Smartphone apps, short-selling rules and steps to ensure broker solvency are all sure to get a closer look from Washington policy makers once the dust settles on the market turmoil that has buffeted GameStop and silver since the start of the year.
Social media is also poised to be scrutinized, with a focus on how Reddit and Twitter have been used to mobilize herds of investors to all make the same trades. Investigations into manipulation will keep the SEC busy for the foreseeable future. The House Financial Services Committee has scheduled a hearing for Feb. 18, likely putting government watchdogs and firms such as Robinhood Markets on the hotseat.
Bloomberg News surveyed ex-regulators, financial analysts and academics to get their take on what remedies are needed to fix the stock market in the months ahead. Here’s an overview of their recommendations.
Apps have fueled the recent proliferation in trading while exposing an army of retail investors to potentially dangerous ways to maximize their bets — including trading options and funding purchases with margin accounts. Lawmakers are already examining what role these new technologies have in making the stock market feel like a video game and sending shares to levels that have no connection to companies’ fundamentals.
Barbara Roper, director of investor protection for the Consumer Federation of America, said the financial incentives of online platforms encourage constant buying and selling, and trading in risky products. “They use nudges that they know will prompt that kind of conduct,” she said.
SEC rules are most strict in cracking down on situations when brokers are recommending stocks, something that Robinhood and other app providers vehemently argue they don’t do. Roper, who has spent her career advocating for retail shareholders, agreed that Robinhood isn’t recommending stocks, which is why she believes the regulations so desperately need to be modernized.
“We need to clearly update our rules to address the way that behavioral psychology prompts can be built into technology driven platforms to ensure that firms can be held accountable for what they’re pushing,” she said.
Jamie Selway, a former executive at broker Investment Technology Group who now works as an investor and an advisor, also said rules are outdated. A big issue for the industry, he said, is whether brokerages are adhering to conduct standards when they allow small-time investors to trade heavily in options.
“Doing something the same way for 20 years is rarely a good plan,” said Selway, who is a financial backer of a startup online trading platform.
In a statement, Acting SEC Chair Allison Herren Lee said the agency is “looking at a number of areas, including compliance with regulatory obligations” and whether investors are getting “adequate and consistent risk disclosure.” A focus is examining “where aspects of our markets need improvement,” she added.
Short-selling rules have enabled hedge funds to make bets that exceed the market values of some companies. In the case of GameStop, AMC Entertainment Holdings and other stocks, such positions became catnip for small-time investors, who coordinated their efforts on Reddit message boards to pursue short squeezes that would hammer the hedge funds.
Larry Tabb, an analyst for Bloomberg Intelligence, said it’s clear that when hedge funds put on short positions that equal 150% of a company’s outstanding shares, the attitude of retail investors is “let’s go charge it.” Key to this debate is what’s known as “naked short selling,” in which brokers allow customers to bet against stocks without arranging to borrow shares in advance.
Doing something the same way for 20 years is rarely a good plan.
Lynn Turner, who was the SEC’s chief accountant during the 1990s boom for dot-com stocks, credits short-sellers for helping uncover Enron and other frauds. But he said allowing them to short more than 100% of a stock looks like manipulation.
Broker solvency rules were a key factor in why Robinhood customers rioted on social media last week, as they were outraged that the firm restricted them from buying more shares. But Robinhood said it had to comply with regulations that ensure firms are well-capitalized and not exceeding risk limits.
A wonky topic that has gotten loads of recent attention on Wall Street is a requirement that stocks be physically deposited in a purchaser’s account within two days of making an order — a process known as “T+2.”
Because stock prices can fluctuate dramatically over those two days, brokers have to post collateral with an outfit called the Depository Trust & Clearing Corp. to ensure that they have the funds to cover the risks that their customers take. The intent is to prevent brokers from getting burned before transactions settle.
This is largely what happened to Robinhood. When GameStop and other stocks rose to astronomical levels last week, the DTCC demanded that Robinhood post more funds. Robinhood responded by tamping down on risk by restricting its customers from adding to their buy orders.
With lightning-fast computers now dominating trading, many market participants have argued that two days is too long to settle trades.
“Moving the industry closer to T+1 settlement is good for everyone because the less risk we maintain in the system, the better off everyone is,” said Shane Swanson, a senior analyst at consulting firm Greenwich Associates and a former director of equity market structure at Citadel Securities.
Graham Steele, a former Senate aide who now runs Stanford University’s Corporations and Society Initiative, noted that post-crisis reforms such as the 2010 Dodd-Frank Act did a good job of tightening regulations and capital requirements for big Wall Street banks. But he said recent events show that more needs to be done to ensure the stability of non-bank broker-dealers.
“A broker-dealer like Robinhood sees the shares its clients bought as their risk and their assets, so the risk is supposed to be small,” Steele said. “But with the leverage the broker-dealer provides to its retail client, it actually becomes its risk too. That’s why stronger capital rules are needed.”
To ensure investors aren’t using social media to manipulate the market, traders should be required to hold on to whatever they are hyping on Twitter and Reddit for at least 10 days, said Joshua Mitts, an associate professor at Columbia Law School who focuses on securities law.
Such a policy would help prevent “pump-and-dump” schemes in which traders spread false information about stocks to engineer a rally before selling at the highs. Mitts added that the ways in which social media is transforming investing — not to mention just about every other aspect of modern life — means that the SEC might have to take on a role in policing content.
“The SEC could take steps to ensure whatever is disclosed is truthful and that social media outlets aren’t being used as ignition sparks to drive prices in one direction or another without ensuring that people who make these statements have skin in the game,” he said.
Turner, the former top accountant at the SEC, said the regulator needs to be much more deliberate in making clear that it’s on the hunt for fraudsters because doing so might eradicate some of the less scrupulous conduct that now seems pervasive in the stock market.
He urged the regulator to announce that it is investigating the actions of both hedge funds and retail investors, and that agency officials are monitoring Reddit chats.
“Neither side here are angels,” Turner said.
He also advised the SEC to conduct a thorough examination of market fairness. Topics that should be part of that review include social media, the role of market makers and high-frequency trading firms, Turner said.
--With assistance from Robert Schmidt and Jeff Kearns.
