By James Hamilton, J.D., LL.M.
With Congress readying legislation directing the SEC to reinstate rule 10a-1, the uptick rule, a consortium of US securities exchanges sent a letter to SEC Chair Mary Schapiro urging the Commission to adopt a modified and modernized version of the uptick rule. The exchanges also urged the Commission to adopt a Circuit Breaker that would trigger the application of the modified uptick rule only after the price of a stock has experienced a precipitous decline by a certain percentage, perhaps ten percent. The letter was signed by the CEOs of NYSE Euronext, NASDAQ, BATS Exchange, and the National Stock Exchange.
The original uptick rule, rescinded by the SEC in 2007, provided that short selling could occur only when the last sale was at or above the previous sale. This longstanding rule was understood by the trading community and supported by issuers. But the exchanges said that the original uptick rule, which had remained virtually unchanged since its adoption over 70 years ago, would be difficult to implement and enforce in the current penny increment market structure. Moreover, the exchanges reasoned that the original rule would not be as prohibitive in markets where transaction prices change multiple times in a single second and message traffic has exploded to billions of messages storming down on the markets every day.
Instead, the exchanges proposed a modernized version of the uptick rule under which short selling could only be initiated at a price above the highest prevailing national bid by posting a quote for a short sale order priced above the national bid. As such, the execution of a short sale would occur only at a higher price than the prevailing market at the time of initiation, and only on a passive basis. This restriction would greatly assist the prevention of manipulative short selling, said the letter, which so harms the markets.
In the exchanges’ view, the modified rule is superior to the original uptick rule in several ways. For one thing, it is conceptually simple. Also, it is likely to be more effective in dampening downward price pressure, and easier to program into trading and surveillance systems than the original rule. While there is no perfect solution, the exchanges believe that the modified rule is the most effective answer to deal with the faster-moving, post-Regulation NMS trading environment and to reduce downward pressure on stocks created by abusive short selling.
In addition, the most practical and effective way to structure adherence to the modernized rule would be similar to oversight of the trade-through rule under Regulation NMS. In this vein, the modified rule would be a policies and procedures requirement, and brokers would have responsibility for ensuring compliance with the rule before sending a short sale order into the marketplace. Exchanges could offer order types to assist brokers in performing their compliance duties, but would rely on a broker’s indication that they had performed the required due diligence on the order when so indicated.
In combination with the adoption of the modified uptick rule, the exchanges urged the SEC to adopt a Circuit Breaker that would trigger the application of the modified rule only after the price of a stock has experienced a precipitous decline by a certain percentage, perhaps ten percent. Noting that markets have successfully used circuit breakers on both broad indexes and individual securities for many years, the exchanges emphasized that a Circuit Breaker permits normal market activity while a stock is trading in a natural range and short selling is more likely to benefit the market by, for example, increasing price discovery and liquidity.
Conversely, a Circuit Breaker will restrict short selling when prices begin to decline substantially and short selling is more likely to become abusive and harmful. The Circuit Breaker is particularly efficient in stable and rising markets because it avoids imposing continuous monitoring and compliance costs where there is little or no corresponding risk of abusive short selling
With respect to the Circuit Breaker, the exchanges recognize that the SEC will have to determine the proper reference price for calculating it, as well as the duration of the Circuit Breaker once triggered. Also, the network processors must determine how to disseminate an indication that a Circuit Breaker has been triggered and, later, lifted. For their part, the exchanges and their member firms must provide estimates of programming and testing requirements for both the Circuit Breaker and the modified uptick rule.