Scott W. Bauguess
Director, Program on Financial Markets Regulation, Salem Center for Policy
What new regulation will GameStop bring?
As the media dust settles and public interest begins to wane, the potential policy implications from the GameStop short squeeze have only just started. Congress is about to hold hearings with some of the players involved, and if they don’t eventually direct the SEC to do something about it, a Gensler led Commission is unlikely to let pass an opportunity to revisit existing rules.
What makes the regulatory attention of this market event so interesting – and uncommon – is the absence of a macro stability concern. Usually it takes a market wide disruption or grand institutional failure. Here, we have an economically insignificant short squeeze of a small cap firm. What makes it newsworthy is the emergence of a new protagonist. No longer is it villain CEO complaining about villain hedge fund. <yawn> The new storyline is social media David against institutional Goliath, and the latter was felled. <wow> So, it is not surprising that a race is now on to produce the first movie.[1]
But it would be a mistake to treat GameStop as a human-interest story without regulatory relevance. In fact, from one perspective, it could be among the most regulatorily relevant events since the global financial crisis. Why? Because it embodies a multitude of market rules and practices that, when considered in isolation, struggle to earn regulatory attention. Now, because of GameStop, they are all wrapped up into one neat package for all to see and evaluate holistically. That rarely happens in government.
Below, I discuss how GameStop opens six areas for regulatory consideration by Congress and the SEC. And I say consideration, not action, because in some cases, the prudent course might be to reaffirm the existing rulebook and do nothing. It is important to remember that risky behaviors and bad outcomes are a natural part of the price discovery process and contribute to market efficiency.
That said, the need for regulatory action is often in the eye of the beholder. The decision depends on a ‘fairness’ versus ‘efficiency’ determination, which to a two-handed economist yields no right or wrong answer, just tradeoffs. Not so for politicians, and that is what will make the upcoming hearing so interesting and potentially polarizing.
- Price Manipulation
Let’s start with the human-interest part of this story – the Reddit trading group WallStreetBets. This will likely be the focus of the upcoming hearings. If you disagree, then ask yourself why the current witness list includes the Reddit ringleader whose online handle contains a word with a scratched-out letter to make it publishable, but leaves off the CEO of the Company without which there would be no event (somewhat embarrassing for GameStop).[2]
Everyone will want to know how a ragtag group of previously inconsequential traders took down a big-time hedge fund, Melvin Capital Management, who reportedly lost 53% of its value, and required a private bailout from a set of investors including Citadel LLC, whose sister securities practice is at the center of another of the issues we will discuss below.[3]
It is hard to argue that they did it with a profit motive, because as all rational investors knew, the price of GameStop would eventually revert to a more intrinsic value. <it did> But this group of traders didn’t care; their losses were a badge of honor and they openly discussed a greater-good cause against evil capitalism – the destructive short sellers. And they taught one a hard lesson – the limit to potential short selling losses is not bounded by rational behavior.
So, the socialists took on capitalism using the tools of the latter. This is how we briefly found ourselves in a world where Ted Cruz and AOC agreed.[4] Their actions also led to early discussion over whether it was illegal price manipulation. But as of now there is no obvious security law violation. Rob Cohen, a former SEC colleague of mine, put it this way[5]:
To the extent people are open and transparent about why they are trading, it is hard to think of that as deceptive in the traditional sense of market manipulation
Unless moderators of the WallStreetBets group arranged a scheme to personally profit, for example, by curating discussion threads to promote a favorable price movement, it is hard to see an enforcement action. And even if they did engage in such a scheme, getting it to work would have been deemed laughable just a few weeks ago. It is one thing to promote a pump-and-dump of a penny stock. Quite another to move prices in a NYSE listed security.
Also in defense of the socialist movement is more recent evidence that institutional investors participated and profited from the price runup.[6] Sentiment and momentum traders operate according to the ‘greater fool theory’ of investing – fine to trade in the direction of irrationally if you are not the last irrationally-trading investor. So, it is possible that sophisticated investors piggy-backed on – and profited from – the GameStop short squeeze.
