The SEC publishd a long-awaited report on the events of late January 2021 in which several “meme” stocks, like GameStop Corp, experienced significant volatility over a several-days-long period. The report makes few firm conclusions and suggests no singular explanation for the extraordinary volatility nearly 100 stocks, including GameStop, experienced, but the report does suggest that multiple structural aspects of U.S. securities markets may have played contributing roles that merit additional study. The tenor of the report, however, is broadly consistent with proposed regulations already placed on the SEC’s Spring 2021 regulatory agenda and with legislation introduced in Congress that would lessen the impact of industry conflicts of interest.
Key recommendations. The SEC’s GameStop report concluded that further study is needed of the following:
- Forces that may cause a brokerage to restrict trading.
- Digital engagement practices and payment for order flow.
- Trading in dark pools and through wholesalers.
- Short selling and market dynamics
However, the report also concluded that the volatility in meme stocks suggested a “broad participation” by persons in U.S. securities markets while also noting that disagreement over a company’s prospects are to be expected but that they should result in price discovery instead of market disruptions.
For those who were looking for a detailed analysis of the phenomenon of meme stock trading, the SEC’s report may be a disappointment because the agency elected to confine its after-action review to issues related to the structure of U.S. securities markets.
SEC after-action review. The SEC’s report did not identify any single cause of the extreme market volatility in January 2021 and the report made only a few conclusions about discreet events within the larger set of events that constituted the unusual market activity observed in January 2021. Overall, the report said that about 100 stocks were involved and that some of these stocks experienced as much or more volatility than GameStop, but that GameStop, the focus of the SEC’s report, had experienced nearly all of the factors the SEC had identified as impacting “meme” stocks in January 2021: (1) big price changes; (2) big volume changes; (3) significant short interest; (4) frequent mentions in social media such as Reddit; and (5) significant coverage in the main stream media.
However, the SEC also said that GameStop itself was not new to such volatility, which had affected the company’s stock at times over a nearly two year period, albeit reaching a peak in January 2021. The SEC noted an increase in individual accounts trading GameStop during the study period. At a later point in the report, the SEC explained that the increase in individual account activity included accounts trading GameStop options; options trading, the SEC said, had been concentrated in three firms that accounted for 66 percent of such activity (the firms identified by the SEC are Robinhood, TD Ameritrade, and E*Trade Securities).
The SEC made some general conclusions with respect to the role specific types of funds may have played in the January 2021 market volatility. First, the report said that while some exchange-traded funds (ETFs) were impacted by the January 2021 market volatility, there were no clear signs that, at the one ETF featured in the report, that that fund’s creation/redemption or arbitrage mechanism had broken down. Second, the report suggested that hedge funds largely were not to blame. “Staff believes that hedge funds broadly were not significantly affected by investments in GME and other meme stocks,” said the report. “Staff did not observe that any advisers to private funds and registered funds experienced liquidity issues or difficulties with counterparties.”
In the longest section of the after-action review, the SEC observed that trading in GameStop exemplified the potential for short squeezes and gamma squeezes, but went on to conclude that these types of squeezes either played a smaller role or that evidence of their existence could not be obtained. First, the report said that a short squeeze was not a “main driver” of events in January 2021 and that positive sentiment about GameStop appeared to be a more significant factor. Second, there was no evidence of a gamma squeeze (where one hedges risk regarding call options on a company by buying the company’s stock) because options volume at the time favored put options instead of call options and market makers bought instead of wrote call options. Third, naked short sales (i.e., short sales in which the failure to borrow securities results in a failure to deliver securities) could not be adequately measured because “fails to deliver” are a poor measure of short selling activity and, with respect to GameStop, there was a lack of persistent fails to deliver.
The report made one additional set of observations about off-exchange market makers. Here, the report found that 80 percent of off-exchange trading in
GameStop was internalized (versus other venues such as alternative trading systems) and that three wholesalers accounted for 88 percent of internalized trades (the report mentioned two of the three firms: Citadel Securities (50 percent) and Virtu Americas (26 percent)). The report also examined liquidity in GameStop. For example, the report noted that despite an increase in volatility and a related decline in measures of liquidity, liquidity providers still provided liquidity but with fewer shares as GameStop’s share price continued to rise. The report also noted that GameStop’s stock experienced 40 limit up/limit down trading pauses over six days in January 2021.
Commissioners’ statements. SEC Chair Gary Gensler issued a brief public statement that largely repeated the GameStop report’s key recommendations. “January’s events gave us an opportunity to consider how we can further our efforts to make the equity markets as fair, orderly, and efficient as possible. Making markets work for everyday investors gets to the heart of the SEC’s mission,” said Gensler.
A joint public statement issued by Commissioners Hester Peirce and Elad Roisman questioned whether the GameStop report offered any conclusions upon which regulatory action could be based. Commissioners Peirce and Roisman also noted that the Commission had recently adopted a regulation to address quoted spreads in the National Best Bid or Offer (NBBO) regarding best execution for retail investors.
