NEW YORK -- Designated market makers are disappointed the Securities and Exchange Commission didn't grant them an exception to the new rule banning short sales on plummeting stocks, but they are already anticipating lucrative trading opportunities just before a stock hits the rule's sweet spot.

"There is plenty of room to get creative," said Ross Moore, an industry veteran and the former CEO of market maker LaBranche Structured Products LLC, speaking at a morning conference on the implications and ambiguities of the SEC's new short sale rule.

Rule 201, also known as the alternative uptick rule, will impose restrictions on short sales once a stock triggers the "circuit breaker," a 10% drop in a single day. The uptick rule will apply to short sale orders in that security for the rest of the day, as well as the following business day.

"But what happens between 8% and 10%, just before the circuit breaker is triggered?" Moore asked. "All that pressure has to go somewhere."

Once a plummeting stock reaches an 8% daily loss, a "magnet effect" will likely kick in, said Gary Distell, counsel at Cantor Fitzgerald Securities, as traders smell fear and rush to get their trades in before the circuit breaker is tripped.

Moore thinks the marketplace will develop trading algorithms and strategies that can preemptively speculate on deals just before a stock triggers the 10% breaker and locks out short sellers.

"The people who provide liquidity will be there before it hits 10%," he said.

"This will spur a lot of innovation," said Joe Wald, managing director at Knight Direct, another market maker. "Firms will need to have algorithms that can execute all these orders. They key is to replicate in multiple venues at the same time."

Joseph Mecane, executive vice president and chief administrative officer of U.S. markets at NYSE Euronext, said trading centers will need to work on their policies and procedures to address potential gaps in the rules, such as what happens when erroneous transactions trigger the 10% breaker.

"There needs to be some kind of mechanism to withdraw the trigger" and reopen the stock to short selling, he said.

"A 10% cushion is a pretty wide band for most stocks," Mecane said. "If a stock is going down, though, it might hit 10% mark quicker" if short sellers rush to make deals in anticipation of the 10% trigger.

Uptick Rule

The legitimate practice of short selling allows investors to sell a security they do not own, usually by borrowing it from a brokerage firm, with the expectation that the stock will fall in value in a short time. They then buy the stock at a lower price than they borrowed it for, generating a profit.

The thousands of market makers in the U.S. continually go long and short on stocks in order to find the true price. Without the ability to short, experts argue that overvalued prices could not come down as easily.

While the short sale issue has generated considerable political attention lately, experts on the issue say the original rule was dropped because it was found to have no benefit and was never implemented.

The SEC enacted former Rule 10a-1, commonly known as the "uptick rule," in 1938. That rule prohibited investors from short selling an exchange-listed security unless the sale price of the security had previously ticked upward. This rule remained virtually unchanged for nearly 70 years.

In 2004, the SEC authorized a study assessing the functionality and necessity of price test restrictions. Following a year-long pilot study, the Commission ultimately eliminated all short sale price test restrictions in 2007.

When it was repealed, "nobody cared about the uptick rule," said Erik Sirri, a professor of finance at Babson College and the former director of the SEC's Division of Trading and Markets.

"News of 10a-1's repeal did not even make The Wall Street Journal," Sirri said. "Two years later, people said it almost brought down the country."

Political Storm

When a disaster follows a change in policy, people often suspect the change as the cause. Even if they may not understand the purpose of short selling, there are powerful people who do not care for it and are demanding restrictions, Sirri said.

He said the SEC is a political entity, with commissioners appointed by the president and funding set annually by Congress. Democrats now control the White House, Congress and the majority of seats on the SEC. After passing a monumental healthcare bill last month, Democrats have turned their sights on financial regulation.

The SEC passed Rule 201 on Feb. 24, with a 3-2 vote along party lines. The rule was immediately criticized for being unnecessary and insufficient by Republican Commissioners Kathleen Casey and Troy Paredes, who voted against it. Paredes said short selling is essential to the dynamics of price discovery and market efficiency and ultimately bolsters investor confidence.

The SEC received more than 4,300 comments on the proposal, with approximately two-thirds in favor of reinstating an uptick rule and a third against.

Critics of the old uptick rule call it a joke and say it never worked. They say Rule 201 will only serve to complicate the buy side and won't prevent stock prices from falling.

Furthermore, the rule only applies to stocks listed under the national market system (NMS), which are the least susceptible to manipulation, said Robert Colby, counsel at Davis Polk & Wardwell LLP.

"The rule doesn't apply to stocks that are the most vulnerable," Colby said.

Rather than reinstate the old uptick rule that didn't work, the SEC's new rule is intended to preserve investor confidence and create certainty about how trading restrictions will operate during periods of stress and volatility.

"As soon as our equity markets experience real volatility again, which they will at some point, the Commission will be criticized for not having taken more aggressive action, including full reinstatement of the old Rule 10a-1, which they will argue would have prevented such volatility," Casey said.

"When it doesn't work, people will say, 'See? We should have put the uptick rule in place,'" Sirri said. "The SEC was damned if they did and damned if they didn't."

(c) Copyright 2010 Money Management Executive and SourceMedia, Inc. All rights reserved.

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