A feline opportunity to study manipulative trading
In sifting through all the possible responses, two should be front and center. First, SEC quants should analyze the trade data. As Tom Selman, a recent podcast guest of mine pointed out, we shouldn’t assume that trading by this Reddit group of investors ‘caused’ the price movements.[7] Indeed, this should be verified and understood, and the SEC now has the perfect tool in place to support such an inquiry – the Consolidated Audit Trail (a.k.a. the CAT). The rule mandating the creation of the CAT was adopted in 2012, and at that time the Commission stated:
…the Commission relies on market data to improve its understanding of how markets operate and evolve, including with respect to the development of new trading practices, the reconstruction of atypical or novel market events, and the implications of new markets or market rules.[8]
The authors of that sentence couldn’t have better anticipated GameStop. And it just so happens, as of December 13, and after a decade of effort, all equity and options trading across the entire market is finally being collected and stored in a single repository.[9] The timing couldn’t be better. The SEC, as well as the exchanges and self-regulatory organizations like FINRA, are all now able to analyze market wide effects of this and other trading events.
Analyzing and understanding this GameStop trading behavior is critical, because until now, economists and their models have assumed that retail investors are not typically the marginal investor – an economic term for relevance in determining prices. That could be changing. And if it is true that herding among small investors can incite price volatility, then this needs to become part of the regulatory calculus.
Revisit momentum ignition strategies
Second, the SEC should dust off a 2010 concept release on equity market structure.[10] More than a decade ago, the Commission recognized the harm in what is called momentum ignition strategies – bursts of trading that target resting orders to temporarily move prices away from fundamental values. This typically occurs when traders manipulate prices down to trigger stop loss orders, which mechanically ignites further downward price pressure. With GameStop we saw the opposite – pushing prices up to force the covering of short positions, which put further upward price pressure on the short positions.
Clever traders can profit from these manufactured swings at the expense of other market participants. What makes it problematic is that the wealth transfers are not based on inherent market risk and steady-state valuations, a violation of the SEC’s fair and orderly market mandate, and thus a potential market failure that deserves regulatory intervention.
As the 2010 concept release explained, such manipulation is already prohibited. Then, somewhat confusingly, the release asked the public whether additional regulatory tools were needed. That was just the SEC’s coded way of saying they didn’t think they had the right enforcement tools to bring a strong case. That is important because bringing a first case sets a precedent, and federal regulators don’t like to leave things to chance when setting precedents. Losing could exacerbate deleterious market conduct, and many of those that allegedly engage in these practices have deep enough pockets to litigate the ambiguities of existing rules.
Making clear what the rules of the road are is certainly a good thing for markets. This market manipulation aspect of the 2010 concept release was never able to pierce the Dodd Frank Act rulemaking calendar, and now is a good time to revisit potential action.
2. Clearing & Settlement
Another area where the SEC could focus effort is on the clearing and settlement of securities. This is the back-office work that ensures property rights are meticulously maintained. Every time a share is traded, it needs to be assigned to a new owner. In the olden days that meant moving around paper certificates. Today it entails pushing around ones and zeros by way of electrons.
The concern is that the process takes too long. Trades are executed in microseconds, but settlement takes up to two days. That’s right, regulators still apply pony express standards. That matters because for two days someone needs to pony up capital – referred to as margin – to protect against the risk that a trade counterparty fails to uphold their end of the agreement.
As Robinhood learned, that can get expensive during volatile times. We will hear more about this on Thursday, but if reports are true, the clearing agency used for settling equity trades asked for an additional $3 billion during the peak of the GameStop trading frenzy. They couldn’t do it fast enough and had to suspend trading in GameStop and other securities.
Shorten settlement times
This is a market efficiency pursuit more than the correction of a market failure. And two things should be done. The first is improve settlement speed. The current two-day requirement, known as t+2, should lose a day, and possibly more. Some are calling for real-time clearing. After all, it’s just moving electrons, and how hard can that be?
As we learned in 2017, when the SEC lowered the settlement time from t+3 to the current t+2, it can be quite hard. Although the vast majority of trades already clear within one day – as far back as 2011 estimated at more than 90%[11] – it proved hard to move the tail. And even though settlement risk falls with a shorter window, the cost of failure can increase, because there is less time for the clearing agency to make good on the failure, e.g., by liquidating a member’s positions.
So, the Commission settled for an incremental improvement. That was a prudent decision at the time given the uncertainty of the impact on the system. But the 2017 experience and the continued electronification of money systems should make a move to t+1 no more challenging and significantly improve the efficiency of trading.
Recalibrate risk management models at clearing agencies
Second, risk management tools used for equity clearing should be revisited. This points to the Depository Trust and Clearing Corporation (DTCC) and its National Securities Clearing Corporation (NSCC) subsidiary. When determining capital requirements, they undoubtedly use a Value at Risk (VaR) model to estimate the maximum likely loss of a member’s clearing portfolio. The maximum loss depends on several factors, including a return distribution assumption, which uses past return behavior as a guide for future returns.
