A month after GameStop (GME) shares reached record levels due to trade fueled by Reddit, Wall Street, online broker Robinhood and Reddit are facing polls from the Department of Justice (DOJ), the Commodity Futures Trading Commission (CFTC) and both chambers of Congress.
During GameStop’s two-week meteoric rise, the S&P 500 fell 5% from the peak to the valley. Wall Street felt the full impact of the chaos. Hedge funds suffered a distressing risk reduction event, comparable to the global financial crisis, when retail investors came together to squeeze institutional investors. Fortunes were made and lost in hours, when the now infamous hedge fund Melvin Capital Management became the poster boy for the Wall Street self-help rescue machine.
Suffice it to say that legislators and regulators are paying attention. The incident also caught the attention of Treasury Secretary Janet Yellen and the United States Securities and Exchange Commission (SEC). What now?
A House Financial Services Committee hearing on the GameStop business frenzy, scheduled for February 18, will illuminate existing secular trends that have allowed capital markets to become ridiculous caricatures of themselves.
“We are still learning new things about what happened every day … [T]Financial markets can move quickly, “Andy Progress, senior economic policy researcher at American Progress and a former SEC adviser, told Yahoo Finance Live.” So I think that is why it is really important for investors to be prudent, to be looking for the long term, to be aware of the basic principles about not taking out margin loans and taking risks that they cannot afford. “
Interest conflicts
Robinhood will have to answer difficult questions. You will need to explain why you temporarily banned investors from trading GameStop and other stocks. Robinhood will also have to disclose how it assesses whether its customers are suitable for trading options (even if they are only call options with defined risk). The explosive volume of call options and the leverage built into them are responsible for much of the recent rise in stock prices. Simply distributing leverage to inexperienced traders can be very dangerous.
Last year, Robinhood reinforced the educational section of his website – but only after a UK university student committed suicide after misinterpreting his account statement and financial loss (a lawsuit, filed by the student’s family, against Robinhood is pending) . With the flood of new retail merchants opening new accounts, it would be useful to revisit how brokers across the industry assess customer risk and suitability – and whether or not brokers are actually adhering to their written controls and procedures.
Green compares Robinhood’s commission-free trading to the free services offered by Big Tech that aren’t really free. “The cost is hidden. And they are passed on to ordinary users of major technology sites or other parts of society. So there are hidden costs for many of these platforms and free services that we are going to pay for and we need to think more carefully.” he said.
Robinhood will also have to explain the margin calls he received from Citadel Securities. Like most retail brokers, Robinhood sells the flow of orders from its users to wholesale market makers like Citadel, which is how brokers make money.
This practice, called the pay-per-order (PFOF) flow, is being examined. Wall Street market makers, such as Citadel, paid brokers like Robinhood $ 2.86 billion for customer orders for shares and stock options in 2020, according to data from Bloomberg. The business model needs to be thoroughly investigated to determine how retail investors are actually being affected by it. There’s a lot of money in it, so the stakes are high.
Robinhood and other brokers say they improve the price of filling customer orders when they are served internally at companies like Citadel, Susquehanna International Group and Virtu Financial. But last December, Robinhood paid the SEC a $ 65 million fine, in part, for providing “lower commercial prices” that cost customers $ 34.1 million. Assuming Robinhood has cleaned up its operations, it must still divide its order price improvement statistics into different classes of shares – particularly by share price and market capitalization.
Doug Cifu, CEO of Virtu Financial (the only publicly traded company that pays for order flow), recently defended the practice in a profit call. He said he never saw a piece of data that would validate the claim that PFOF distorts the market.
Traders are concerned about PFOF because it reduces overall market transparency (as well as all over-the-counter transactions) by definition, as the details of these internally combined trades do not reach public data feeds. In addition, there is a reason why these orders are so valuable that they need to be sniffed and recorded. Traders will want companies that buy customer orders to disclose whether they trade before such orders or otherwise seek to profit from the data.
Finally, the stock trading structure itself is likely to be explored. The term pump-and-dump (whether fair or not) is likely to come up during the Congressional committee hearing. In other words, questions will arise about whether or not there was a joint effort to artificially increase stock prices with the intention of selling them at a profit.
Hedge funds pay billions of dollars each year for high-speed exchange data that is much more useful than the slower feed retail investors receive. And it’s that slow retail data feed called National Best Bid and Offer, or NBBO, that is used as a benchmark to determine whether customers are getting a better price at Citadel et. al.
If NBBO were faster and not so archaic, retailers would probably get better fills. But that would affect PFOF’s profitability, and that’s where the problem lies. The NBBO provides a in fact structural safe haven for brokers to deliver fillers at lower prices at the expense of retail merchants.
A 2014 study compared the retail NBBO to the direct feed that hedge funds buy, looking for price shifts. His findings: “Price shifts between NBBOs occur several times per second in very active stocks and typically last one to two milliseconds. The short duration of the shifts makes their costs small for investors who trade infrequently, while the frequency of shifts make them expensive for frequent traders. The higher security price and days with high trading volume and volatility are associated with shifts. “
High trading volume and volatility were hallmarks of the GameStop saga, so it would be useful to quantify exactly what price shifts occurred and how much they cost investors.
“I am not going to propose … a comprehensive reform of the order payment flow, because it is necessary to look at the market as a whole. But I think conflicts of interest are not good for investors. They are not good for our financial markets. We need to reduce them, not … allow them to increase, “said Green.
Jared Blikre is a correspondent focused on markets or Yahoo Finance Live. Follow him @SPYJared