Uptick Rule

The SEC is considering re-instating the uptick rule.

The assumption behind the uptick rule is that the primary problem with short selling is that short selling accelerates market declines.

If this assumption is wrong; then the uptick rule is likely the wrong fix.

Even worse, the uptick rule might even make things worse.

Looking at the massive sales volume of the day, one realizes that it is very easy for market makers and brokers with access to multiple accounts to generate an uptick for a client. It is also possible to programmatically manipulate trades to prevent prevent small investors from short sales.

The uptick rule is likely to devolve into a regulation that gives further advantage to insiders.

The uptick rules being considered by the SEC are all programmatic rules. That is, they are rules that will automatically kick in according to market conditions. As a general principle, programmatic rules simply give an advantage to those engaged in programmatic trading.

To manipulate the programmatic rules, one need simply enter the new rules into a computer model. Run simulations on different trading strategies. Then create a programmatic trading system that manipulates the programmatic system.

An immutable law of the financial universe is that programmatic rules lead directly to programmatic manipulation.

Need I mention that giving an advantage to programmatic traders gives a disadvantage to value trader.

My Solution

Before implementing the uptick rule, I would want the SEC to do serious thinking about short trading itself.

Historically, short trading came into existence as a way to overcome market inefficiencies. In ancient days, a person might have to send a rider from Liverpool to London to make a trade. The short sale allowed for efficient trades.

Modern communication technology has eliminated the inefficiency that led to the need for short selling. It is absurd, but regulatory regime on Wall Street has implemented an artificial three day clearing period for transactions for the sole purpose of continuing the short selling practice.
I contend that short selling is inherently anti-market in that it allows people to sell things that they do not own. Naked short selling is plain evil in that it allows traders to sell things that do not exist.

A large number of our currently economic woes are directly related a regulatory regime that allows widespread short selling.

In recent history, we have found large number of traders engaged in a practice of hedging investments with leveraged positions. In 2008, we learned the hard way that this paradoxical act of hedging with leverage creates systemic risk.

I contend that the best method for market reform would be to remove the artificial inefficiencies created by DTCC and to move to a system of real time trading.

A system of real time trading transfers ownership of the stock at the moment the transaction takes place. Questions of market efficiency are moot because one can't get more efficient than instantaneous. Real time trading is the ultimate in market efficiency.

We would not need a new large regulatory regime with complex programmatic rules. A Real time trading system would use the inherent physical constraints of reality to prevent people from selling shares that do not exist.

A real time system does not completely eliminate the ability of people to engage in short selling. Investors would still be able to enter contracts that allow other investors to borrow and sell their stock. A system of real time trading, however, would force discipline on the practice. When an investor lends to a short seller, then they would have their stock replaced with an IOU slip.

The goal of a real time system is not to eliminate short selling. The goal is provide a system that lets people know exactly what they own at all points during a stock transaction. People should know that the second they lend stock to a short seller that they are no longer invested in a stock. Instead, they have a loan to a short seller.

I am happy that the SEC is addressing the systemic problems created by the currently regulatory regime. I ask that, before slapping regulations on the market, they think deeply about the nature of the market, and about the effects of programmatic regulations.

Programmatic regulations like the uptick rule would give advantage to programmatic traders. Transition to a real time exchange would give the advantage to value investors. I opt for the latter for the value investor is the true source of our prosperity.