23-27 on "Mad Money," Jim Cramer showed a clip of Fed Chairman Ben Bernanke's Humphrey-Hawkins testimony. Bernanke said that, if asked, he would advise SEC Chair Mary Schapiro that there may be merit to the concept of bringing back the uptick rule.

While the clip aired, a line flashed across the screen stating that the uptick rule was eliminated in 2007. That got me thinking a little bit about the timing -- I frankly couldn't believe the uptick rule had only been gone for less than two years. Please note, I am not a conspiracy theorist at all, but I was interested in reconstructing the time frame around the growth in levered and short-side ETFs and the elimination if the uptick rule.

ProShares, "the world's largest provider of short and leveraged funds," launched its first Ultra Funds (two times levered) and Short Funds in June of 2006. In July of 2006, it launched its first UltraShort (two times levered short) funds. These initial funds were based on broad indices -- the Dow Jones Industrial Average, the S&P 500, the Nasdaq 100 and the S&P Mid Cap 400. All of these indices had active futures markets at that time, which made the hedging of these products relatively easy, and such hedging would create minimal market disruption.

Then in January and February 2007, ProShares expanded its product offerings to include Ultra/Short/UltraShort Funds based on the Russell 2000, the Russell 1000 Value and 1000 Growth, the S&P Small Cap 600 and a few other broad indices, most of which had futures or could have been hedged using a simple beta in relation to the futures contracts. ProShares also launched a series of Ultra/Short/UltraShort products on 11 specific sectors that did not have active futures contracts and would have been much more difficult to hedge using a simple beta vs. a broad index future.

Since the fourth quarter of 2007, ProShares has expanded its product range to include Ultra/Short/UltraShort funds based on Treasury indices, currencies, commodities, various MSCI indices in EAFE, Japan and emerging markets, the telecom sector and the FTSE/XINHUA China 25 index. As the market leader in short and levered ETFs, ProShares had grown from under $6 billion of assets under management (AUM) in June 2007 to over 20 billion AUM by June 2008 -- ProShares had gone from zero to 20 billion in just two years. Today, ProShares has roughly 28 billion in AUM, so make that going from zero to nearly $30 billion in less than three years.

In December 2006, when ProShares was just six months old, the SEC proposed amendments to Regulation SHO to remove the price test of Rule 10a-1 (the "uptick rule"), and formally enacted the removal of the price test effective July 2007. The SEC also prohibited any self-regulatory organization (SRO) from instituting its own price-test rules. (Question: Why would they do that? If an SRO entity finds it in its best interest to be more conservative, shouldn't it be allowed to do so? I find that strange ... but I digress.)

(Don't miss " Uptick Rule: Meaningful or Meaningless?")

The SEC had established a one-year pilot program, approved in 2004, launched in May 2005 and subsequently extended until August 2007 (an end date later rendered moot by the recommendation in December 2006 to remove the price test, a decision which was enacted in July 2007), which allowed one-third of the stocks in the Russell 3000 to be free of the uptick rule as a test case. A study was conducted by the SEC's Office of Economic Analysis in February 2007, detailing the observations of the pilot program.

There has been criticism that the SEC's analysis and the pilot program were conducted over too short a time period and warranted further study. Note that from the launch date of the pilot program (May 2, 2005) until the date of this SEC paper (Feb. 12, 2007) the S&P 500 rose from roughly 1,160 to 1,450 generally unimpeded, with two modest pullbacks (both times establishing higher lows) over that period.

The SEC study concluded that "most evidence shows that the pilot had a minor effect. The most intriguing results are in volatility. Some evidence that the tick test has a bigger effect in small stocks." (Question/observation: If the tick test has a bigger volatility effect on smaller stocks, and that is presumably because the smaller stocks cannot handle larger volume brought about by the relaxation in trading constraints, what does that then say about the volumes created by the short-sided sector ETFs and the resultant effects on the underlying stocks? This never would have been picked up in the study, because the study was concluded before these short-sided sector ETFs were rolled out.)

The authors of the study made a couple of other interesting empirical observations. First, they noted that depth of quotes decreased in the pilot stocks. They conjecture that this is because a short-seller without an uptick rule is a liquidity demander, and the uptick rule may force them into being a liquidity supplier. This is fascinating, because many short-sellers argue about the liquidity they bring to the market, yet the evidence was that short-sellers were perhaps liquidity takers without the uptick rule.

The other intriguing statement the SEC staffers made was the caveat that perhaps during the pilot program, short-sellers with manipulative intentions were on good behavior, knowing that their actions were under scrutiny (and if they fouled it up, they may lose their chance to do away with the uptick rule).

