In testimony Thursday before the House Financial Services Committee, newly appointed SEC Chairman Gary Gensler signaled that he is prepared to change existing rules to better adapt to the challenges of today’s market environment, and to ask Congress for more authority where needed.
Gensler was there ostensibly to speak about the speculative trading in GameStop shares that occurred in late January. But the hearing went beyond GameStop and Robinhood to include a discussion of the Securities and Exchange Commission’s regulatory response about a wide range of topics.
In unprecedented fashion, retail investors quickly bid up GameStop shares from $20 to $480 to punish hedge funds shorting the stock. That effort was led by a trader calling himself “Roaring Kitty” and their trading was coordinated in one of social news website Reddit’s subforums (subreddit). The extraordinary trading in GameStop led app-based brokerage Robinhood, a favorite of retail traders for its no-fee trades, and others, to halt trading in GameStop and some other securities.
Despite the notoriety of the GameStop episode, as Gensler stated at the hearing, the larger story is about the intersection of finance and technology. Technology innovates and brings greater access to the capital markets, he said, and regulators need to refresh their rules—but not necessarily their core policy goals— to keep up.
This analysis identifies many of the issues raised during the hearing and, based on Gensler’s oral and written testimony as well as the statements and actions of former acting SEC Chair Allison Lee, anticipates the Commission’s next steps and the ultimate regulatory response to each one.
1. Gamification and User Experience
Issues: The gamification of investing and user experience features, such as behavioral prompts, encourage overtrading, to the investor’s financial detriment.
Next SEC Step: SEC staff to review and assess earlier market events. Staff report to be issued summer 2021. Gensler has also asked staff to prepare a request for public input.
Ultimate Regulatory Response: Depends on staff recommendations, but the SEC is actively looking for violations and Gensler has asked staff to consider expanded enforcement mechanisms. Expect the SEC to look into whether broker-dealers are fully adhering to Regulation Best Interest.
2. Payment for Order Flow
Issues: Payment for order flow is a brokerage’s alternative to charging its customers fees for trading. Wholesalers who purchase a brokerage’s order flow have choices in how orders get executed—and those choices may not be in the retail customer’s best interest. Order flow payment agreements between broker-dealers may represent a conflict of interest with a brokerage’s retail clients because price improvement for customers can result in lower payment to the brokerage, and vice versa.
Ultimate Regulatory Response: Depends on staff recommendations. Expect the SEC to look into whether broker-dealers are fully adhering to Reg BI. Also, the SEC may move to increase transparency and regulation, or even prohibit broker-dealers from routing retail orders to off-exchange market makers in return for payments, as is the case in Canada and the United Kingdom.
3. Equity Market Structure
Issues: Retail volume is dominated by just seven wholesalers. This market structure may deter competition, cause market fragility, and limit innovation.
Next SEC Step: Unclear at this time. SEC staff to make recommendations.
Ultimate Regulatory Response: Depends on staff recommendations. Expect the SEC to look into whether broker-dealers are fully adhering to Regulation BI and to take some steps to encourage more competition for executing retail orders, possibly by restricting or prohibiting off-exchange market makers from routing retail orders.
4. Short Selling and Market Transparency
Issues: The lack of transparency in short-selling positions presents risks to market participants and creates systemic (e.g., GameStop) risks.
Next SEC Steps: SEC staff has been directed to prepare recommendations on short sale disclosures and increasing stock loan market transparency.
Ultimate Regulatory Response: Depends on staff recommendations, but expect a proposal for new disclosure requirements for total return swaps and other security-based swaps.
5. Family Offices
Next SEC Step: SEC staff has been directed to prepare recommendations to increase market transparency.
Ultimate Regulatory Response: The SEC and CFTC have limited authority over family offices and may need to ask Congress for additional regulation and/or authority.
6. Social Media
Issues: Social medial influencers may hype investments, contribute to price volatility, and engage in stock manipulation.
Next SEC Steps: No action against ordinary retail investors stating their opinions. For influencers abusing their status, the SEC will monitor for possible enforcement actions and work to expand its social media monitoring expertise and capabilities.
Ultimate Regulatory Response: The SEC is likely to use its existing authority to restrict the hyping and manipulation of investments by social media influencers.
7. Market ‘Plumbing': Clearance and Settlement
Issues: Unusual increases in trading volumes and price volatility led to broker-dealer imposed trading restrictions during the GameStop phenomenon. Those actions denied retail investors the ability to buy additional shares of so-called meme stocks at critical times.
Next SEC Step: SEC staff have been tasked with considering the adequacy of brokerage disclosure of their policies and procedures regarding potential trading restrictions, the sufficiency of margin requirements, and the appropriateness of broker-dealer tools to manage their liquidity and risk. Staff to prepare a draft proposal for Commission review.
Ultimate Regulatory Response: Depends on staff’s draft proposal, but a shortening of settlement cycle duration is likely to receive close consideration (e.g., shortened from T+3 days to T+1 day or shorter).
8. System-Wide Risks
Issues: Recent market events such as GameStop and Archegos highlight issues of insufficient liquidity, denial of trading access to retail customers, large bank losses, concentration (e.g., market makers and clearinghouses), and systemic risk.
Next SEC Step: Likely increased focus on systemic risk issues and market access. Staff report should include some discussion of these issues and make recommendations.
Ultimate Regulatory Response: Depends on staff recommendations. The SEC should have ample authority to regulate in these areas.
9. Cryptocurrency Trading
Issues: There is no cryptocurrency regulatory framework under the SEC or Commodities Futures Trading Commission. Consequently, there is no market regulator of crypto exchanges and no investor protection from fraud and manipulation.
Next SEC Step: The SEC should provide greater clarity on custody.
Ultimate Regulatory Response: The SEC may ask Congress to consider bringing greater investor protection to the crypto exchanges.
10. ESG Disclosures (Including Climate and Board Diversity)
Issues: Should the SEC mandate ESG disclosures, and what should be included? Are these disclosures material for investors?
Next SEC Step: Gensler appears to be picking up where acting Chair Allison Lee left off. Staff is considering these issues, after which there will be a public comment period on climate risk disclosure, human capital, and diversity.
Ultimate Regulatory Response: Inclusion of ESG disclosures is likely to turn on materiality. Gensler testified that beyond the larger question of disclosure materiality, individual disclosures can represent a meaningful component to someone’s investment decision. Look for Gensler to try to provide investors with information that provides the consistency and comparability of data across various regimes that many want.
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