Thursday, March 18, 2021

Game Stopped, Part II: House hearing explores best execution, short sales, and gamification in wake of GameStop surge

By John M. Jascob, J.D., LL.M.

The House Financial Services Committee held its second hearing to investigate issues concerning the fairness and stability of the U.S. equity markets following the volatility resulting from the retail short squeeze in shares of GameStop, Inc. and other “meme stocks.” In a session lasting over four-and-a half hours, committee members followed up on the previous hearing in mid-February by questioning witnesses about the conflicts of interest between payment for order flow and best execution, including the relationship between no-fee brokerages like Robinhood Financial and dominant market-makers such as Citadel. The wide-ranging hearing also explored the adequacy of short sale disclosures, whether settlement times should be accelerated, and the impact of gamification on America’s capital markets, among other topics.

The hearing had a partisan flavor from the outset, with Ranking Member Patrick McHenry (R-NC) suggesting that the Democratic members of the committee were using the events surrounding the GameStop volatility to justify further regulations on the capital markets while putting forth the “same old tired ideas.” Representative Brad Sherman (D-Calif), however, rejected the idea that the Democrats were using GameStop to advance some sort of radical agenda, quipping that he had never attended a far-left wing rally where protesters were shouting “end payment for order flow” or calling for retail price improvement.

“Undeniable” conflict of interest. Sal Arnuk of Themis Trading LLC, which acts as a trading agent for large money managers, testified first by saying that the most damaging elements of the meme-stock craze have resulted from: (1) extremely poor investor education; and (2) an “undeniable” conflict of interest presented by the practice of payment for order flow. While payment for order flow may enable broker-dealers such as Robinhood to explicitly charge their customers zero commissions, Arnuk observed, other larger implicit costs dwarf it. And although he acknowledged that payment for order flow is legal, Arnuk expressed wonder at how it possibly could be: “How can a broker, charged with the duty of getting its clients the best available prices, possibly do so by selling that client’s orders to amazingly sophisticated HFT firms, who in turn will make billions of dollars trading against these orders?”

In Arnuk’s view, payment for order increases overall costs in the market for all investors, including pension funds. Arnuk explained that when a few market-makers buy up orders so that as much as a third of the retail trading volume is not represented on exchanges, what is left on the exchanges is much more toxic and costly to trade with. As a result, market impact costs are higher, and spreads are wider as well. Arnuk also cited a study which found that when Robinhood experiences technology outages, spreads in the general market become narrower.

NYSE suggests areas for reform. Michael Blaugrund, chief operating officer of the New York Stock Exchange, said that the NYSE believes at least four areas merit consideration by the SEC for potential equity market regulatory reform. First, the NYSE believes that the SEC should consider shortening the delay for 13F reporting by institutional investment managers of their long positions in equities and listed options from the current 45 days after the end of the calendar quarter. In addition, the SEC should consider mechanisms to complement the public 13F filing process that would enable direct disclosures to corporate issuers when a reportable position is established or fully divested.

The SEC should also consider improving transparency in the securities lending market by establishing an analogous Consolidated Tape for securities lending. Although FINRA collects equity short position information from member firms twice a month, this aggregate data is insufficient for market participants or regulators to understand how supply and demand are changing for stock loans in an actionable fashion, Blaugrund said.

Third, NYSE believes that the SEC should consider eliminating competitive barriers for public investors by allowing sub-penny trading on public lit exchanges. Finally, NYSE supports the growing consensus to accelerate industry settlement cycles from two days (T+2) to one day (T+1) after the trade, Blaugrund said.

Gamification. Dr. Vicki Bogan, Associate Professor of Applied Economics and Management at Cornell University, testified that research in the area of household finance is clear in finding that participating in financial markets is a pathway to building wealth in the U.S. Dr. Bogan acknowledged that the payment for order flow business model used by Robinhood and other online brokers does reduce a significant market friction that historically inhibited access to financial markets for retail investors, and that no direct fee per transaction pricing represents a beneficial way in which the barriers to participation have been lowered.

Dr. Bogan believes, however. that the gamification of investing, which has been pioneered by Robinhood, is not a responsible practice because it has the demonstrated ability to create harm by creating financial fragility through wealth erosion. She noted that online brokers like Robinhood employ powerful behavioral science techniques to influence investor behavior. This is not solely engaging the user in a fun and interactive way by means of the user interface, but also involves using prompts, push notifications, and other nudges for the purpose of eliciting specific behaviors—increased trading by the investor. Given the payment for order flow model, it is in the firm’s best interest to have more trading volume because more volume equates to more revenue, she said.

Dr. Bogan said that one of the key insights from behavioral science research is that nudges have strong and powerful effects. Nudges exploit behavioral biases to trigger specific responses, and knowledge of a bias is not sufficient to mitigate its effect on behavior; mistakes are made even when the stakes are high. In addition, even experienced investors can get caught up and influenced by bias exploiting nudges applied by online brokers engaging in gamification, she observed.

Payment for order flow “has to go.” Dennis Kelleher, the president and CEO of Better Markets, began his testimony by stressing the importance of the issues before the committee, given their impact on the nation’s economic growth. Referencing an exhibit attached to his extensive written remarks, Kelleher said that the business model employed by Robinhood involving payment for order guarantees that retail traders will receive the worst execution for their trades, while high frequency traders will receive the best. As a result, the financial markets have been transformed from a wealth creation system for the many into a wealth extraction system for the few.

Our markets may be the envy of the world, Kelleher said, but that is not preordained or destined to always be the case. The U.S. markets are the envy of the world only because investors believe that they are transparent, well-regulated, and policed. Confidence underpins our markets, he stated; if we lose that, they will not function properly. Kelleher suggested that we are standing on a precipice, as polls show that investors may be losing faith and may be coming to regard the financial markets as being rigged for insiders.

In Kelleher’s view, “payment for order flow has to go.” He urged Congress to remain deeply skeptical of the argument that retail investors have “never had it better.” Kelleher stated that the causes of increased market access for retail investors and the narrowing of spreads over the last 25 years have had essentially nothing to do with payment for order flow. Rather, these improvements stem from technological innovations and cost reductions, the introduction of electronic trading, and implementation of decimalization and other elements of the Regulation NMS framework.

Achieving more equitable access. Michael Piwowar, executive director of the Milken Institute and the former acting chair of the SEC, expressed his confidence that the Commission will identify and pursue any evidence of noncompliance or wrongdoing that occurred during the trading in late January. Accordingly, he focused his testimony on the regulatory policy issues that have been raised in the aftermath of the events.

Piwowar reminded the lawmakers that retail investors enjoy more choices and face lower costs and barriers when investing in public companies than ever before. Low-income households, however, still lag high-income households in ownership rates of public companies. And while he was not aware of any statistics on ownership rates by household income level for private companies, Piwowar stated that the gap there is undoubtedly worse. In Piwowar’s view, this is because SEC rules effectively prohibit low-income investors from investing in this high-growth sector of the economy.

Accordingly, Piwowar believes that the SEC should revisit the accredited investor definition and engage in rulemaking to open up private investment opportunities to all Americans. Because riskier securities must offer investors higher expected returns, prohibiting non-accredited investors from investing in high-risk securities is the same thing as prohibiting them from investing in high-expected-return securities, Piwowar said. Moreover, by adding higher-risk, higher-return securities to an existing portfolio, investors can reap higher portfolio returns with little or no change in overall portfolio risk. And if the correlations are low enough, the overall portfolio risk could actually decrease.