As Lehman, Merrill, and other banks learned during the global financial crisis, the future need not follow the past. The real-world doesn’t adhere to well-behaved statistical patterns that modelers crave, and the likelihood of extreme events is often underestimated. This is the fat tail problem.
The GameStop trading provides a great opportunity to recalibrate those models, including answering the question of whether an order of magnitude increase in capital requirements was appropriate. This is what the Options Clearing Corporation (OCC) did in 2018 after the February 5 market volatility spike of that year. In a filing with the SEC they concluded:
Due in large part to the over-reaction of the Implied Volatility Model’s to the rise in the VIX, a future shock to the VIX during a time of market stress could result in an increase in margin requirements that likely would impose additional stresses on Clearing Members.[12]
Sound familiar? The NSCC should undertake a similar analysis and work with the SEC to either confirm or adjust their methodologies. Importantly, being overly conservative might at first blush seem prudent, but if conservatism unduly knocks out a clearing member during a period of stress, this puts all clearing members at risk, and creates a crisis where none need exist. Similarly, forcing a clearing member to suspend services to its customers, as happened here, creates a market disruption. As prudential regulators know well, even a healthy bank can fail during times of stress, with contagious consequences, and the SEC should have a similar mindset when it comes to regulating non-bank financial intermediaries.
3. Payment for Order Flow
Turning to a more controversial topic, the GameStop short Squeeze put payment for order flow (PFOF) back in the spot light. Many brokerages sell their customer orders to market makers like Citadel Securities and Virtu Financial instead of routing them to an exchange. Some believe that this is deceptive and harms customers. Robinhood recently paid a $65 million fine to settle charges with the SEC because of this practice, albeit without admitting or denying guilt, as their Chief Legal Officer Dan Gallagher clarified on a recent podcast.[13]
If you don’t understand how PFOF works, don’t feel bad. Most don’t and the media often struggles to explain it well. But not Matt Levine – his recent column makes the issue relatively easy to understand, and is worth reading if you are interested.[14] The short of it is that exchange prices are different depending on whether you are buying or selling. The difference is the bid-ask spread, which becomes the profit for intermediaries who facilitate both sides of a trade. Historically that was earned by market makers operating on exchanges. More recently, large brokerages have worked with firms like Citadel and Virtu to ‘internalize’ the orders by filling them off exchanges.
The current controversy centers on how the off-exchange profit pie is split. Citadel and Virtu offer some of it to the broker, which is the ‘payment’ piece of PFOF. Some of it can also go back to the customer, referred to as ‘price improvement’. Robinhood got in regulatory trouble in part because they weren’t sufficiently clear with their customers about the split.[15] There is now rising concern that the practice is predatory, and should be banned.
Banning PFOF would most likely harm retail investors
As far as trading costs to retail investors go, banning it would be a setback. Prohibiting payment for order flow wouldn’t shrink the profit pie – spreads would remain as they are – but it would increase the likelihood that retail investors do not get any of it. And unless a broker can offer a different subsidy, commission-free trading disappears.
Of course, this argument breaks down when it comes to overall investor welfare. Investors who use lower trading costs to trade more are unlikely to reap long term benefits to their wealth. As Barbara Roper advocates from her position as the director of investor protection at the Consumer Federation of America, investors are better off being boring, by pursing buy-and-hold investing strategies.[16] But taking actions in pursuit of this objective is not squarely within the remit of the SEC. When it comes to securities registered and overseen by the SEC, the focus has historically been on making risks transparent, not preventing investors from taking them.
It makes sense to look (again) at order routing for institutional investors
Where payment for order flow is concerned, attention is likely better placed on the impact of fees and rebates related to the order routing of institutional trades. Their large positions are harder to execute without price impact, and order routing can exacerbate the challenges they face. Many complain that displayed liquidity isn’t real – it disappears before they can reach it – and that the system is rigged against them (think Michael Lewis’ Flash Boys). These are long-standing industry ‘buy-side’ complaints.
The SEC’s transaction fee pilot adopted in 2018 was an attempt to study these concerns, but was struck down in the courts last June as an overreach of their authority. This was an experiment designed to understand the effects of market innovations related to trading fees and rebates that trading venues use to attract order flow. Court decision aside, this strain of PFOF is less well understood and a far greater economic concern than of the kind likely to be discussed at the hearing.
4. Gamification of Trading
Free trading, and apps that allow it to occur at warp speed, have changed the established orthodoxy on investing. The effects are plain for all to see, and the consequences are both good and bad. In dealing with them, regulators may be keen to throw out the baby with the bath water.
