Gamestop new

Social media-led rallies of so-called ‘meme stocks’ have fuelled debate around functioning of US stock markets. 

Rarely has a stock’s price attracted as much attention as that of US video games retailer, GameStop. In late January, its shares, which ended 2020 at $18.84, soared to $483 before falling to around $50 in early February. As of mid-March, at time of press, shares were trading at around $200, following a second rally which had hit upwards of $300. Several other shares, including Blackberry and AMC Entertainment, experienced similar spikes in January, albeit nowhere near as high as GameStop’s.

Surging share prices are interesting enough, but that the frenzied trading seemed to be stoked by discussion on WallStreetBets, a forum on social media site Reddit, where much of late-January’s discussion focused on squeezing short sellers, particularly certain hedge funds. This has raised many questions about the growing influence of retail investors.

But what really thrust events into the spotlight was when, at the rally’s height on January 28, some brokers, notably Robinhood, restricted GamesStop trading. Conspiracy theories abounded that Robinhood was in cahoots with hedge funds and was working to limit their losses. In reality, Robinhood pointed to substantially increased clearing house margin requirements as the reason.

The events have raised a whole gamut of questions about the functioning of US equities markets, and prompted several probes by policy-makers and regulators. The ensuing debates look set to run for some time.

Retail influx

Individual investor activity in US equities markets has undoubtedly increased substantially in recent years, encouraged by the advent of zero-commission trading — introduced by the aforementioned app-based broker Robinhood in 2013, and copied by other brokerages in 2019. The pandemic, creating a cohort of housebound and time-rich traders, boosted by government stimulus cheques, further amplified this trend.

A spokesperson for retail broker, TD Ameritrade, says: “The industry at large has seen an incredible swell in retail engagement over the past 12 months. To offer a ballpark figure, these days, we’re facilitating about 10 times the trading volume we facilitated on a given day in 2018.”

A spokesperson for broker Schwab (which also owns TD Ameritrade) says it “had added more than a million new accounts in January 2021 for Schwab and TD Ameritrade combined, up 75% compared to December 2020”.

According to estimates from Bloomberg Intelligence, as of mid-February, retail investors accounted for 23% of equity trading (by number of shares) compared to 20% in 2020, 14.9% in 2019 and 10.1% in 2010. Data also suggests these newer investors are bolder than more-experienced peers. A February survey of 430 US online broker users by Deutsche Bank found 26% of those with less than one year’s investing experience engaged in leveraged investing, compared to 9% of those with one to two years’ experience and 3% with more than two years’ experience. Although this is a small data set, it seems to confirm what many in the space suspected.

Retail investors on social media sites talking up the stock in order to squeeze short sellers may have grabbed attention — but it’s not illegal

Craig Marcus, Ropes & Gray

Similarly, new investors were also more likely to frequently trade options, with 50% trading options more than 10 times per month, compared to 35% with one to two years’ experience and 19% with more than two years’ experience. Options trading played a significant role in the GameStop rally. With this new cohort of investors entering the market, perhaps it was inevitable that market dynamics would get a little shaken-up.

Jennifer J Schulp, director of financial regulation studies at the Centre for Monetary and Financial Alternatives, a think tank, believes growing retail investor activity was “likely” to bring changes and that is broadly beneficial. “I think it’s for the better, as it means the market is able to synthesise more information, because there are more participants,” she says, adding that events around GameStop may have “brought some changes in how institutional participants interact with the market,” with them looking at “different risk factors”.

James Angel, associate professor at Georgetown University’s McDonough School of Business, says: “We’re seeing a new generation of investors getting into trading via new technology. Some will do great and some will discover they don’t have any skill at it. But that is not necessarily a bad thing — they are learning by doing.”

Indeed, all market participants providing comment for this feature felt that greater retail investor activity is a development to be welcomed.

Despite some anti-hedge fund rhetoric on social media recently, Bryan Corbett, president and chief executive of the Managed Funds Association, a trade body representing many hedge funds, suggests the “assumption that there is tension between professional investors and individual investors is simply untrue. All investors have a place in the markets.” He adds that “greater access and more participation in financial markets is a good thing. It’s good for the economy, good for the financial markets and ultimately good for workers.”

