This level of speculative short-squeezed frenzy over such a short period is rare but not unprecedented. What was unique about this episode was the genesis of at least some of the buying – a chat group on the online forum Reddit of (purportedly) individual, novice investors, that targeted these stocks at least in part because of their large short positions, and the degree of media attention, as the short squeeze played out for the world to see in real time. Several large hedge funds had shorted stocks like GameStop and AMC and publicized their short positions. Fueled by a perceived David vs. Goliath challenge of taking on Wall Street, the Reddit forum members metaphorically ‘stormed the Bastille,’ helping to drive the stock prices of these companies to dizzying heights and forcing the hedge funds to cover their short positions at enormous losses. Of course the fun could only last so long, and it ended abruptly after several stock brokerage houses, including Robinhood, the trading app favored by many of the Reddit traders, were forced to limit purchases of the targeted stocks due to collateral requirements, eliciting protests from investors, politicians, and celebrities alike.
Although the stocks have already come back to earth, the frenzy and associated media attention of this episode got the attention of Washington. And Washington is not ready to let this one go as quickly as the market has. Though it is not yet clear if there are problems that need solving, this does not mean that Washington will not find a solution. The end result from the Washington side could well be more Wall Street regulation, and perhaps even a financial transactions tax or similar provisions that could significantly affect the financial services industry.
The activity in Washington stemming from the ‘GameStop’ episode has already begun. Treasury Secretary Janet Yellin met on February 4th with SEC, CFTC and Federal Reserve officials to discuss concerns related to the GameStop events and related market volatility. In Congress, the House Financial Services Committee, led by Chairwoman Maxine Waters (D-CA) has scheduled hearings for February 18th, that will include government witnesses from the SEC, FINRA, and DTCC, as well as industry representatives including the CEO of Robinhood, a likely Reddit representative, financial trade association representatives, and possibly a member of the Reddit forum that started the GameStop frenzy. In the Senate, Banking Committee Chairman Sherrod Brown (D-OH) has indicated plans to hold a hearing, but has not yet scheduled a date or named potential witnesses. Many members of Congress, including the unlikely grouping of Senator Elizabeth Warren (D-MA), Alexandria Ocasio-Cortez (D-NY), and Ted Cruz (R-TX), have criticized Robinhood and other brokerages for suspending trading of GameStop and other volatile stocks, echoing the sentiments of protests by individual investors. When Senate nomination hearings commence for President Biden’s SEC Chairman nominee, Gary Gensler, it is safe to assume that the ‘GameStop issues’ will take up a considerable part of the discussion. Gensler’s hearing should also provide some clues as to what actions the SEC may be taking in the future to address these issues. The SEC’s recently released Sample Letter to companies regarding securities offerings during times of extreme price volatility also offers insights into how federal regulators may look to address this issue.
What should you expect from Washington?
As the inquiries proceed in Congress and the Executive Branch, we expect the lines of inquiry to include the following:
- The activities of the Reddit forum. Did this constitute collusion to manipulate the market, and should this kind of activity be subject to enforcement by the SEC?
- The suspension of trading by Robinhood and other brokerages. Why was this necessary and did this help hedge funds at the expense of the small investors?
- The state of the financial markets. Is the GameStop episode a sign that the financial markets are unhealthy?
- The details of transaction flows in financial market trades, such as market makers paying for order flow, and the 2 day settlement rule. Do these hurt average investors?
- What really happened to cause the GameStop frenzy? Were hedge funds secretly profiting on both sides of the trade?
- Was high frequency trading involved?
- Should the SEC be investigating actors (in particular those with deeper pockets) who encouraged the ‘pump and dump?’
What action might Washington take as a result?
It is of course possible that the Congressional hearings and other Washington activity to come will amount to mere political theater, with no significant policy changes resulting. The issues discussed, however, and related concerns, will not be easily forgotten, and could very well result in policy changes down the road. This could include consideration of:
- A return of the ‘uptick rule’ for shorting stocks;
- Broader SEC disclosure requirements related to short positions;
- Limiting or prohibiting short positions beyond the amount the available shares;
- A capitalization requirement for clearing houses;
- Consideration of elimination of the 2-day settlement rule;
- Consideration of a financial transactions (‘Tobin’) tax;
- Prohibiting brokerages from receiving payment for order flow; and
- Imposing new conflict of interest rules related to brokerages and their business relationships with their own equity investors.
As Congress and the Biden Administration continue its investigation into these events and issues, there is undoubtedly the potential for significant policy and enforcement changes that could affect a broad array of those in the financial services industry. We are happy to discuss how we can help you navigate those waters.
Authored by James Wickett, Aaron Cutler, Chase Kroll, Michael Bell, Robert Glennon, Kolo Rathburn.
