While keeping the Delaware Senate seat warm for Joe Biden's kid, Senator Ted Kaufman's decided to monkey about with the capital markets:
Continuing his efforts to restore confidence in America's financial markets, U.S. Senator Ted Kaufman (D-DE) introduced bipartisan legislation today that will reinstate the "uptick rule," which aided market stability for 70 years. Since the uptick rule's repeal in July 2007, the abuse of naked short-selling – selling stock that the trader does not own – has added fuel to the fire of distressed stocks and markets.
"Abusive short selling is tantamount to fraud and market manipulation and must be stopped – now," Sen. Kaufman said on the Senate floor this evening. "The uptick rule should have never been repealed. To permit people to sell shares they don't have and won't be able to deliver turns investment into pure speculation. The time has come for this practice to stop."
There's some seriously shoddy thinking in those couple of paragraphs. First, naked short selling and the uptick rule have nothing to do with one another. In traditional short selling, the seller borrows securities from a current shareholder and delivers them to a buyer. The seller, of course, eventually must return the borrowed shares to the lender. The seller anticipates that the price will fall, however, permitting him to buy shares on the market at a price lower than the price he got from the buyer. As such, short selling is a basic form of speculation, in which the short seller is gambling that the price will go down.
In naked short selling, the short seller does not borrow the shares. Instead, he simply "sells" shares to a buyer, hoping that the price will drop quickly, so that he can acquire shares at a lower price before he is obliged to deliver them to the buyer. Naked short selling is thought to be problematic in that it increases the risk of failed transactions.
The SEC has regulated naked short selling through Regulation SHO and special emergency rules adopted during the financial crisis of 2008.
The uptick rule does not address the question of whether the short seller has borrowed the shares being sold short. Instead, the uptick rule for bids selling shares short on a downtick (i.e., at a price lower than the last traded price) or a zero minus tick:
A zero minus tick transaction occurs when a listed stock trades at the exact same price as the previous price, but at a lower price than the last different price. A zero minus tick is also referred to as a zero downtick. For example, a zero minus tick occurs if a stock trades at $9.05, $9.00 and $9.00. The first $9.00 transaction is a minus tick, however, the last $9.00 transaction is a zero minus tick since it was executed at the same price as the previous trade, but at a lower price than the last different price.
Bringing back the uptick rule thus does nothing to address the purported problem of naked short selling.
Second, naked short selling is economically indistinguishable from regular short selling: "In permissible short selling, the party owed shares is the security lender (who used to own the shares before lending them for short selling), while the party owning the shares is the new buyer. In naked short selling, the party owed the shares is the new buyer, while the party owning the shares is (still) the current owner. The buyer in both cases is the same, so the price should not be different. The only difference is who acts as the effective lender of the security: in permissible short selling, the lender is the current owner; in naked short selling, the new owner acts as the effective lender. From a price perspective, it is difficult to see how that matters." In short, the hysteria over naked short selling is, well, hysterics.
Third, Even if naked short selling were a problem, it is not in any way related to the present financial crisis: "Repeat after me: The trouble is not with short-sellers. The trouble is not with short-sellers. The trouble is with an over-levered financial system built on a house of cards comprised of under-collateralized toxic paper that was applauded all the way up by "housing is the American dream" nutters who couldn't see that vast expansions in thinly-traded credit are a path to economic ruin."
Lastly, the uptick rule has always been—and remains—a bad idea. The United States and Hong Kong are the only countries to have ever adopted an uptick rule. Regulators of all of the capital markets have recognized that the uptick rule significantly impedes liquidity.
Short selling had nothing--nada, zilch--to do with the falling value of CMOs, inter-bank lending rates, or any of the other real problems exposed by the financial crisis. All short selling does is promote market liquidity and efficiency by helping prices adjust to new information faster, which is a good thing. The uptick rule simply makes that desirable process less efficient.
Academic research on the uptick rule has found that it confers no benefits and has significant costs. There is no evidence that the uptick rule prevents market manipulation, while there is plenty of evidence that it interferes with the process of orderly price discovery and market liquidity.
There simply is no sound economic reason for bringing back the uptick rule. It is pure populist posturing.
Update: Bipartisan populist posturing at that. (See Senator Johnny Isakson R-Ga.) God save us from politicians who simply refuse to learn anything about how markets work.
