Washington is working to understand what it can and should do in the wake of the sudden and unexpected boom-and-bust of GameStop Corp. shares.
The reality may be that there is no easy answer.
From payment for order flow to real-time settlement to the gamification of trading, the facets of the U.S. stock market's inner workings that have come under scrutiny amid the meme stock craze have long been debated and discussed across the nation's capital and Wall Street.
"People have been raising these issues for years, and none of them have been particularly solved because they're complex," said Graham Steele, who was the chief counsel to Democrats on the Senate Banking Committee from 2015 to 2017 and now works as the director of the Corporations and Society Initiative at Stanford University's Graduate School of Business.
"You have these salient public moments, but then the policy conversation," Steele said in an interview. "First it goes to a congressional hearing. Then it goes to the SEC. They convene some sort of working group or advisory committee, and then it just goes behind closed doors again. And you get incremental change, if anything."
On Capitol Hill, members of the U.S. House Financial Services Committee will get the first crack on Feb. 18 at debriefing how the financial industry handled the trading volatility and fallout at brokers, hedge funds and among retail traders. Sen. Sherrod Brown, D-Ohio, has also pledged to hold a hearing in the Senate Banking Committee he chairs on the current state of the stock market.
Among the witnesses scheduled to testify are Robinhood Markets Inc. co-founder and CEO Vlad Tenev, Chicago billionaire and Citadel Advisors LLC CEO Ken Griffin and Melvin Capital Management LP founder Gabe Plotkin. Reddit Inc. CEO Steve Huffman has agreed to speak at the hearing too, as has Keith Gill, the former Massachusetts Mutual Life Insurance Co. employee who helped spark the retail trading buying frenzy in GameStop on the popular Reddit board WallStreetBets. Jennifer Schulp, director of financial regulation studies at the Cato Institute, will testify as well.
Here is a breakdown of key points of discussion lawmakers are expected to focus on at the hearing:
At the height of GameStop's rise in late January, Robinhood, whose app has become the face of the pandemic-inspired retail trading boom, began restricting its users from buying certain volatile stocks including the video game retailer, AMC Entertainment Holdings Inc. and BlackBerry Ltd.
Robinhood was not the only brokerage that week that limited trading in the stocks, but it has faced the brunt of the backlash. Customers posted on Reddit that they planned to change brokerages, with some speculating that Robinhood acted at the behest of Wall Street hedge funds like Melvin whose short positions were squeezed by GameStop's soaring price. Others filed lawsuits against the company. And lawmakers spanning the political divide from Sen. Ted Cruz, R-Texas, to Rep. Alexandria Ocasio-Cortez, D-N.Y., blasted Robinhood on Twitter over the irony that its slogan revolves around democratizing finance. Ocasio-Cortez is a member of the House Financial Services Committee.
In reality, Robinhood faced a margin call of more than $3 billion from its clearinghouse to settle the flurry of trades, an increase 10x higher than what the broker had been required to submit the prior week. National Securities Clearing Corp., which is owned by Depository Trust & Clearing Corp., notified Robinhood on Jan. 28 it was raising its daily deposit requirement by more than $3 billion, in part because of the increased risk that the clearinghouse determined the brokerage's customers were taking in trades to buy stocks like GameStop and AMC, according to a Feb. 8 declaration of Robinhood Securities LLC COO James Swartwout that was recently filed in the U.S. District Court for the Central District of California. To offset the unexpected spike to its required deposits, Swartwout said that Robinhood proposed to the clearinghouse that it would limit its customers' purchases of the stocks. The deposit required for the day was eventually dropped to $1.4 billion.
"No doubt that we could have communicated this a little better to customers," Tenev said in a recent episode of the All-In podcast, which is hosted by venture capitalist Chamath Palihapitiya and Robinhood angel investor Jason Calacanis, among others.
Robinhood ended up raising $3.4 billion of additional capital in the days after limiting trading.