Clearly, social media has figured out how to get our attention, and most of us spend way too much time on our phones. Robinhood is the first among the larger security brokerages to tap into the phenomenon. Trading is simple, free (of fees), and can be set up without a minimum account balance. This has encouraged many Americans, particularly young Americans, to start investing for the first time, and earlier than they would have otherwise. This can have long-term societal benefits and should be celebrated.
However, trading too much and treating losses as a badge of honor is not good for most investors. Gamification – making it fun to trade – can exacerbate bad outcomes. Think of how many regrettable things you’ve said over email because the simplicity and ease of doing so catered to your impulses. Like regrettable words, regrettable trades may require long periods of healing.
This doesn’t mean a market failure exists, or that regulation is the best path to improving investment outcomes. You can make a strong argument that it is better for investors to learn from their mistakes, and better they do it earlier in their careers when the stakes are lower. My lesson was the dot.com bubble and have ever since been barbara-roper boring. I do exactly what I teach my students – hold the market portfolio in combination with the risk-free asset (US Treasuries). I focus on keeping costs low. Refreshing that the financial disclosures of Biden’s pick to run the SEC reflect the same.[17]
5. Market Timing and Insider Trading
Changing gear, the SEC recently issued a “Dear Issuer” letter – historically referred to as a “Dear CFO” letter – warning about issuing equity during periods of price volatility. This was likely prompted by AMC Entertainment’s attempt to capitalize on its recent run-up in stock price by issuing new equity. It too became a darling of the Reddit trading group, but unlike GameStop, it used the episode to shore up finances to stave off bankruptcy.
The SEC is clearly taking aim at opportunistic behavior. AMC was already in the midst of raising capital when the Reddit trading frenzy hit, and many new investors likely overpaid for any equity issued during that period (prices are back to where they were pre-Reddit).
This is an interesting development because the current offering rules are clearly designed for issuers to be opportunistic. Shelf registrations like what AMC and other issuers use seek ‘pre-permission’ from the SEC to issue new securities, and once granted, issuers wait for the right time to do so – a high stock price. When that time comes, they can do so quickly. The strategy is no secret. In fact, that is the whole point of the shelf registration (Form S-3) offering rules for well-known seasoned issuers (WKSIs).
The Dear issuer letter isn’t prohibiting this activity, but it is clearly reminding issuers of their responsibilities with the “accuracy and adequacy of their disclosures.” Some will view this as a small dose of ‘merit’ regulation – a bit of moral suasion. Ordinarily a reminder of this sort isn’t needed, but these aren’t ordinary developments. Companies will now be left wondering if there is a problem with being ‘too’ opportunistic – when management would have a hard time arguing that price fundamentals support valuations. Similarly, some investors might be left wondering why GameStop wasn’t more opportunistic.
Not yet receiving attention – that I’m aware of – is insiders selling during trading frenzies. Nothing prohibits them from selling based on favorable information or trading behaviors generated by outside parties, except their conscious if they don’t believe in the valuations. But profiteering of this nature will quickly get the attention of media and Congress if perceived.
Whether it be market timing or insider trading, it is hard to see a policy change without fundamentally altering the underpinnings of the existing and transparency-based regulatory regime. The broader question of what managers should do when someone manipulates their company’s stock price up is an interesting one.
6. Short Selling
Let’s get this one out of the way. Short selling is good for markets and investors. We should celebrate those willing to take risks like Melvin Capital. It helps prevent equity from becoming overvalued and protects investors from buying securities whose prices might otherwise reflect misinformation, foolishness, and at times even fraud and misconduct. It also helps ensure that new capital is allocated to the right companies, making the economy more productive. Short selling is good for market efficiency.
Of course, many CEOs disagree. Their job is to maximize shareholder value (or at least it used to be) and short sellers can appear to undermine this objective as well as their job security. So, it is no wonder that they complain, and they have powerful voices that can influence regulators, particularly during times of stress and volatility. That’s what happened during the global financial crisis. But retrospective analysis of the 2008 short sale ban showed it was a mistake. Credit goes to the SEC for ignoring such calls during the panic period of the pandemic – markets proved resilient and SEC leadership right.
With (evil) short sellers back into the spotlight, and if history proves prescient, it is only a matter of time before pundits start clamoring for the return of the uptick rule and other draconian measures designed to curb the practice. But the better path is to focus on disclosure, not permissibility.