Hedge fund performance

Interestingly, despite the WallStreetBets-orchestrated short squeeze activity, general hedge fund performance does not appear to have been dented; instead, quite the opposite appears to have happened. Data organisation, Hedge Fund Research’s (HFR’s) February 2021 summary of industry performance states: “Equity hedge strategies … led February performance as the influence of retail investors increased trading volumes and investors expanded their focus to a wider range of individual equities.”

“There’s a been a lot of media attention on a handful of funds that may have experienced losses because they were short. But our data shows there were many more funds that benefitted from the bidding-up of these names, because they were long,” says Kenneth J Heinz, president of HFR. “The hedge fund industry is not five funds. We estimate that 9,100 funds exist globally, and for every one that might be short one position, theres dozens, maybe even hundreds, that could be long.”

Social media behaviour

Such data throws a sceptical light on narratives around squeezing hedge funds. It also leaves open questions about the wider behaviour of social media users promoting GameStop shares. Although there is cause for debate, many financial analysts do not believe the company, which has struggled to adapt to a changing retail landscape, deserves a high valuation.

But while perhaps controversial, offering positive opinions of an unpopular stock, and encouraging others to buy, is not of itself market manipulation, and is unlikely to break US Securities and Exchange Commission (SEC) rules.

Craig Marcus, partner and co-chair of capital markets group at international law firm Ropes & Gray, says: “On the face of it, it’s hard to see there is a claim for market manipulation. What we saw with retail investors on social media sites, talking up the stock in order to squeeze short sellers, may have grabbed attention — but it’s not, on its own, illegal.”

Bridget Moore, co-chair of international law firm Baker Botts’s litigation department, echoes this view: “At this stage, without access to any additional information, it appears to have been a group of people that got together exercising their first amendment rights, not putting out misinformation, but expressing their opinion as to the value of GameStop.”

T+2 under pressure

It is not only Redditers who are having their actions probed. Brokers, as well as the equities settlement infrastructure itself, have been under the spotlight. When brokers temporarily prevented customers from buying GameStop shares on January 28, the restrictions sparked outrage from customers. It also prompted wild speculation about brokers conspiring with ‘Wall Street’ to protect the interests of institutional investors. The reality appears to have been more mundane. 

In testimony to the US House Committee on Financial Services, Vlad Tenev, chief executive of Robinhood, described how margin requirements with its main clearing house, National Securities Clearing Corporation (NSCC), increased from $124m on January 25 to $1.4bn at 9am on January 28, reflecting increased trading volume and additional market volatility risk. Robinhood, he said, had introduced temporary buying restrictions “for one reason and one reason only: to allow us to continue to meet our regulatory deposit requirements”.


Michael McClain, DTCC

In the wake of these events, there have been calls to shorten the trading settlement cycle from its current T+2, or two-day, period.

DTCC, parent of NSCC and the firm responsible for settling most US securities transactions, recently published a white paper outlining proposals for moving from T+2 to T+1 by 2023 — a move that Michael McClain, managing director and general manager of equity clearing at DTCC, says will create increased “capital efficiency”.

“If we reduce the period of time in which central counterparty guarantees are offered, we are also reducing the amount of risk as there will only be one day’s risk for every counterparty, instead of two,” he says. “So that reduces the amount of margin that we have to collect to cover that risk.”

There is some clamour for further shortening, such as T+0 (settlement at the end of the same trading day) or even real-time gross settlement (although this would require a major shake-up of how business is currently conducted, with some potential substantial downsides). Mr McClain says: “We would still like to aim for T+0, but right now we want to deliver as many of the benefits of compressing the settlement cycle with the least amount of operational resource, and T+1 is the optimum settlement cycle to achieve that at this time.”

Off-exchange trading

Growing retail investor activity also appears to be shaking up markets in other ways. Retail brokers typically send trades to market makers for execution. Most of the time market makers will internalise the orders (manage them via their own inventory), rather than executing on an exchange.

There appears to be a correlation between growing retail investor activity and growth in off-exchange trading. In January, 47.2% of trading activity was off-exchange; in February it fell slightly but was still 46.6%, compared to 37.7% in February 2020, according to data from Rosenblatt Securities.

