The frenzy driving the price of Gamestop Corp. shares up and down last month revealed weaknesses in the infrastructure of traditional U.S. capital markets that many in the financial industry say could be addressed with technology.
Robinhood Markets Inc., which operates an app that allows small investors to buy and sell stocks with no fees, is facing scrutiny from Congress and regulators over its decision to block users from purchasing shares of GameStop, AMC Entertainment Holdings Inc. and others during a market surge last month.
The Menlo Park, California, company cited capital requirements imposed by regulators and clearinghouse risk policies as the reason behind the temporary buying halt. Regulators are reviewing compliance and the facts surrounding Robinhood’s decision.
The House Financial Services Committee will hold a hearing Feb. 18 to examine GameStop’s stock surge, at which Robinhood CEO Vladimir Tenev is expected to testify.
Ian Combs, an attorney who formerly handled broker-dealer oversight at the Financial Industry Regulatory Authority, told CQ Roll Call that the circumstances surrounding the trade halt will be central to investigators.
“Broker-dealers have so many things to consider: capital requirements, margin rules and liquidity risk,” Combs said in an interview. “These events really can pose an existential threat to the broker-dealer,” who may legitimately have to restrict customer trading in some circumstances, according to Combs, who now tracks financial regulations at Thomson Reuters Practical Law.
Many of the broker requirements are meant to protect the financial system during a two-day lag between the execution of a stock trade and its final settlement. Broker-dealers, including Robinhood, execute trades on demand but must ensure that they have enough capital under SEC regulations to cover that two-day period.
Clearinghouses can also add a volatility multiplier to require additional cash deposits to back specific trades in certain market conditions, and that might also have prompted the trading halt.
The GameStop case revealed weaknesses in the traditional financial system that could be better managed with a shift to technology-based solutions such as blockchain, said Brock Pierce, venture capitalist and director of the Bitcoin Foundation.
Fintech could help reduce the 48-hour lag, he said. Robinhood has called for what’s known as real-time settlement, which would instantaneously transfer shares for money but would require a huge technology upgrade by the industry.
Demand for shares of GameStop, AMC and other companies skyrocketed as investors on the internet message board Reddit spread news that several large hedge funds had staked out heavy short positions on those companies. Short selling involves selling borrowed shares with the hope of buying them back at a lower price.
Individual investors rapidly bought up shares using apps like Robinhood to drive up the price and squeeze the hedge funds, often touting the effort as a populist rebellion against institutional power. Users were incensed when they were blocked from purchasing shares amid this surge. Similar trading apps, WeBull and Public, also restricted purchases of the shares for hours on Jan. 28, citing the capital requirements.
“I find it to be very concerning,” Pierce said in an interview with CQ Roll Call. “By preventing people from buying, they cooled the market and stopped momentum. It definitely had a chilling effect.”
Pierce said he hopes regulators take a “deep dive” to see if any laws were broken, but, as a member of the fintech industry, he has a vested interest in preventing regulatory creep from stifling it.
“People are feeling emboldened by technology,” Pierce said. “I don’t think the answer for regulators is to limit retail traders from trading on market momentum.”
Robinhood secured additional lines of credit and lifted its restrictions gradually. It wasn’t until Feb. 5 that the cap on GameStop stock was fully lifted.
Robinhood gets some of its livelihood from Citadel Securities, a market maker that pays to receive orders from customers. Citadel, a hedge fund, pledged $2 billion to prop up Melvin Capital, one of the hedge funds that had heavily shorted GameStop stock and that stood to lose billions from a rally. This relationship caused public uproar, but Robinhood, Citadel and Melvin Capital denied any collusion. Citadel and Citadel Securities are separate companies, but both were founded by Ken Griffin.
Robinhood customers, meanwhile, filed lawsuits over the trading restrictions, flooded the company with negative reviews and protested outside the company’s headquarters.
Treasury Secretary Janet L. Yellen on Feb. 4 held a closed-door meeting with the heads of financial regulatory agencies, including the Securities and Exchange Commission, to discuss the incident.
Acting SEC Chairwoman Allison Herren Lee said in an interview with National Public Radio that the agency is looking into the events “from a number of different angles.” The SEC will review compliance with applicable regulations, transparency and consistency, Lee said. It will also review whether there was any market manipulation.
Robinhood has denied any misconduct in multiple statements and maintained that it made a risk-management decision based on capital rules. In response to a request for comment, the company referred CQ Roll Call to the recent statements.
Ken Joseph, an attorney who heads the compliance and regulatory consulting practice at Duff & Phelps LLC in New York, told CQ Roll Call that regulators will look for compliance failures and may end up crafting or revising rules based on what they find.
The capital requirements that Robinhood and other platforms cited are “a legitimate concern,” Joseph said. However, regulators will determine if there were other influencing factors.
“As a market participant, part of a broker-dealer’s role is to provide the platform,” said Joseph. “Unless there is some valid reason, you have to fulfill those obligations and keep the doors open.”
He predicts that Robinhood will characterize the GameStop surge as an unforeseeable “black swan” event.
The SEC could review compliance with rules surrounding electronic trading, short selling, liquidity and risk management, and investor disclosures, Joseph said. The Federal Trade Commission, Consumer Financial Protection Bureau, state attorneys general or numerous other regulators could investigate as well.
“This whole series of events has generated a lot of cross-agency interest,” he said.
The effort by large numbers of diffuse retail investors sharing information online and trading on fintech apps to move markets, sometimes with a social agenda in mind, “is not something that the federal regulators have contemplated,” Joseph said.