Y. Bar-Yam, D. Harmon, V. Misra, and J. Ornstein, Regulation of Short Selling: The Uptick Rule and Market Stability. Report presented at the Securities and Exchange Commission (February 22, 2010).
Following the market crash in 1929-1930, Congress created the Securities and Ex- change Commission (SEC) in 1934 with a mandate to regulate short selling of se- curities to protect investors and the public interest. In 1938, the SEC instated the uptick rule to allow relatively unrestricted short selling in advancing markets while preventing short selling from driving the market down or accelerating a declining market. In 2005, the SEC conducted a pilot study, to investigate the effect of the uptick rule, removing it from 943 stocks of the Russell 3000. Data collected over six months starting in May 2006 were interpreted to mean that the uptick rule had no significant impact on market behavior, and the uptick rule was repealed on July 3, 2007. In 2008-2009 US markets experienced a crisis of similar proportions to the market crash in 1929-1930. Here we show that the original pilot study provides evidence predicting a market crash as an outcome of the repeal of the uptick rule.
The market crisis has prompted many calls for reinstating the uptick rule. Beginning in April 2009, the SEC has announced two comment periods on short-selling regulations, the last of which ended on September 21, 2009. The purpose of these comment periods is to consider whether to reinstate the uptick rule, and whether alternatives to the uptick rule should be implemented instead. These include the original uptick rule, an upbid rule, or these rules only implemented after large market drops, i.e. as “circuit breakers.” Here we provide a method for analysis of the impact of alternative rules. We show that the upbid rule weakens the up- tick rule by a small but quantifiable amount, while the circuit breaker alternatives would have much less effect. Our analysis of the uptick rule and its alternatives also shows that decimalization and electronic markets weaken but do not eliminate the effect of these rules. Still, the weakening could be reversed by setting a price increment for short selling above the recent price or bid.