From December 2006 to April 2007, the SEC received 27 comment letters on the proposed removal of the uptick rule. Fifteen of these letters (mostly from individual investors, but one came from a consultant on behalf of the International Association of Small Broker-Dealers and Advisors -- which urged caution) either spoke out against the proposal, against the elimination of the uptick rule or against the practice of naked short-selling.

Eleven of the letters (including letters from the NYSE, UBS Securities, the Managed Funds Association, the Security Traders Association, E*Trade, Trillium Trading and the Securities Industry and Financial Markets Association) applauded the SEC for proposing the elimination, and many added that they commended the fact that the SEC had conducted such a "comprehensive," "careful" and "thoughtful" pilot program (amazing how the industry all seemed to use the same plaudits...).

Curiously, the American Stock Exchange had a mixed opinion. The Amex was cautious and felt it was "premature to remove price tests from smaller securities at this time pending further analysis." So they had 15 against (mostly individuals), 11 for (mostly industry) and one neutral (industry) respond. So much for the little guy being heard ... but I digress once more.

OK, so let's return to the beginning. We know that ProShares initially launched products that could be easily hedged via a liquid futures market. They began to launch products on narrower sectors that could not be easily hedged via futures in January 2007 -- one month after the SEC proposed to abandon the uptick rule. It seems as though these levered short-sided ETFs flourished because of the change to Regulation SHO (and remember that ProShares is merely one of several purveyors of these products).

There is a very good chance that one of the biggest consequences of the removal of the uptick rule has been the proliferation of these vehicles, which give leverage and shorting power outside the margin rules. Their impact has been astounding in some cases, creating indiscriminate selling pressure and volatility in some sectors. Remember, just last Friday (Feb. 20), if you summed up the dollar volume in the 1x, 2x, and 3x short-sided ETFs based on financials and subtracted the dollar volume in the 1x, 2x, and 3x long ETFs based on financials, you'd still have close to $18 billion dollars of selling pressure brought to bear against the financials, representing a good chunk of the daily trading volume of the individual index constituents.

I will always be curious as to what the decision would have been regarding the uptick rule had the initial pilot program been carried though to today -- a period of high volatility, declining prices and spiraling deterioration in the credit crisis. Even if the uptick rule still existed, maybe we would have gotten to where we are on our own anyway, but I can't help but wonder if the same conclusion would be have been reached regarding whether or not the uptick rule made sense.

Postscript: Now that the uptick rule has been eliminated, it may be complicated to bring it back. Although ProShares did not make any public comments during the SEC's comment period surrounding the proposal to remove the tick test, my guess is that you will see significant lobbying, should talk to reinstate the rule start to heat up. It is all about economics: ProShares has now grown to almost $30 billion in AUM, and with fees of 95 basis points, we are talking about several hundred million at stake for the firm.

And the revenue line should be fairly close to the income line -- the firm does not have the employment load of the typical asset-management firm. ProShares has a relatively lean staff, since the nature of these types of ETFs is to basically just use swaps. There is no need for expertise in the underlying stocks and sectors -- one just needs expertise in swap documents. You can replicate the fund management process on almost anything as long as you can find a swap counterparty and negotiate the docs. In fact, the prospectus lists just five individuals who have day-to-day management responsibility for the 50-plus ProShares funds.

Since ProShares does not necessitate expertise in the stocks and sectors, it does not need an army of research analysts, although ProShares did announce this week that it hired a high-powered equity derivatives strategist to head up its investment strategies unit. I believe readers know what I think the shortcomings of these products are, so I can't help but wonder if the first "strategy" may be to dazzle the regulators as to why these need to exist and the uptick rule doesn't.

Know What You Own: ProShares funds include the ProShares Ultra Real Estate ETF ( URE), the ProShares UltraShort Real Estate ETF ( SRS), the ProShares Ultra Financial ETF ( UYG), the ProShares UltraShort Financial ( SKF), the ProShares UltraShort FTSE/Xinhua China 25 ( FXP), the ProShares UltraShort QQQ ( QID), the ProShares UltraShort Oil & Gas ( DUG) and the ProShares UltraShort Industrials ( SIJ).

This was originally published on RealMoney on Feb. 27, 2009. For more information about subscribing to RealMoney, please click here.

More on TheStreet.com: "Uptick Rule: Meaningful or Meaningless?"
Eric Oberg worked in fixed income, currencies and commodities for Goldman Sachs for 17 years before retiring as a managing director.

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