«Impact of elimination of uptick rule on stock market volatility Vivek Bhargava Alcorn State University Daniel Konku Northern Michigan University ...»
Journal of Finance and Accountancy
Impact of elimination of uptick rule on stock market volatility
Alcorn State University
Northern Michigan University
The uptick rule is a former rule established by the SEC that required that every
short sale transaction be entered at a price that is higher than the price of the previous
trade. The purpose of this rule was to prevent short-sellers from adding to the downward
momentum of a sharp decline by continually selling short, inducing profits, thus contributing to potential crashes. On June 6, 2007, SEC eliminated the uptick rule after a pilot test on 30% of Russell 3000 stocks.
The purpose of this paper is to determine whether the elimination of uptick rule increased the short-term volatility of the market. Using data from DJIA, S&P 500 index, and 30 Dow companies, it is found that both intraday and inter-day volatility went up in response to the elimination of the rule.
Keywords: uptick rule, stock market volatility Impact of Elimination of, Page 1 Journal of Finance and Accountancy
Other investors also use short selling to hedge the risk of a long position in the same or related security.
Opinion is divided among academicians and practitioners about the role of short selling in providing liquidity and pricing efficiency to the market. Short sellers provide liquidity by offsetting temporary imbalances in the supply and demand of the securities they trade in. In so doing they reduce the risk that the price paid by other investors is either too high or too low, due to temporary supply or demand disparities. Short sellers also add to market efficiency because their trades reveal to the market the overvaluation of the securities they trade in. Their trades set up a speedy correction of the overvalued security to its true value and, therefore, regulation prevents the market from reflecting the efficient price of a security. Furthermore, it imposes a “cost of waiting” – the earnings lost by the short seller as a result of waiting for an price uptick to trade Proponents of the uptick rule contend that unregulated short selling may be used as a tool for manipulation when a security is sold short without restraint, thus creating a sell-side imbalance, resulting in an increased momentum of a decline and subsequently, a market crash. The regulatory objective of the uptick rule was to discourage this type of manipulative conduct.
In response to the sudden-price-decline argument, the Securities and Exchange Commission (SEC) originally adopted the “uptick Rule” (more formally known as Rule 10a-1) in 1938 to restrain short selling in a declining market. This followed an official inquiry into the effects of short selling during the market break of 1937. Many analysts also blame the stock market crash of 1929 on short selling, in what has become known as the “bear raid”. The uptick rule has remained, perhaps, the most debated rule of the many restrictions on short sales.
On June 6, 2007, SEC decided to eliminate the uptick rule. This decision sparked a new wave of debate among investors and researchers; many argue that the elimination would cause the volatility of the market to increase significantly. The purpose of this paper is to determine the impact of the elimination of the uptick rule on price volatility.
The rule provided that a listed security may be sold short: (i) at a price above the price at which the immediately preceding sale was executed (plus tick), or (ii) at the last sale price, if it is higher than the last different price (zero-plus tick). Conversely, short sales were not permitted on minus ticks or zero-minus ticks, subject to limited exceptions. The uptick rule meant that a trader could not short a stock if the movement prior to the short sale was down. The operation of these provisions is commonly described as the "tick test." The reference price for the tick test is either the last transaction price reported following an effective transaction reporting approved by the SEC or on a particular exchange.1 Both the New York Stock Exchange, Inc. (NYSE) and the American Stock Exchange LLC (Amex) have elected to use the prices of trades on their own floors for the tick test.
Impact of Elimination of, Page 2 Journal of Finance and Accountancy In adopting the rule, the SEC said it sought to achieve three objectives (a) allowing relatively unrestricted short selling in an advancing market;
(b) preventing short selling at successively lower prices, thus eliminating short selling as a tool for driving the market down; and (c) preventing short sellers from accelerating a declining market by exhausting all remaining bids at one price level, causing successively lower prices to be established by long sellers.
Most market participants believe that the elimination of this rule will increase the volatility in the market. Gregory Drahuschak, vice president of Janney Montgomery Scott, wrote in a note to clients in the same week; "Increased volatility is here to stay as long as the new regulation remains."
On the March 20, 2008 television episode of Mad Money on CNBC, host Jim Kramer launched a campaign to reinstate the uptick rule, claiming that the elimination of the uptick rule has caused wild swings in the market. So high was the concern that on July 16, 2008, Senator Gary Ackerman, N.Y, introduced legislation in the Senate for reinstating the rule.
Ironically, former SEC Chairman Christopher Cox sent a letter to the Congressman dated January 20, 2009 – the day he left the agency – in which Cox said he supports the reinstatement of the uptick rule. Cox sent the correspondence despite the fact that the SEC declined several appeals to restore the regulation during his tenure as Chairman. Other voices for reinstatement of the rule include NYSE Euronext CEO Duncan Niederauer, and the US House Financial Services Committee Chairman Barney Frank.
Impact of the removal of uptick rule on market participants a. Individual Investors The absence of the tick rule could lead to fairly consistent selling pressure as there is no impediment to shorting a security. Extreme selloff patterns that occur during periods of stock market panic could be exacerbated, driving prices lower than fundamental values and increasing volatility. The absence of the uptick rule could lead to more active trading and a wider variety of trading strategies, which in turn could lead to wider spread and a higher short-term volatility. In the long term, however, no significant adverse effect on individual investors is expected, as short sellers buy back stocks to close their position.
