The Covid-19 crisis came at the end of more than two decades that witnessed a significant transformation of financial markets with main catalysts such as financial innovation, technology adoption, and financial regulations. The 2020 stock market’s roller coaster (record price levels and volatility) exposed the financial system’s fragility. This year, the increased volatility in so-called ‘meme’ stocks – i.e., stocks whose trading volume increases not because of the company’s good performance, but because of hype on social media –, has highlighted several problems in financial markets. Although seemingly unimportant, the risk that these events could pose to the entire financial system opens the door for discussions on the implementation of new regulations (or the improvement of older ones).
The GameStop (GME) short squeeze in January 2021 was a strategy by retail investors – specifically, users of the Reddit forum r/wallstreetbets –, to coordinate buying the stock and drive up the price. The dramatic increase in its price, from $18.84 on December 30, 2020, to $347.51 on January 2021, had major consequences for the financial markets and, in particular, for financial intermediaries that were short-selling the stock (a strategy consisting of betting the stock will fall). Thus, Melvin Capital Management, a hedge fund that had publicly announced it was short-selling GME, lost 53% of its value in January and needed a private bailout.
The first regulatory concern raised by the surge in the GME share price is whether it constituted market abuse. A series of questions followed. Did traders engage in illegal price manipulation? Price manipulation affects market integrity and impedes the existence of fair, honest, and orderly markets, which is the main objective of regulators. Did retail investors collude to manipulate prices? The laws governing securities trading consider market manipulation strategies such as “pump and dump” (driving up the price, selling at maximum, and then letting it fall), rumors (creating and spreading false or misleading information), “ramping the market” (actions designed to artificially raise the market price by giving the impression of large trading volume), or “cornering the market” (buying enough of a stock to control the price) to be illegal. All these strategies were used in one way or another in the GME stock’s trading. What is difficult to prove is whether these actions were an intentional conduct, and they were designed to deceive or defraud investors by controlling or artificially affecting the price of securities. Interestingly, the buyers were not only Reddit users; they also included retail investors driven by investor sentiment (quite a few trading through a trading app named Robinhood), short-sellers closing on their positions, and other institutional traders that decided to take advantage of the momentum and make a profit.
The GME case is just an example, but it points to other markets with huge media-induced volatility, such as cryptocurrencies. On May 19, 2021, Bitcoin plunged as much as 30%, while Ether dropped more than 40% in less than 24 hours. However, both had recovered most of their losses by the end of the day. Clearly, regulators have a lot of catching up to do in this field, the questions being not only how to regulate cryptocurrencies, but also who has to do it.
The David and Goliath fight that pitted retail investors against hedge funds put the old topic of the unfair advantage of big players in the financial markets back on the regulators’ focus. One such advantage may be the lack of short-selling disclosure requirements. Regulators had previously discussed this issue and there was no consensus on the measures to be taken. While short-selling has often been associated with market crashes, the empirical literature shows it is a key ingredient for a well-functioning and efficient market, providing liquidity and promoting price discovery.
Today, a lot of retail traders use brokerage houses that offer zero-commission trading. The most popular trading app among retail investors for trading the GME stock was Robinhood. On January 28, Robinhood restricted trading, citing issues with volatile stock and regulatory requirements for clearinghouses. Some people accused Robinhood of manipulating prices, but it was mainly due to large increases in collateral demands from the National Securities Clearing Corporation (the collateral demands are part of a settlement system that takes two business days to settle a stock trade). Although nowadays trades are executed in microseconds, the settlement takes up to two days. Shortening the settlement cycle is already on regulators’ agenda, as the system is considered obsolete in an age where modern computing systems enable much faster trade settlement. Robinhood’s behavior during the GME event also focused regulators’ spotlight on the practice known as “payment for order flow”, whereby a broker receives payments from market makers (dealers) for routing trades to them. This means that even though Robinhood does not have trading commissions, there is a hidden cost due to the execution prices, as the retail investors can be front-run by other market players.
What did we learn from this event? Retail trading increased significantly during the pandemic (not only in meme stocks). A lot of trading (almost 50%) occurs off-exchange, as the order flow is internalized. The result is a deterioration in market quality on the stock exchange, where most institutional investors trade, which therefore negatively impacts long-term investors. To enhance investor protection, regulators should increase transparency and address broker-dealer conflicts of interest.
Do we need more regulation or wiser regulation? We need to understand how the regulatory system can effectively protect retail investors and whether those investors have the financial knowledge to assess the risks involved in their trading. We might also want to understand how regulations adopted with the hope of protecting retail investors could drive them out of the system or diminish the services provided to them. Finally, we should make sure that any new attempts at regulation keep pace with the tremendous change facing financial markets without slowing down technological innovation – and its positive effects.