The U.S. Securities and Exchange Commission on 18th October published a report analyzing the frenetic activity in shares of retailer GameStop Corp and other ‘meme’ stocks, in January, and suggested certain areas for additional regulatory review.
The report will have consequences that alter where retail stock orders are processed and how that service is compensated for when brokers can limit the trading and the degree of openness surrounding short sells. The report comes after US securities authorities investigating the unexplained rise in GameStop shares in January asked for further investigation of ‘game-like elements on certain trading platforms.
SO, WHAT HAPPENED
Shares of GameStop surged more than 1,600 percent in January as retail investors collaborated in discussion boards like Reddit’s WallStreetBets to attempt to bid up the heavily shorted stock and force hedge funds to unwind their bets against it, with the hope the short squeeze would drive the price even higher.
The fluctuation in GameStop shares, among other prominent meme stocks, led the clearinghouse that ensures transactions before they are completed to increase the collateral from brokers to clear the deals. That prompted many brokerages, notably Robinhood Markets, to temporarily suspend trading in the red-hot stocks, helping halt the surge, upsetting ordinary traders, and shaking market confidence. Others, including Charles Schwab Corp altered margin requirements and restricted sophisticated options strategies on the impacted equities
WHAT ACTUALLY PROMPTED THE SET UP OF RETAIL TRADING
In late 2019, major retail brokers like Schwab and Fidelity copied Robinhood’s lead and removed trading fees. Then, in early 2020, with COVID-19 lockdowns confining people at home, big entertainment and sports events canceled, and government stimulus payments delivered to many U.S. families, retail trade volumes surged.
While the primary story surrounding the GameStop craze was individual investors taking on large hedge funds, institutional investors were also significant participants in buying and selling.
WHAT HAPPENED TO THE MARKET BECAUSE OF THIS
To comprehend what happened in January 2021, it is essential to understand the market framework within which the incidents happened. From the viewpoint of individual traders, the lifespan of a stock transaction begins with an investor putting an order via an account they create with a broker-dealer.
The broker-dealer then directs the order for execution to a trading center, such as a national securities exchange, an alternative trading system (‘ATS’), or an off-exchange market maker. Once a trading center executes the order, the client receives a confirmation and the transaction is reported to a securities information processor that gathers, consolidates, and publishes the price and volume data to market data suppliers and others.
This processor will go on to publish the transaction information (that the buyer and seller both report the same security, price, shares, and dollar amount.) The transaction information in question is also transmitted to the clearing broker, who confirms the deal by checking the trade data.
The clearing broker must ‘settle’ an equity trade inside of a couple of days of the completion of the transaction by formally shifting the stock from the seller’s brokerage firm’s account to the buyer’s brokerage firm’s account and relocating the money from the buyer’s brokerage firm to the seller’s brokerage firm, a process made possible by clearing agencies enrolled with the Commission under the Exchange Act.
REPERCUSSIONS FOR GAMESTOP
Congress conducted numerous hearings on the GameStop episode. The SEC has sought public opinions on the impact of the ‘gamification’ of trading applications and if the public is in danger. Additionally, the major post-trade utility for U.S. equities has suggested reducing the settlement period for stock transactions to one day after the deal occurs, from two days. Various businesses and industry organizations have made suggestions on increasing transparency surrounding the execution of retail orders.
LAWS SURROUNDING BROKER-DEALERS
Broker-dealers are usually required to register with the Commission according to the Exchange Act and are subject to federal securities laws as well as the rules and supervision of the SROs to which they belong. Generally, broker-dealers that do business with the public in securities must join FINRA. Broker-dealers are also beholden to a multitude of regulatory standards, including those imposed by the Commission and, where applicable, FINRA and the exchanges to which they belong, such as customer account opening obligations, sales practices obligations, and net capital and other financial responsibility rules.
Numerous such laws and regulations establish responsibilities on the way client orders are handled. Broker-dealers are subject to various conduct obligations, including the duty of ‘best execution,’ which usually requires a broker-dealer to execute client orders at the most advantageous terms reasonably available in the circumstances, which is typically the best reasonably available pricing.
Additionally, FINRA Rule 5320 (commonly referred to as the ‘Manning Rule‘) prohibits FINRA members from trading ahead of customer orders (e.g., receiving a customer order to buy and then purchasing for its own account at a price that would satisfy the customer’s order without providing the customer with that price or a better price).