The uptick rule only covers short sale of securities listed or traded on an exchange or the NASDAQ’s National Market System (NMS). Securities traded on the Over-theCounter (OTC) markets (National Small Cap, NASD OTCBB and the Pink Sheet) are not subject to short sale restrictions. However, the National Association of Security Dealers (NASD) has its own rules (NASD Rule 3350) covering the short sale of securities traded on that market.2 Securities traded on the NASDAQ National Market will be affected by NASD Rule 3330 prohibits short sale by NASDAQ Members in NMS securities at or below the current best (inside) bid as shown on the NASDAQ screen when that bid is lower than the previous best (inside) bid. This is referred to as a “bid test”. The rule also includes exemptions similar to those provided under the SEC Rule 10a-1 regulating securities on the exchanges.
any changes in the uptick rule in a fashion similar to those on the NYSE and the AMEX.
Securities on the OTC markets should be largely unaffected by the changes.
b. Institutional Investors It is widely believed that, institutional investors put in a significant amount of buy orders to move a stock to an uptick and then put in their real short sale order. Aitkins et al (1977) investigate the price behavior of short-sell orders on the Australian Stock Exchange (ASX) and report that both market bid and ask prices move systematically upward in the 15 minute interval prior to short trades initiated by market orders. They attribute this to the enforcement of the uptick rule on the ASX.
The SEC requires institutional investors to report information concerning short sales of securities electronically on its EDGAR system. Even though this information will not be made publicly available until after two weeks, such public disclosure may increase volatility when it is eventually made public. This is because less sophisticated investors will likely emulate the trades of the institutional investors.
The purpose of this paper is to determine whether the intra-day and inter-day volatility increased after SEC eliminated the uptick rule on June 6, 2007. This is accomplished by measuring the pre- and post-elimination date volatility using four different methods. One should expect intraday volatility to increase more than the daily volatility. Two different methods are used to measure intraday volatility. In addition, the daily historical volatility and the daily conditional volatility are used to measure inter-day volatility. It is found that the volatility goes up significantly for both indexes and a number of stocks, especially the intraday volatility for the 50 day trading period.
The uptick rule and the general issue of short sale remain the most debated issues in finance literature. More than seven decades after adoption, academic research and analyst opinions still remain divided over the usefulness of the rule. In 1991, the House Committee released a report on short selling which stated that the “effects of short selling on the securities markets are not widely understood” and that “many people have questioned the effectiveness of the uptick rule.” Nearly two decades after the Committee expressed these concerns, the impact of the short sale rules have not been understood any clearer, neither have market participants stopped questioning their effectiveness.
Short sellers trade when they believe stocks are overpriced or that there is some adverse news about the stock. In the presence of constraints binding short sales, stocks can be overpriced because these constraints prevent adverse information or opinions from being freely expressed in security prices. Consistent with this argument, Jones et al (2002) find that stocks that enter the borrowing market for shorting have high valuations, high market-to-book values and subsequent negative excess returns. Furthermore, the excess returns are higher than the cost of shorting, making an arbitrage possible to the shorter but not to the lender.
Miller (1977) argues that restrictions on short selling increase the price of risky assets above those that would occur without any restrictions. He showed that an increase Impact of Elimination of, Page 4 Journal of Finance and Accountancy in aggregate demand occurs because if restrictions bar investors from shorting overpriced securities, the most rational alternative is to avoid holding the stock.
Chen et al (2002) and Figlewski (1981) find evidence consistent with the Miller hypothesis. Using data from mutual fund holdings, Chen reports that stocks whose change in breadth in the prior quarter are in the lowest deciles of the sample underperform those in the top deciles by 6.38% in the twelve months after formation.
Jarrow (1980) examined the influence that short sale restrictions have on relative risky asset prices. He showed that relative risky asset prices could rise or fall due to short sale constraints. However, if investors hold a homogeneous belief about future prices, short sale constraints will only increase risky asset prices.
Diamond and Verrencchia (1987) model the effect of short sale constraints on the speed of adjustment of security prices to private information. They observe that constraints eliminate some informative trades but do not bias prices upwards. They also find that prohibiting traders from shorting securities reduces the adjustment speed of prices to private information, especially bad news.
Ho (1996) reports that volatility of stock returns increases when short sales are severely restricted on the Singapore Stock Market. There is also evidence that short sale restrictions suppress asymmetric effects. More recently, Bris et al (2007) did a more comprehensive global comparison of 46 equity markets to determine the effect of short sale restrictions on market efficiency. They report evidence that prices incorporate negative information faster is countries where short sales are allowed and actually practiced and that short sale restrictions inhibit downward price discovery.
Market developments and the elimination of the uptick rule
There have been considerable developments in the securities markets that have compelled the SEC to reconsider regulations on short sales. The most notable among them were the decimalization of trade prices, the Commodity Futures Modernization Act 2000 that lifts the ban on securities futures, and the growing number of securities that trade outside the NASDAQ markets and therefore are not subject to the tick test.
Prior to the elimination of the uptick rule in June 2007, the SEC had temporarily suspended the short sale price test in May 2005 on a subset of the Russell 1000 Index on a pilot basis to determine the effect of unrestricted short selling on market volatility, price efficiency and liquidity (SEC Regulation HSO).