The SEC still needs to implement 929X(a) of the Dodd-Frank Act
A good place to start would be to finally implement the short sale reforms mandated by section 929X(a) of the Dodd-Frank Act. That’s right, it is still marked as “remaining” on the SEC’s website.[18] At some point during the past 11 years they were supposed to have written rules to make short position information available to the public. And it is not as if market participants don’t care about it. The NYSE reminded the SEC of its tardiness in 2015, petitioning that they complete the rule by requiring short-sale activity to be reported on Form 13F the same way long positions are required to be reported.[19] After all, fair is fair.
But as recent as 2019, the Managed Fund Association reminded the SEC that Section 929X envisioned aggregate short disclosure, not individual short positions.[20] Short funds don’t want to make their positions known unless, of course, they want to make their positions known, and even then, they may wish they didn’t. Confusing? So is the economic rationale for keeping short positions hidden, as they currently are.
So, there is Congressionally mandated work to finish. To be fair to the SEC, FINRA has already done some of it for them, reporting daily short interest twice monthly.[21] It almost meets the minimum requirements of 929X. And one area for obvious improvement is to report daily short interest daily instead of twice monthly, to help prevent pockets of short interest to develop in the dark, and perhaps defuse some of the GameStop-type trading episodes. Short selling reporting is a controversial issue, and SEC leadership has for years shied away from tackling it, and now is a good time for Congress to nudge the SEC into action.
FullStop
[1] See, https://www.theverge.com/tldr/22268952/gamestop-stock-stonks-reddit-wallstreetbets-movies-tv-shows-hbo-netflix
[2] As of February 14, the list includes Robinhood CEO Vlad Tenev, Citadel CEO Ken Griffin, Melvin Capital CEO Gabriel Plotkin, Reddit CEO Steve Huffman, and Keith Gill, whose pseudonym is too embarrassing for the House Financial Services to list on the website. See, https://financialservices.house.gov/news/documentsingle.aspx?DocumentID=407152
[3] See, https://www.wsj.com/articles/melvin-capital-lost-53-in-january-hurt-by-gamestop-and-other-bets-11612103117?page=1
[4] See, https://www.wsj.com/articles/why-brokers-had-to-restrain-trading-in-gamestop-shares-11612201242?page=1
[5] See, https://www.washingtonpost.com/business/2021/02/04/yellen-regulators-gamestop/
[6] See, https://www.wsj.com/articles/this-hedge-fund-made-700-million-on-gamestop-11612390687?page=1
[7] Podcast episode found here: https://podcasts.apple.com/uz/podcast/market-self-regulation-with-tom-selman/id1551868502?i=1000508248342
[8] See at Consolidated Audit Trail adopting release at 45727. https://www.govinfo.gov/content/pkg/FR-2012-08-01/pdf/2012-17918.pdf
[9] See, e.g., https://www.iflr.com/article/b1lmx9hd02cr4b/primer-the-consolidated-audit-trail
[10] https://www.sec.gov/rules/concept/2010/34-61358.pdf
[11] In the 2017 adopting release, the Commission stated “2011 DTCC affirmation data indicate that, on average, 45% of trades were affirmed on trade date, while 90% were affirmed on T+1.” See, https://www.sec.gov/rules/final/2017/34-80295.pdf
[12] See, https://www.sec.gov/rules/sro/occ/2018/34-84879.pdf
[13] See, https://podcasts.apple.com/uz/podcast/from-regulator-to-regulated-with-dan-gallagher/id1551868502?i=1000507483411
[14] See, https://www.bloomberg.com/opinion/articles/2021-02-05/robinhood-gamestop-saga-pressures-payment-for-order-flow
[15] See, https://www.sec.gov/news/press-release/2020-321
[16] See, [insert podcast episode once published]
[17] See, https://www.wsj.com/articles/bidens-nominee-for-sec-chief-gary-gensler-reports-net-worth-between-41-million-and-119-million-11613147087
[18] See, list of rules remaining Dodd-Frank Act rules to be implemented here – https://www.sec.gov/spotlight/dodd-frank.shtml#
[19] See, https://www.sec.gov/rules/petitions/2015/petn4-689.pdf. Also, and although I believe my views here to be unaffected, I must note that I was recently retained by the NYSE Group to write a comment letter on data security provisions in the Consolidated Audit Trail. See, https://www.sec.gov/comments/s7-10-20/s71020-8077422-225998.pdf
[20] See, https://www.sec.gov/comments/s7-26-18/s72618-6082119-191807.pdf
[21] See, https://www.finra.org/filing-reporting/regulatory-filing-systems/short-interest