Stopping the madness—on the way up and down

One of the hardest things to control in the investment world is the movement to extremes. Sometimes asset classes go parabolic, exploding higher, which leads everyone scrambling to find ways to force a more gradual ascent. Conversely, when the high-fliers take a nose dove, everyone wants it to be a gradual descent, not a crash. Right now, there are dual efforts to limit both the upside and downside in financial markets.

On the upside, there have been Congressional efforts to create more stability in the soaring commodities markets. Lawmakers have discussed everything from banning pension funds from commodities markets (this seems a bit extreme and unlikely to pass) to increasing reporting requirements to setting speculation limits on over-the-counter trading. Yet sometimes the simplest solutions are buried in the conversation.

When I started my career, my stock-trading father marveled at the low margin requirements in the commodity futures and options markets. While poor ol’ Dad had to slap down 50% to trade stocks on margin, my friends and I were only required to put down less than 10% for our trades. I think it’s probably time to increase the margin requirements for commodity futures traders. To that end, Senator Byron Dorgan (D., N.D.), is trying to rally support for raising margins to 25% for any energy traders that aren't commercial producers or purchasers. This would clearly reduce speculative activities, although that does not mean that the price of oil, or any other commodity, will fall. But it might slow down the ride up.

There are also those who believe that evil short sellers are responsible for the current bear market in stocks. I don’t think this is the case, but there has been a significant change in trading rules over the past year. On July 6, 2007 Rule 10a-1 of the SEC 1934 Act, the so-called “Uptick Rule” was eliminated and in my mind, this was a bad decision and has led to increased downside volatility in markets.

The 70 year old regulation attempted to constrain short selling in declining markets by requiring that listed securities be sold short only at a price above their last different sale price. The rule was adopted in response to negative sentiment toward short sellers (sound familiar?) and was enacted to prevent short selling from being used to drive down stock prices in so-called “bear raids” and to limit short sellers from accelerating declines in securities.

The SEC in all of its infinite (and short-sighted) wisdom abolished the rule after determining that it was not necessary. Of course the regulators took this action after a five-year period of rising stock prices and abnormally low volatility. Given the current market conditions, it would seem reasonable to reconsider this decision. With short sales at record levels, rumors swirling on a daily basis and the SEC fighting for its relevancy, it’s time to bring back the Uptick Rule. This action, along with increasing margin requirements, will not stop excesses, but they will help slow them down.