Commissioners Peirce and Roisman summarized their understanding of the GameStop report thus: “In the wake of an anomalous market event, it can be tempting to identify a convenient scapegoat and leverage the event to pursue regulatory actions without regard to the factual record. The report, however, finds no causal connection between the meme stock volatility and conflicts of interest, payment for order flow, off-exchange trading, wholesale market-making, or any other market practice that has drawn recent popular attention.”
Does the report portend further regulation? While the report made few conclusions, it did recommend four topics for further SEC study and potentially guidance or regulation: (1) forces that may cause a brokerage to restrict trading; (2) digital engagement practices and payment for order flow; (3) trading in dark pools and through wholesalers; and (4) short selling and market dynamics. Aspects of these topics dovetail with the SEC’s Spring 2021 regulatory agenda and with legislation introduced in Congress.
For example, the rulemaking agenda contains a pre-rule stage item on gamification that would address the panoply of digital engagement practices, including “gamification, behavioral prompts, predictive analytics, and differential marketing.” In August 2021, the SEC issued a request for information and comment on how broker-dealers and investment advisers address trading technology, including digital engagement practices such as gamification. SEC Investor Advocate Rick Fleming also has spoken on the question of whether gamification features in trading platforms could rise to the level of a recommendation under Regulation Best Interest.
A market structure item at the proposed rule stage would address “payment for order flow, best execution (amendments to Rule 605), market concentration” and other matters. Although payment for order flow and best execution are mentioned in the GameStop report, the SEC’s after-action review seemed to look more closely at market concentration as it related to options trading and internalization. Yet another item at the proposed rule stage would address broker-dealer liquidity stress testing, which could in turn address the GameStop report’s discussion of thinly-capitalized broker-dealers.
Moreover, a regulatory agenda item on the settlement cycle, also at the proposed rule stage, could further shorten the settlement cycle. A few years ago, the Commission shortened the settlement cycle for most securities from T+3 to T+2. The GameStop report noted that equities are currently settled on a T+2 basis and options are settled on a T+1 basis.
Lastly, two items on the SEC’s regulatory agenda would address short sales and the lending/borrowing of securities. The first item would implement the Congressional mandate contained in Dodd-Frank Act Section 929X(a), which requires the Commission to adopt rules to require, in the context of short sales, the public disclosure of “the name of the issuer and the title, class, CUSIP number, aggregate amount of the number of short sales of each security, and any additional information determined by the Commission following the end of the reporting period.” These disclosures would have to occur on at least a monthly basis. A second agenda item would implement Dodd-Frank Act Section 984(b)’s mandate for the Commission to “increase the transparency of information available to brokers, dealers, and investors, with respect to the loan or borrowing of securities.”
Some of these regulatory agenda items also have counterparts in the 117th Congress. The gamification issue would be addressed by a bill (H.R. 4685), sponsored by Rep. Sean Casten (D-Ill), that would require a GAO study of the gamification of stock trading. Studies typically can get bipartisan support on their way from committee to the floor when bills explicitly authorizing agency rules might not, but it is unclear if this bill will get such support because a Republican amendment offered by Rep. Warren Davidson (R-Ohio) was handily rejected by Democrats who said it would gut the bill, although a later colloquy between Rep. Casten and Rep. Bill Huizenga (R-Mich) at least suggested a remote possibility that later revisions could help the bill’s chances. However, Congressional action in the form of a study may or may not have its desired impact because the Gensler-led SEC already has placed gamification on its regulatory agenda. The Casten bill was reported favorably by the House Financial Services Committee in late July 2021 by a vote of 28-23.
The Order Flow Improvement Act (H.R. 4617), sponsored by Rep. Brad Sherman (D-Calif), would require the SEC to study the many facets of payment for order flow (PFOF), including whether broker-dealers should be required to disclose to customers information about the degree of price improvement received on each order so that customers can compare the services offered by different broker-dealer firms. The SEC would have to report to Congress on its findings within six months of enactment, although the SEC could pursue rulemaking on the subject before the study is completed. Representative Sherman said that, unlike other versions of the bill that have been floated, it would not ban PFOF. Republicans on the committee had called foul over a provision that would explicitly allow the SEC to act before the study is completed, although Rep. Sherman suggested that he might be able to accept some technical changes to the bill, but not the wholesale revisions contained in an amendment proposed by House FSC Republicans. The House FSC favorably reported the bill, also in late July 2021, by a vote of 28-22.
A third bill introduced by House FSC Democrats would address the issue of trading ahead, which the GameStop report mentioned in the regulatory overview section of the report but otherwise did not discuss in detail. H.R. 4619, sponsored by Rep. Al Green (D-Texas), would explicitly ban market makers from engaging in the practice of trading ahead. The GameStop report’s brief discussion of the existing ban on trading ahead noted The Financial Industry Regulatory Authority’s Rule 5320, which bans the practice and requires members to have a written methodology regarding the execution and priority of pending orders that is consistent with other FINRA rules. A comment on the bill submitted by The North American Securities Administrators Association, Inc. (NASAA) urged FINRA to mull whether Rule 5320 goes far enough in protecting retail investors, while The Securities Industry and Financial Markets Association (SIFMA) and the American Securities Association (ASA) separately echoed the view of some Republican House FSC members that the bill would duplicate existing limits on trading ahead. The House FSC favorably reported the bill in late July 2021 by a vote of 27-22.