Looking beyond the headlines around payment for order flow (PFOF[1]), the SEC’s recent report[2] on the meme stock volatility in early 2021 provides some clues on where we might see further rulemaking – and where we likely won’t.
To recap the events of January and February 2021, several issuers including GameStop (GME), AMC Entertainment Holdings (AMC) and Bed, Bath & Beyond, Inc. (BBBY) saw rapid increases in the price of their stock followed by almost as precipitous declines over a period of about six weeks. As an example, GME climbed to $483.00 on January 28, representing a staggering 2700% rise from its intraday low on January 8. This price volatility of otherwise un-newsworthy issuers was accompanied at the time by talk of a ‘short squeeze’ aimed at forcing short sellers out of their positions by driving margin calls beyond acceptable limits.
The report does indeed conclude that PFOF needs to be examined further. The practice by some exchanges of offering rebates to brokers that provide liquidity (and charging brokers that take liquidity) potentially create incentives that go beyond simply deciding the best execution venue of a particular trade. Since more flow in total means more opportunity for payment, the SEC is interested in whether this may be creating incentives for brokers to generate more trading volume in the first place and whether this is harmful to investors. Gary Gensler has not been shy about his own views on PFOF and this report may add further fuel to the fire that could eventually lead to restriction or even the elimination of this practice.
Going beyond the PFOF headline, the report provides support for SEC rule-making activity in three other areas: settlement times; digital engagement and dark pools. The trading restrictions imposed by several brokers on January 28 provided the most direct threat to investors. These restrictions took several forms, including: trading limits on the number of contracts in certain securities; restricting activity to existing customers only; and placing certain securities in position-closing only status. Each of these actions limited investor opportunity to act. One conclusion the SEC staff appears to have drawn in the report is that since these restrictions were triggered directly from the margin calls on thinly-capitalized brokers imposed by the clearing houses, and since those margin requirements are a hedge against settlement risk, this risk could itself be mitigated by reducing settlement times further. Anything that inherently reduces settlement risk should reduce the need for, and impact of, margin requirements. Of course, the SEC cannot practicably demand reduced settlement time—this requires changing the settlement infrastructure itself—but it can provide useful encouragement to re-set the priorities of market participants and to support the efforts of the Depository Trust & Clearing Corporation (DTCC) in moving ahead at pace with efforts to push settlement to T+1 or even ultimately T+0[3]. This outcome would not only reduce settlement risk but would require risk and compliance teams to rethink risk as core procedures and supporting technologies undergo fundamental change.
More direct action may come in the area of digital engagement. The report charts the emergence of a new class of investor, typically younger and with less capital but armed with technologies that make placing a trade as simple as just about any other action on your hand-held device. For example, it cites the average Robinhood customer as being 31 years old with an account balance of just $240. Trading apps today may include gamification features that could potentially encourage more – or more leveraged – trading that exposes the investor to heightened levels of risk. The answer is not to impose limits on trading, but it is clearly within the SEC’s mandate to regulate selling and marketing of securities to investors. Features that encourage an investor to ‘go again’ fall within the spirit of marketing and this may be just another area where regulation needs to catch up with technology. Brokerages therefore need to take a look at whether software developments in their retail-facing applications need to pass marketing compliance tests.
When it comes to trades made on private exchanges without published prices, or dark pools, the SEC report notes that off-exchange trades of GME fell from 63% of total trades on January 21 to just 33% on January 28, a period during which the price of GME rose approximately seven-fold. The implication from this report is that off-exchange market makers were reducing their exposures by routing orders to other exchanges rather than taking them internally as they saw risk escalate. Given the SEC’s mandates to protect investors and to maintain the fair operation of markets, the likely area of focus for the SEC here is whether dark pools provide privileged access to information that creates advantages for some market participants over others. This is another area with respect to which the SEC has already signaled its interest, which it could address, for example, by requiring more, and more timely, data on price and activity from off-exchange venues to be published.
Finally, there are some indications within this report of areas that may not attract further rulemaking, either because they did not appear to contribute to distortions or because they stood up well during a period of intense strain. The report appears to conclude that short-selling was not a contributing factor, stating that “it was the positive sentiment, not the buying to cover, that sustained the weeks-long appreciation of GameStop stock,” and it is anyway hard to conclude that short-sellers made anything at all out of this event. Short-sellers tend to play a long game and, in the case of GameStop, the price settled above $100 after the traumatic first two months of the year, more than five times its price at the beginning of the year. Institutional fund managers came out of this creditably, too. Certainly, while some funds that were short lost value, others that were long gained, and no advisors “experienced liquidity issues or counterparty difficulties.” So in many ways the market infrastructures held up well. Even the SPDR S+P Retail ETF, which saw its GME position balloon from 1.5% of its portfolio at the beginning of the year to 19.98% by January 27,continued to operate through some significant redemption activity.
Events like the meme stock frenzy test our infrastructure, the fitness of our regulatory environment and the practices of market participants. The Department of Justice has been clear in its expectation that lessons-learned exercises form an essential part of an effective compliance program[4]. Market participants and their compliance teams need to use studies like this as part of these lessons-learned exercises, regardless of whether the Firm concluded it was actually stressed by these events. This is because the study points to possible future changes in rules, such as those proposed by the SEC in December for money market funds[5]. Stress-testing their compliance systems against potential future changes in standards will help market participants demonstrate that they are not asleep at the switch.
[1] Agreement between an Exchange or Market-maker and a Broker that offers compensation to the Broker for liquidity provided by the Broker’s order flow (or charges a Broker that takes liquidity). As described in this report, while retail brokers have reduced commissions they charge to their clients, some have increased other sources of revenue, including PFOF.
[2] Staff Report on Equity and Options Market Structure Conditions in Early 2021 (https://www.sec.gov/files/staff-report-equity-options-market-struction-conditions-early-2021.pdf).
[3] DTCC issued a Working Group report (PDF: 1.7 MB) on December 1, 2021 that reinforces that the primary benefit of reducing the time between order placement and settlement from 2 days to 1 day is the reduction of risk especially in periods of increased volatility since market participants remain exposed to default risk until settlement occurs.
[4] See ‘Evaluation of Corporate Compliance Programs’, US Department of Justice, June 2020.
[5] See proposed rule issued December 15, 2021: Proposed Money Market Fund Reforms (PDF: 2.5 MB).
Anthony O’Reilly has served as a partner at PricewaterhouseCoopers, the Chief Ethics Officer at State Street Corporation, and the Head of Quality for Siemens’ internal audit group. Anthony has developed deep experience in risk management, controls, compliance and business ethics, helping to steer global giants to recovery while under SEC and DOJ monitorships imposed in the wake of compliance failures.
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