The lack of a market making exemption in the US Securities and Exchange Commission’s new short-selling restriction, adopted last week, could limit market makers’ ability to provide liquidity in declining stocks, according to US equities market makers.
On 24 February, the SEC agreed to implement the ‘alternative uptick rule’, which only takes effect once a stock price falls more than 10% in a day. Once the rule is activated, short-selling in the affected stock is only permitted if the price is higher than the current national best bid for the rest of the trading day and throughout the following day.
Unlike the previous uptick rule, which the SEC adopted in 1938 and repealed in July 2007, the new version does not contain an exemption for market makers acting on behalf of clients.
“We are in a position where we can’t do our job as a market maker and provide liquidity to the market because if we are flat or short we can’t sell to a buyer,” Jamil Nazarali, managing director of US broker Knight Equity Markets, told theTRADEnews.com. “If a stock opens down because of poor earnings and we have a retail buyer who wants to buy the stock because it has dropped, we can’t sell it to them unless we are long.”
The lack of a market making exemption could also affect options trading, argues Nazarali. “Not only is the liquidity in the equity market going to dry up, but the same will happen in the options market because options market makers are now not going to be able to hedge their risk.” he said.
Despite expressing support for uptick rules in principle, Bernie McSherry, senior vice-president for strategic initiatives at US agency broker Cuttone & Company and a former New York Stock Exchange floor trader, said he was surprised by the catch-all nature of the new SEC rule. “There has to be some kind of market maker exemption and I hope the SEC will revisit that before the rule is fully enacted,” he said. “Market makers have to be able to liquidate their positions and make sales in anticipation of clients’ buy interest.”
The market now has 180 days to implement the new rule.
While the new uptick rule is negative for market makers, it will arguably do little to cheer those who support short-selling restrictions either. The previous uptick rule was watered down after the decimalisation of the US equities market in 2001, which cut minimum price change increments to one cent from one sixteenth of a dollar. And McSherry says
the 10% ‘circuit breaker’ in the new rule makes it even less likely to be triggered.
“10% is an awful lot – we don’t see stocks move by that much that often,” he said adding, “Even in times of extreme duress, it doesn’t take much to tick something up a penny.”
However, the fact that the restriction may not be triggered very often will be cold comfort to the brokers and exchanges that have to pay to implement the new rule. The SEC estimates that each broker would face one-off implementation costs of $68,381 and ongoing monitoring and surveillance costs of $121,356 just to deal with the provisions in the rule that enables brokers to enter an order as “short exempt” during an uptick.
Some estimates suggest that the total cost to the industry will be $1 billion for implementation and $1 billion in ongoing expenses. Nazarali at Knight likens the cost to a tax. “The financial system is still recovering so we think it is unwise to impose a billion-dollar regulation when there is no evidence it is going to help anyone.”
While many studies and commentators argue that short-selling restrictions have few benefits – as did the SEC when it abolished the old uptick rule in 2007 – McSherry feels shorting limits can provide vital reflection time in challenging markets.
“You can read study after study that an uptick rule means nothing but until you stand in a trading crowd and you are trying to sell stocks short, and you can’t because the tick is not in your favour, you can’t truly understand it,” he said. “When panic and emotion spreads, it slows the process down a little bit and I believe it does help ameliorate emotional swings.”