The multi-faceted impact of Covid-19 on the American economy over the last two weeks has resulted in extreme financial market volatility in the U.S. and around the globe. This is causing an unwelcome déjà vu for many as the memories of market gyrations from the 2008 financial crisis are dredged up.
As it stands today, there are significant, fundamental differences between the financial crisis and the current environment. Not only are the sources of market instability radically different, but the regulatory construct in which this volatility exists today is very different.
From a regulatory perspective, one area in particular—short selling— illustrates the stark difference between 2008 and today. Indeed, as the once familiar cry to reinstate the uptick rule is now back in the mainstream, it is critical for policymakers to remain focused on fact and logic instead of emotion.
During the throes of the financial crisis, the Securities and Exchange Commission took the extraordinary step of issuing emergency orders imposing borrowing and delivery requirements on short sales of the equity securities of certain financial institutions.
SEC Orders in 2008
The SEC issued the first of these orders in July 2008. The order referenced the events preceding the sale of Bear Stearns, where rumors about the company’s liquidity led to a crisis of confidence. As Bear Stearns’s stock price fell, its counterparties became concerned and were ultimately unwilling to make secured funding available to the company on customary terms.
On Sept. 18, 2008, the SEC issued another emergency order prohibiting short selling in the securities of a wider range of financial institutions. Advocates of these restrictions, which included private sector and senior officials across the government, argued vociferously that unconstrained short selling artificially depresses the price of securities and creates excessive downward pressure, undermining investor confidence in our markets generally.
The short sale bans starkly highlighted the difference in pre-crisis and mid-crisis policymaking. Just one year before the bans were imposed, the SEC had repealed the then 70--year-old, “uptick” rule.
The decision to repeal the uptick rule stemmed from a comprehensive empirical analysis by SEC economists and outside experts finding that the rule did not effectively perform its intended purposes and imposed unnecessary costs on the markets.
Specifically, the SEC engaged in a multi-year review of the potential impact of repealing the rule and conducted an extensive pilot program that allowed for detailed economic study of the effects of doing so.
Data analyzed by the SEC’s Office of Economic Analysis (OEA) (now the Division of Risk and Economic Analysis) from the pilot program supported the conclusion that price restrictions constituted an economically relevant constraint on short selling, but that removal of price restrictions for the pilot stocks had not, on balance, had a deleterious effect on market quality or liquidity. Four privately conducted studies similarly supported the removal of short sale price restrictions.
Despite the thoroughness of the analysis underlying the repeal of the uptick rule, chants of “bring back the uptick rule” could be heard loudly and clearly along the Acela corridor in 2008. The bans that ensued in 2008 made the uptick rule look tame.
Subsequent studies of short selling activity during the crisis found that shorting, in fact, was not responsible for the extreme downward selling pressure that was prevalent in the markets. For example, data reviewed by the SEC’s OEA for three weeks in September 2008—probably the most volatile period during the crisis—found that during periods of extreme negative returns, selling pressure was more intense for long sales, rather than for short selling activity.
In fact, the study found that the short sale ratio is mostly higher during periods of positive returns than during periods of negative returns, which is consistent with the view that short sales are, in part, a price discovery tool. Go figure.
2010 SEC Rule
With the lessons of the 2008 financial crisis fresh on its mind, the SEC in 2010 adopted an “alternative uptick rule,” including a circuit breaker feature. Under the new rule, when the price of a security decreases by 10% or more from the prior day’s closing price, short selling in that security is subject to the alternative uptick rule.
In particular, when the 10% circuit breaker is triggered, short selling in that security is prohibited at a price that is less than or equal to the current national best bid. The price test restriction remains in place for the rest of the day on which the circuit breaker is triggered, as well as for the entire following day.
This new rule has reportedly been put to the test in the last couple of weeks and is functioning as intended. Indeed, the many trading infrastructure reforms implemented by the SEC and the exchanges in response to the 2008 financial crisis and the 2010 flash crash seem to be working as intended.
Policymakers and CEOs are right to decry abusive short selling activity in our markets—it does exist and it warrants the full response of our law enforcement arsenal. For legal short selling, however, the proper controls are now in place and the cries of “bring back the uptick rule” should be consigned to the financial crisis history books.
This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.
Daniel Gallagher, a partner at WilmerHale, is a former commissioner of the SEC and chief legal officer of Mylan. He advises corporate boards and management on the full range of legal and strategic issues they face, and counsels financial services and accounting firms in investigations, regulatory proceedings and policy matters.