SO, WHAT DID THE REPORT SAY
Investors were anticipating Securities and Exchange Commission Chair Gary Gensler’s findings and recommendations on GameStop/Robinhood/Reddit saga for well over six months. Gensler’s Report centers around Gamestop as well as the market structure of the US trading system. Investors in Reddit chatrooms and subreddits like WallStreetBets pushed up the value of GameStop shares in January, according to Robinhood/Reddit. Many of these transactions were made on Robinhood, which later ran into financial difficulties.
The ‘gamification’ of trading in the United States was a major talking point. Gensler is concerned about a number of elements of the country’s trading system (trading with game-like features such as points, rewards, leaderboards, bonuses, and competitions to increase engagement). He’s also been outspoken against the practice of brokers like Charles Schwab sending their orders to market makers in return for fees known as payment for order flow. As a result, some brokers are able to provide zero-commission services.
The Securities and Exchange Commission report analyzing volatility in GameStop and other so-called ‘meme’ stocks, stated the dramatic market movements underlined the need for ‘possible investigation and additional consideration’ of measures to guarantee ‘fair, orderly and efficient markets.
RECOMMENDATIONS FROM THE REPORT
SEC Chair Gary Gensler has already criticized ‘gamification’ on the online platform Robinhood, which is appealing to young investors. Robinhood has been credited with bringing a generation of new individual investors to the stock market, but the platform is also renowned for features that detractors claim may make it addictive.
Under the arrangement, termed payment for order flow, brokerage companies sell the right to execute small investors’ transactions to larger trading houses, which earn modest profits on the difference between the purchasing and selling prices. This method has allowed Robinhood and other brokers to provide free stock trading, but opponents argue this is worrisome. Retail brokers have a motivation to promote greater trading by individual investors, even if it may not be in their best interest.
The tactic was challenged in a proposed class-action lawsuit by retail investors against Robinhood, and some opponents have argued that the time had come to prohibit it. Mr. Gensler had indicated on Capitol Hill and to news outlets that he was ready to explore restrictions or an outright prohibition, but the report offered no evidence that such dramatic changes would be coming since it does not provide details as to recommendations.
WHAT THE REPORT SAID ABOUT GAMESTOP
The SEC report details GameStop‘s rapid increase of a little under USD20 a barrel at the end of 2020 to a high of USD483 on January 12. Yet the SEC said that story did not stop here alone. GameStop purchases by those covering shorts were ‘a small fraction of overall buy volume’ and the company’s share price remained high even after the direct effects of such trades should have waned, according to the regulator
The increase was viewed in the financial media as motivated at least in part by a desire of ordinary investors talking on the Reddit platform cooperating in an attempt to revenge against short sellers.
Seasoned investors saw GameStop’s moves as disconnected from basic concerns about the company’s financial performance and its future. The S.E.C.’s study was the latest effort by regulatory authorities to make sense of the meme-stock rise when a trading frenzy caused stratospheric price gains for companies such as GameStop and the struggling movie company AMC Entertainment.
The report revealed that the fast price rises had been driven in part by so-called short squeezes, as investors who bet against the company, notably hedge funds, had to rapidly reverse course and purchase the shares themselves to close out their holdings.
Momentarily, it appeared, tiny traders had upended the conventional balance of power on Wall Street. But when trading volume increased and prices climbed, many brokers prevented ordinary investors from purchasing the shares of major meme stocks, reversing their gain. The stoppage sparked anger among ordinary investors, a rush of lawsuits, and a variety of internet theories claiming that big Wall Street companies had ordered trade to cease.
WHAT DID THE REPORT SAY ABOUT THE CLEARINGHOUSE
The S.E.C.’s report alternatively highlighted that Robinhood and other platforms had stalled trading in certain shares after the industry-run clearinghouse that settles most stock trades- a technique that requires two additional business days -demanded nearly seven billion dollars from thirty-six clearinghouse members on January 27th, the peak of the frenzy.
That demand is called a margin call. This was intended to guarantee that the stock trading system would continue even if the increasing risk connected with the high trading in meme stocks caused a brokerage company to fail. To minimize the amount required, several platforms restricted trading in certain hot equities.
The clearinghouse’s demands, the S.E.C. concluded, represented a market operating properly — but it indicated that regulators might explore measures to speed up the settlement of transactions, possibly lessening the effect of similar margin calls in the future.
