Uptick Rule Replaces Flash Trading as Market Scapegoat

Bring back the uptick rule? It's the new bogeyman, but the odds of it coming back are not great, and the odds that it would destroy high frequency trading is not great either.

Two weeks ago, hedge fund traders were screaming that they couldn't make any money because of those damn "machines" (which is short for "high frequency traders" or "algorithms" or "anything I don't understand").

This week, the bogeyman is the lack of an uptick rule. If only we bought back the uptick rule, life would return to normal, and hedge fund traders could go back to making obscene obscene amounts of money without all the damn volatility that is shaking their confidence.

And it is shaking their confidence. "I can't be this bad," one famous hedge fund trader said to a trader friend of mine, meaning it was not possible that he could lose this much money.

Of course it's not possible. I mean, these guys are geniuses, right? Hell, a lot of them have been on CNBC. That makes them geniuses, right? They insist: it just isn't normal for the market to move this way, meaning: it's just not possible that the markets could move against my positions. There must be something wrong.

For those of you not in the know: the uptick rule was an SEC rule that restricted the short selling of securities except on an uptick. It was instituted in 1938 after a big selloff in 1937. The selloff was caused because the Roosevelt government stupidly raised personal and corporate taxes and hiked interest rates that broke the fragile recovery. Never mind: evil short sellers got the blame.

After years of debate and study, the uptick rule was removed by the SEC in 2007. Among the reasons cited for its removal was: "they modestly reduce liquidity and do not appear necessary to prevent manipulation."

The elimination of the rule came at an unfortunate time. They got rid of it just before the credit crisis of 2008-2009. More volatility of course ensued, and (surprise!) many famous hedge fund traders (and others) stood up and loudly proclaimed that repealing the uptick rule was why we had so much volatility.

There has been considerable call to bring it back since then, largely as a means of reducing volatility. Even Ben Bernanke has said he would at least be in favor of having the SEC re-examine the restoration of the rule.

In 2009, the SEC did seek public comment on a proposal to restore a form of the uptick rule in 2009. They did make a change earlier this year: they instituted a "short sale rule" that said when a stock is down 10 percent or more from the prior close, it can only be shorted on the uptick for that day and the following day.

Regardless, there is once again a clamor to bring back the old uptick rule. Proponents hope that it will kill high frequency trading, which is obviously the reason stocks are so volatile. Never mind the global financial crisis, and the fact that no one has a clue what the "E" is in P/E ratio.

It's not clear it would hurt high frequency trading at all. One famous high frequency trader I know started his business in 2001...they traded with an uptick rule all the way through 2007, and did just fine. "It's not about pushing stocks away from fair value, it's about pushing stocks toward fair value," he said, amused at all the hoopla.

Another high frequency trader wrote to me: "Because of our ultra-fast feeds, we would know before most other players when the stock is no longer in an uptick. you can imagine how that would be a big advantage."

Also: any uptick rule would have exemptions for market makers, and since many high frequency traders are also market makers, they would likely be exempt.

Finally, here's the bottom line: the chances the SEC would bring back the old rule is close to zero. They studied this for years, and changed it after careful study. Bringing in a "short sale rule" earlier this year was another way of throwing a bone to those demanding a change.

Here's my prediction: next week we will move on. The cause of all this volatility will be pinned on: exchange-traded funds (ETFs)! Market manipulators! They buy the ETF and short the underlying stocks! Or something like that!

Whatever! Somebody...do something! I'm famous and I'm losing money!

And of course, I will write a blog post on it. It never ends.

Bookmark CNBC Data Pages:


Want updates whenever a Trader Talk blog is filed? Follow me on Twitter: twitter.com/BobPisani.

Questions? Comments? tradertalk@cnbc.com