WASHINGTON (AP) — After steep stock market losses, momentum is growing in Washington to place restrictions on when traders can bet stocks will fall.
Investors and some lawmakers are pressuring regulators to restore a rule — crafted during the Depression — that was repealed in July 2007, when the Dow Jones industrials average was near its peak.
What is this so-called "uptick" rule, and why has it ignited passionate argument? Why was it repealed? Would restoring the rule help stem the slide in stocks?
Below are some questions and answers about a pressure point in the financial regulatory debate sparked by the worst economic crisis since the 1930s.
Q: What's the uptick rule, and how does it work?
A: Before it was lifted in 2007, the uptick rule served as a sort of blinking yellow light for traders who bet against a stock, also known as short sellers.
In a typical transaction, these traders borrow a company's shares and then sell them. After the stock price falls, they buy back the shares, return them to the lender and pocket the difference in price.
The uptick rule required short sellers to wait for a stock to rise at least slightly, or "tick up," before they could sell the shares. The goal was to prevent an unstoppable selling spree.
Here's how it worked: If a company stock was trading at $50 and a trader anticipated it would decline, he could borrow shares but couldn't sell them until after the stock traded higher. If the stock fell to $49, for example, the trader couldn't sell his shares until they had risen to at least $49.01.
Q: What's the origin of the rule? Did it succeed as intended?
A. The Securities and Exchange Commission established the uptick rule in 1938 as the Great Depression raged. Short-selling was blamed for exacerbating the 1929 market crash.
Up until its repeal 19 months ago, the uptick rule had been criticized for constraining trading and failing to shield stocks from manipulation.
Those pushing to restore the rule say its demise has fanned volatility in the market, prompting bands of hedge funds to target weak companies with an avalanche of short-selling.
Q: Why did the SEC lift the uptick rule in July 2007?
A: The SEC ran a test in which it removed the uptick rule for one-third of the stocks in the Russell 3000 index. The agency determined that there was no link between the uptick rule — or its absence — and potentially manipulative short-selling.
Before the repeal, the SEC had granted exemptions from the rule in response to changes in stock markets.
Q: What kind of changes?
A: An example was the adoption of decimal dollars-and-cents prices in stock trading in 2001. This system replaced the 200-year-old practice of quoting prices in fractions, like 1/8 or 1/2. Some say decimal pricing eroded the uptick rule's effectiveness, because the possibility of a stock ticking up by the smaller increment of a penny makes it easier to sell the stock.
It's "not a well-adjusted rule for a world where stocks trade in pennies," says John Coffee, a professor of securities law at Columbia University.
The possibility for manipulation arose, he noted, because traders could create an uptick of a penny or so by buying, say, 2,000 shares of a stock, and then selling short 10,000 shares.
Coffee suggested keeping the uptick rule in place as a sort of circuit-breaker in periods of market stress and lifting it during market bubbles.
Q: Is the rule likely to be reinstated? If so, when?
A: On Friday, the SEC it would meet on April 8 to discuss a proposal to reinstate the uptick rule.
Q: My stock holdings have taken a heavy beating. Whether the uptick rule is restored — or not — will my investments be affected?
A: It would likely depend on whether the stocks you hold are companies that are targeted by short sellers or decline sharply for other reasons.
Q: Why not just ban short selling?
A: Even most critics of market excess don't advocate an outright ban on short-selling. That would be considered a radical step. The SEC temporarily banned short-selling last fall in the stocks of hundreds of financial companies — an unprecedented action taken in a market emergency.
Experts say short-selling provides cash to keep market trading flowing and stock pricing efficient.
"After all, the short sellers discovered Enron," said Coffee.
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