Some concern has been raised about the potential impact of off-exchange trading on price discovery across the market. Justin Schack, a partner and managing director at Rosenblatt Securities, says: “There is a basic starting assumption that if you’re trying to value something, the more people you have within the marketplace for that item who are interested in buying or selling, and are able to interact, the more likely you are to get an accurate price. If you contrast that with a situation where nearly half of the activity is segmented in a way where it’s not interacting with the rest of the market, you have to wonder whether you’re still getting the price right.”

This is a contentious issue because market makers compete to offer the best buy or sell prices in order to attract broker orders, and typically offer better prices than those on exchanges — known as price improvement.

Mr Schack acknowledges this point, but explains his concern is a broader one. “In terms of retail investors, and how market makers compete for their orders from the brokers, more often than not the customer will be getting a better price than if the broker sent their order to an exchange. My question — and I don’t claim to know the answer to it, but I think it needs investigating — is would the exchange price in fact be much better if so much activity was not being segmented and happening off-exchange?”

Doug Cifu, chief executive of Virtu Financial, a major market maker, is sceptical about such concerns, labelling it a “false narrative”. He says retail investors often invest in low-value stocks, an area largely avoided by institutional investors, and therefore questions their ability to impact wider market pricing. Mr Cifu says that of Virtu’s circa 2000 institutional clients, “not a single one of them has ever raised a concern about prices being distorted”.

Virtu also does not, he says, internalise all trades — to manage risk, some trades are executed on exchanges. For retail investors, he argues the current system is “incredibly beneficial” as, along with other major retail market makers, Virtu “competes hard every day to provide better price, better service and guaranteed execution”.

Market data compiled by Bloomberg Intelligence suggests that in 2020, retail market makers collectively generated $3.7bn worth of price improvement.

Payment for order flow scrutiny

Another aspect of the relationship between some retail brokers and market makers, known as payment for order flow (PFOF), has also come under scrutiny in recent weeks.

When a market maker receives customer orders from a retail broker, it will execute those trades on the broker’s behalf and seeks to make profit via differences in the bid–ask spread across all the orders it handles. In some cases, market makers will also send retail brokers a rebate for those orders, or PFOF. Robinhood and several other zero-commission brokers, such as Schwab, TD Ameritrade and E*Trade, receive PFOF. All the above-mentioned brokers state that order routing decisions are based solely on achieving best execution for clients, and are not impacted by PFOF.

In terms of retail investors… more often than not the customer will be getting a better price than if the broker sent their order to an exchange

Justin Schack, Rosenblatt Securities

However, critics argue that brokers are pocketing rebate money which could potentially be directed to customers, allowing them to get better pricing. The campaign group Better Markets, for instance, describes it as a “hidden tax”.

For others, this mechanism is what has enabled zero-commission trading. Fidelity is often cited as an example of a broker which offers commission-free trading, yet does not receive PFOF. However, as one market participant pointed out, Fidelity has a broad business model; for players with less diverse income streams, such as Robinhood, PFOF is of higher importance.

“This is nothing nefarious and it’s nothing new. [PFOF] has been going on for 20 years and it's been reviewed by the SEC at least half a dozen times,” says Mr Cifu. “My view is that those payments have forced innovation and have benefitted the ecosystem. Without PFOF, there wouldn't have been a Robinhood. And I understand there are critics of Robinhood, but ultimately those payments created more competition.”

Although SEC rules already mandate some PFOF disclosure, enhancing it could be one area of potential compromise.

“I don’t think there’s anything inherently wrong with [PFOF]. There is a potential conflict there, but it can be managed,” says Ms Schulp. “But as [PFOF] has become more important, particularly for retail investors, we should look at whether any additional disclosures should be made, so that investors can better understand how their trades are being paid for.”

Mr Cifu echoes this view, saying: “I don't think disclosures around price improvement and PFOF are as crisp and clear as they can and should be. I think as an industry, we can do a lot better.”

The many discussions prompted by recent events seem likely to run for some time. For instance, notably, during a senate banking committee confirmation hearing, incoming SEC chair Gary Gensler pledged to review equity market structure, including PFOF. There will be hopes within the industry that Mr Gensler, a former investment banker turned public servant and regulator, will take a balanced approach to these issues.


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