May 11, 2021 — On May 6th, the House Financial Services Committee (HFSC) held its third (and final) scheduled hearing in response to the GameStop (GME) saga from earlier this year. Democratic lawmakers used the hearing as an opportunity to introduce six draft bills – including those that would require the Securities and Exchange Commission (SEC) to study “gamification” of online trading and prohibit payment for order flow (PFOF). But the hearing was much more noteworthy because it featured testimony from Gary Gensler, the recently confirmed Democratic Chair of the SEC. It also featured the CEOs of the Financial Industry Regulatory Authority (FINRA) and the Depository Trust & Clearing Corporation, or DTCC.
Gensler used the hearing as an opportunity to outline an ambitious plan to have SEC staff review market structure issues in response to the volatility of earlier this year. Some of his ideas (such as a review of PFOF) were expected, while others (such as hinting at a potential rulemaking surrounding “gamification”) were less so. Overall, his comments suggest he will pursue an ambitious rulemaking agenda across several market structure issues.
Below, we summarize Gensler’s apparent plan to address market structure issues coming out of the volatility:
1. Staff report: Gensler flagged in his remarks that the SEC plans to publish a staff report this summer to evaluate the market events from earlier this year. We expect that the report will touch on each of the major issues that he highlighted in his testimony, including a) gamification and user experience, b) PFOF, c) market-making and equity market structure, d) short selling, e) social media, f) settlement timelines, and g) system-wide risks highlighted by the GameStop saga. This report will be an important marker in how the SEC is approaching each of the above issues.
2. Gamification: In the hearing, Gensler expressed concern that “gamification” and behavioral prompts – like “points, rewards, leaderboards, bonuses, and competitions,” and things like push notifications – encourage retail investors to trade more. Gensler referred to academic research that more frequent trading can result in lower returns, and announced that he has asked SEC staff to prepare a request for public input seeking feedback on those issues. While Gensler did not propose a specific solution, he previewed: “I think we need to evaluate our rules, and we may fund that we need to freshen up our rule set.” Overall, it appears that the SEC will consider potential rule changes to address the use of techniques that drive retail investor engagement with broker-dealers like Robinhood.
3. Payment for order flow: As expected, Gensler indicated that the SEC will be taking “a closer look” at the practice of PFOF. Currently, PFOF is legal in the United States, but it cannot interfere with broker-dealers’ best execution obligations. Gensler suggested that the SEC’s review will be broad – looking at not just PFOF from market makers, but also rebates paid by exchanges. While he did not propose a ban or a specific solution, he pointed to a recent SEC enforcement action with Robinhood – in which the broker-dealer accepted worse price improvement for customers in exchange for higher PFOF – as part of the need for a review. He also highlighted that other countries, the United Kingdom and Canada, do not permit PFOF, potentially implying that significant changes to the practice could be on the table.
4. Market makers: One of the more noteworthy parts of Gensler’s testimony was his apparent interest in reviewing broad equity market structure issues, like the growth of dark pools and market making. He noted that the exchanges handle about 53% of volume, while alternative trading systems (“dark pools”) handle 9% and market makers the remaining 38%. He noted that Citadel Securities handles close to half of all retail trading volume, before warning that: “market concentration can… lead to fragility, deter healthy competition, and limit innovation.” Gensler announced that he asked SEC staff to review these issues and explore potential policy approaches as necessary.
5. Short selling: Section 929 of the Dodd-Frank Act required the SEC to promulgate rules that provide for, at a minimum, monthly disclosures of aggregate short positions in companies. In his testimony, Gensler announced that he has asked staff to formulate recommendations on the issue of short sale disclosures.
6. Settlement: Lastly, Gensler opined on the issue of settlement, as the lengthy, T+2, timeline for securities settlement led certain brokers to restrict trading in certain securities (and even have to raise capital) earlier this year. In response, Gensler announced that he asked SEC staff to look at issues, such as whether the brokers were properly disclosing their policies surrounding potential trading restrictions, whether existing margin requirements are adequate, and whether brokers have “appropriate tools to manage their liquidity and risk.” In addition, he expressed his support for shortening the T+2 settlement cycle, and announced that he has asked SEC staff to draft a proposal on the issue. A couple of weeks ago, the DTCC announced alongside industry groups that it is working to shorten the settlement cycle from T+2 to T+1. It appears the SEC will get involved in this effort as well.
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