In this research commentary, Capstone discusses four policy debates we expect to emerge from the recent market volatility.

February 5, 2021 – Last week’s market volatility was remarkable on many fronts—the magnitude of the GameStop Corp. (GME) short squeeze, the breadth with which volatility spread across the market to other heavily shorted stocks, and the fact it was, at least in part, orchestrated by a group of retail investors on a subreddit who call themselves “degenerates.” In the aftermath of the episode, eyes should turn sharply to how regulators and policymakers will respond. Just two weeks into the Biden administration, Congress and securities regulators now must confront front-page headlines surrounding potential market manipulation, the responsibilities of retail brokers, short sales, and payment for order flow (PFOF). In other words, after years of relative inaction, the equity market structure debate may reemerge with some momentum.

Here, we offer four “policy debates” that we believe will emerge from last week’s market volatility and then provide some thoughts on how each may play out. While much remains to be seen about the ultimate response, early signs are that “Wall Street”—retail brokers, market makers, short-selling investors—will be far from immune from the discussion.

1. The first, and maybe most obvious, area of inquiry will be whether any market participants violated securities laws. Market manipulation can take two broad forms, according to the Securities and Exchange Commission (SEC): “pump-and-dump” schemes and trading manipulation. The GameStop situation does not look like a textbook example of either, but it may share some characteristics of each. The SEC surely is already reviewing trading activity, looking for any signs that market participants created or spread false information. Many securities lawyers argue that it would be unrealistic to bring dozens of enforcement actions against retail investors, but it could be easier if there are signs of significant manipulation involving a small number of individuals. On January 29th, Senator Elizabeth Warren (D-MA) wrote a letter to the SEC asking whether practices on the Reddit message boards violated securities laws and implied that the SEC may have to update its rules surrounding market manipulation.

2. The second area of policy inquiry involves the retail brokers that facilitated the trading—and some of which became ensnared in it. Robinhood Markets Inc., the privately held app that catalyzed the industry’s shift to commission-free investing a couple of years back, is the best example. Like some other brokers, on January 28th, Robinhood limited customers’ ability to purchase shares in GameStop and AMC Entertainment Holdings Inc. (AMC), among other volatile securities. Its rationale was to “protect the firm and protect our customers,” causing uproar among their young retail investor client base, some of whom accused the broker of trying to affect market prices or abandoning its mission to “democratize finance for all.” Members of Congress across the political spectrum, from Representative Alexandria Ocasio-Cortez (D-NY) to Senator Ted Cruz (R-TX), blasted Robinhood and asked for investigations. New York Attorney General Letitia James (D) said she was reviewing Robinhood trading activity. A class action was filed. Late on January 28th, it emerged that Robinhood’s decision to limit trading was likely done to meet margin requirements from the Depository Trust & Clearing Corporation (DTCC)—which requires more collateral for volatile and heavily traded securities. Robinhood raised $1 billion from existing venture capital investors that night. Nonetheless, on January 29th, the SEC cautioned that it will review steps taken by brokers “that may disadvantage investors or otherwise unduly inhibit their ability to trade certain securities.”

The Robinhood scrutiny was especially noteworthy in light of recent enforcement actions involving the company. In December 2020, Massachusetts sued the firm for allegedly employing “gamification” techniques and otherwise violating the commonwealth’s new fiduciary rule, and a day later, the broker settled with the SEC for misrepresentations about its payment-for-order-flow relationships. More than half of Robinhood’s customers reportedly owned GameStop stock at some point this week, which could feed the Massachusetts regulator’s narrative that the firm encourages risky trading. Overall, we believe the activity will cast an even brighter spotlight on the marketing tactics of retail brokers and the steps they (and their regulators) should take to rein in risky trading behavior.

3. A third area of fallout from the GameStop situation, short-selling, is back in the crosshairs, at least among some Democratic politicians. On January 28th, the Senate Banking Committee and the House Financial Services Committee (HFSC) both announced that they will hold hearings focused on the state of the stock market. Without specifics, HFSC Chairwoman Maxine Waters (D-CA) accused hedge funds of “predatory conduct” and said the hearing will be focused on “short-selling, online trading platforms, gamification, and the systemic impact on our capital markets and retail investors.” Senate Banking Committee Chairman Sherrod Brown (D-OH) was only slightly less scathing in his announcement. The last time short-selling attracted this level of attention was during the financial crisis, when regulators halted short sales of certain companies and ultimately adopted new rules aimed at restricting naked short-selling. The SEC has a history of arguing that short-selling can have beneficial effects on the market, so a ban is unlikely. But regulators respond to crises—and the current situation raises the possibility that policymakers again could pressure the SEC to review its rules surrounding short sales, perhaps from the lens of reducing volatility.

4. Fourth, and finally, we expect the issue of payment for order flow, once again, to resurface. Many retail broker-dealers, including Robinhood, route customer order flow to market makers in exchange for either price improvement (which benefits the retail customer) or payment for order flow (revenue for the brokerage firm). SEC rules allow payment for order flow. Nonetheless, there are potential conflicts between the broker and the retail customer, as well as between the retail customer and the market maker (market makers may be incentivized to not execute trades at the best prices). While generally permitted, brokers must continue to meet their “best execution” requirements, as well as test execution quality through “regular and rigorous” reviews. The conflicts in PFOF are well-known to the SEC and industry, but each of the potential responses—banning PFOF or requiring PFOF payments to be passed on to customers, for example, in turn, would raise even more market structure questions.

Several narratives have emerged behind the volatility, but one of the more appealing ones is that commission-free retail trading has clearly enabled retail investors, at least when working together, to manipulate prices in a way that perhaps was not possible before. If there were greater restrictions on PFOF, would retail brokers still be able to offer commission-free trading like they can now?

At this early juncture, there are still more questions than answers regarding how the volatility will move the needle on each of these hot-button issues. In the near term, the SEC will conduct deep investigations into market activity and Congress will hold hearings on each of the above issues (these are yet to be scheduled). It also may give some greater credence to progressive policy ideas such as a “financial transaction tax,” which otherwise faces a challenging political landscape to enactment. History indicates the SEC is tremendously cautious when considering equity market structure reforms. But in the longer term, we believe these issues may rise in the priority stack for incoming SEC Chairman Gary Gensler, who we know is not afraid to take on big battles.

To learn more, contact us at sales@capstonedc.com.