For Tenev, the GameStop situation should be a catalyst to speed up what is now a two-day-long process of settling U.S. equity trades.
The Robinhood chief executive has gone on a media tour in recent weeks to advocate for a move to real-time trade settlement. It is an ambitious and complicated goal that would take a massive technological upheaval across Wall Street and much of the global financial system to achieve, while upending certain practices across trading such as securities lending in the process, said Larry Tabb, head of market structure research at Bloomberg Intelligence, in an interview. But moving to real-time settlement would also lower the need for brokerages like Robinhood to post as much capital with their clearinghouses as they do today.
"It's time for T+2 to go," Tenev wrote in a Feb. 2 blog post, referring to the industry jargon for the trade-date plus two days it takes for a trade to settle. "The clearinghouse deposit requirements are designed to mitigate risk, but last week's wild market activity showed that these requirements, coupled with an unnecessarily long settlement cycle, can have unintended consequences that introduce new risks."
Payment for order flow
Under perhaps the harshest scrutiny already in the capital is the practice of payment for order flow, or PFOF.
PFOF involves wholesale trading giants like Citadel Securities Americas LLC and Virtu Financial Inc. paying some retail brokerages like Robinhood, Charles Schwab Corp. and E*TRADE Financial LLC to execute their clients' stock and options orders. The brokers net millions of dollars in revenues, while the wholesalers collect part of a small spread on each of the buy and sell orders they execute throughout the trading day. Not every broker charges for order flow, but for those that do, they set an equal rate for all the wholesalers, who then compete with one another for more orders based on their execution quality.
Brokers and trading firms say payment for order flow has been instrumental in the industry's adoption of zero commissions and that retail investors often get better prices than what is currently displayed on exchanges. However, its critics, including many investor and consumer advocates, have raised conflict-of-interest concerns about how retail investors' trades are being executed.
"We fully expect lawmakers to draw parallels between PFOF and some BigTech activities — the line 'If something is free, you are the product' will be repeated ad nauseam — but any structural changes to PFOF would increase consumer costs and that is politically unpalatable," Compass Point Research & Trading analyst Isaac Boltansky wrote in a Feb. 15 report. "PFOF helped push trading commissions lower, and eventually to zero in many instances, and Washington is highly unlikely to reverse that trend."
The gamification of trading
For Barbara Roper, director of investor protection at the Consumer Federation of America, payment for order flow is emblematic of a much larger concern: Whether brokers are pushing their clients to trade more often through flashy social media-esque designs.
It is a central question in a lawsuit recently filed by the Massachusetts Secretary of the Commonwealth against Robinhood. In the complaint, filed Dec. 16, 2020, the Massachusetts Securities Division argued that Robinhood used aggressive strategies to draw in new and unexperienced investors and gamified trading "to encourage and entice continuous and repetitive use of its trading application."
Concerns over the gamification of stock trading have taken on even more weight since the summer of 2020 when Alex Kearns, a 20-year-old from the Chicago suburbs, died by suicide over concerns that an options bet he made on Robinhood had gone sour, leading him to believe he owed more than $700,000. The Kearns family recently filed a wrongful death lawsuit against Robinhood.
"Free and frictionless trading is not an unadulterated good thing," Roper said in an interview.
Robinhood has continually denied the claims that its platform gamifies trading.
In a Jan. 27 opinion piece published by CNBC, Tenev wrote that those critiques "miss the point" and that investors using Robinhood are "hard-working, pragmatic individuals making sensible, steady choices, as opposed to clinging to some hackneyed stereotype of sports betting on smartphones at the fraternity house."
The broker has made several changes to how its customers trade options in light of Kearns' death, including more educational materials about the financial products and live voice support for customers who have an open options position or one that recently expired, a spokesperson said in a statement. The brokerage has also began escalating customers' emails with questions about exercising their positions.
"We remain committed to making Robinhood a place to learn and invest responsibly," the spokesperson said.