CAMBRIDGE, Mass.--October 17, 2008-- Recent analysis by researchers at the New England Complex Systems Institute suggests that the repeal of the uptick rule contributed to the current market crisis. The U.S. Securities and Exchange Commission repealed the long-standing rule in the summer of 2007. While many commentators have attributed the recent market turmoil to the loss in value of mortgage-backed securities, NECSI researchers have found that the repeal of the uptick rule may have damaged the market's stability, thereby making the market more susceptible to fluctuations.
"We have performed a preliminary analysis of market behavior that suggests the repeal of the uptick rule makes markets highly vulnerable to manipulation resulting in severe under-valuations and market instability," says NECSI President Yaneer Bar-Yam.
The uptick rule, which had been in effect for over seventy years, was instituted to regulate short selling. The rule required short sellers to sell a security at a price higher than its previous sale. In effect, the rule limited the rate of short selling by allowing short sellers to sell only when the price increased.
Professor Bar-Yam argues that regulating the rate of short selling is essential in order to prevent dangerous vulnerability of the market. "Rapid short selling manipulates the market by driving prices down...Such price manipulations undermine market efficiency and thus the inherent reliability and security of markets for investors." Recently, the SEC has responded to the extreme market fluctuations by limiting naked short selling on all companies, but Bar-Yam claims this does not address the root of the problem. "The SEC's actions may limit the overall volume of short selling, but they do not affect the rate of short selling at any given time. It is the rate of short selling that determines the ability of short sellers to manipulate prices."
Without the uptick rule, the rate of short selling is unregulated, and the market is more vulnerable to unforeseen events. Bar-Yam suggests that the drop in value of mortgage-backed securities may have been one of the events that sent the vulnerable market into turmoil. "Mortgage-backed securities may be the disturbance that is being amplified by an unstable market. A stable market need not have the same response: it could better recover from the disturbance."
Bar-Yam believes more research must be done in order to determine the precise effects of manipulators, as well as what benefits can be derived from their actions. "Such analysis would enable a more careful discussion of how to improve market efficiency." Nevertheless, Bar-Yam insists that the restoration of the uptick rule has clear advantages for the immediate future. "[The reinstatement of the uptick rule] is a minimal strategy for risk reduction. Further analysis can be done afterwards."
The New England Complex Systems Institute (NECSI) is a non-profit research and education institute developing new scientific methods, and applying them to the challenges of society.
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