OVERALL THEMES OF THE REPORT
In the report, the SEC focussed on four aspects as a broad area regulation rather than providing recommendations being [A.] forces that may cause a brokerage to restrict trading; [B.] digital engagement practices, [C.] trading in dark pools and through wholesalers and [D.]short selling and market dynamics.
The SEC report did not draw inferences on the main reason for GameStop’s uncertainty, saying, ‘Whether driven by a desire to squeeze short-sellers and thus profit from the resultant rise in price, or by belief in the fundamentals of GameStop, it was a positive sentiment, not the buying-to-cover that sustained the weeks-long price appreciation of GameStop stock.’
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Sources
1. staff, Science X. ‘SEC Report Questions Trading Apps after Gamestop Frenzy.’ Tech Xplore – Technology and Engineering News, Tech Xplore, 19 Oct. 2021, https://techxplore.com/news/2021-10-sec-apps-gamestop-frenzy.html.
2. This is called ‘T+2’
3. The Securities Exchange Act of 1934 (also called the Exchange Act, ’34 Act, or 1934 Act) (Pub.L. 73–291, 48 Stat. 881, enacted June 6, 1934, codified at 15 U.S.C. § 78a)
4. Hatmaker, Taylor. ‘Lawmakers Announce Hearings on GameStop and Online Trading Platforms.’ TechCrunch, TechCrunch, 28 Jan. 2021, https://techcrunch.com/2021/01/28/gamestop-hearings-congress-waters-robinhood/.
‘Rep. Maxine Waters (D-CA), chairwoman of the House Committee on Financial Services, announced plans for an investigation into the situation, pointing to a history of ‘predatory conduct’ from hedge funds.’
5. ‘Concept Release: Securities Transactions Settlement.’ Concept Release: Securities Transactions Settlement; Release No. 33-8398; 34-49405; IC-26384; File No. S7-13-04, https://www.sec.gov/rules/concept/33-8398.htm.
6. The Financial Industry Regulatory Authority (FINRA) is a private American corporation that acts as a self-regulatory organization (SRO) that regulates member brokerage firms and exchange markets. FINRA is the successor to the National Association of Securities Dealers, Inc. (NASD) as well as the member regulation, enforcement, and arbitration operations of the New York Stock Exchange. The US government agency which acts as the ultimate regulator of the US securities industry, including FINRA, is the US Securities and Exchange Commission (SEC).
7. The term Manning rule is the informal name for a financial industry rule in the United States: Financial Industry Regulatory Authority (FINRA) regulation, Rule 5320. It prohibits a FINRA member firm from placing the firm’s interest before/above the financial interests of a client.
8. ‘Consideration should be given to whether game-like features and celebratory animations that are likely intended to create positive feedback from trading lead investors to trade more than they would otherwise,’ stated the 45-page SEC study, which fell short of recommendations.
9. The S.E.C.’s study reiterated that concern: ‘These payments may constitute a conflict of interest for the retail broker-dealer,’ the report stated.
10. Number of clearing brokers experienced intraday margin calls from a clearinghouse. In reaction, some broker-dealers decided to restrict trading in a limited number of individual stocks in a way that some investors may not have anticipated. This episode highlights the integral role clearing plays in risk management for equity trading but raises questions about the possible effects of acute margin calls on more thinly capitalized broker-dealers and other means of reducing their risks. One method to mitigate the systemic risk posed by such entities to the clearinghouse and other participants is to shorten the settlement cycle.
11. Consideration should be given to whether game-like features and celebratory animations that are likely intended to create positive feedback from trading lead investors to trade more than they would otherwise. In addition, payment for order flow and the incentives it creates may cause broker-dealers to find novel ways to increase customer trading, including through the use of digital engagement practices
12. Much of the retail order flow in GMEwas purchased by wholesalers and executed off-exchange. Such trading interest is less visible to the wider market—and payments to broker-dealers may raise questions about the execution quality investors receive. Further, though wholesalers increasingly handle individual investor order flow, they face fewer requirements concerning their operational transparency and resiliency as compared to exchanges or ATSs.
13. While short selling and calls on social media for short squeezes received a great deal of media attention, the interplay between shorting and price dynamics is more complex than these narratives would suggest. Improved reporting of short sales would allow regulators to better track these dynamics.
