House Financial Services Committee Staff Issues Recommendations in GameStop Report
Commentary by Steven Lofchie
The House Financial Services Committee's majority staff published a report on the "Meme Stock Market Event" that provides suggestions for both legislative and regulatory changes as well as a detailed description of the events and the back-office problems that resulted.
The detailed description of the events includes numerous snippets of internal emails. The report discusses the strain that the heavy volume of trading put on clearing and executing firms and describes Robinhood's various payment-for-order-flow arrangements, which Robinhood made to obtain additional capital in order to meet collateral calls from DTCC.
The report found that (i) stock trading platforms were not prepared for the growth that the Meme Stock Market Event was promoting, (ii) broker-dealers imposed significant trading restrictions to try to mitigate liquidity and operational issues, (iii) most firms did not have polices in place for excess capital premium charges that could be imposed by DTCC, and (iv) DTCC did not have policies in place for waiving capital default charges.
As a result of the investigation, the report recommended multiple regulatory and legislative changes:
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Congress should require the SEC and FINRA to consider how current rules should change to address new technology, including social media-driven activity
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SEC should have authority to halt trading in a limited number of stocks as to which there is high volatility
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Brokers that execute a high number of customer orders should be required to become a member of, or connect to, a national securities exchange
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Broker-dealers that make markets above a certain level should be required to comply with Regulation SCI (which establishes operational requirements as to certain market intermediaries and firms)
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Regulators should require that retail brokers be subject to stress testing and liquidity requirements
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Clearing brokers should adopt contingency plans to deal with events of extreme market volatility
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FINRA should be required to conduct "more through supervision" of broker-dealers
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Broker-dealers should be required to inform the SEC and FINRA of any trading restrictions that they impose
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Clearing brokers should be subject to additional capital and liquidity requirements
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DTCC and NSCC should conduct additional surveillance of members and should increase the capital and liquidity requirements that they impose on members.
Commentary
For those interested in the back office operations of broker-dealers (or even those who are looking for a great summer beach read), the report's description of the behind-the-scenes doings around GameStop is a page turner.
The report finds fault and recommends more legislation and regulation. This is not a surprise. The more is better approach is not an unexpected response, though it should be looked at critically. To take one example, the report chastises various retail brokerages for shutting down trading in GameStop when the trading resulted in excessive risk to the firms. At the same time, the report recommends that the SEC have authority to halt trading in all stocks that become volatile. That seems contradictory. Isn't it better that an individual firm stop trading in a stock rather than having the SEC shut down the whole market for that stock?
As to other recommendations, it is difficult to know whether they are justified or overreactions to unusual events. For example, is it better to impose liquidity requirements (which are effectively ongoing costs) on retail brokers or to recognize that they might need to temporarily stop trading in a stock creating a liquidity issue? The answer to that question is not obvious, but a report such as the one issued takes as its base assumption that more regulation is the right answer. (See GameStop: Regulators Should Focus Less on "Solving the Problem"; More on "Improving the Situation".)
Of course, there may be areas where additional regulation may help, though a full analysis requires looking at whether regulation may itself create issues. Here are a few questions on that point:
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The report states that Robinhood was in financial trouble because it could have trouble meeting its clearinghouse margin requirements. It does not appear from the report, however, that Robinhood was at market risk from the trading. So did Robinhood's financial problems result from taking on too much risk, or is it a consequence of DTCC's authority to demand additional margin in an amount that far exceeded Robinhood's actual risk? Does the authority of CFTC clearinghouses to demand unlimited margin create systemic risk because clearinghouses have the ability to suck unlimited liquidity from the markets generally or from individual market participants? (See, e.g., FIA Considers Effects of CCP Demands for More Margin during Pandemic, and commentary.)
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The report points to the volatility risk created by investors' reliance on social media. Might the SEC's Regulation Best Interest have the perverse effect of driving small retail investors away from "full-service" broker-dealers (who might provide recommendations and guidance to customers) because the legal risk of providing such recommendations make full-service brokerage for small customers a bad business? Perhaps as a result, these customers turn to Reddit and other social media as an information source, and that may not be a great result. (See Choose One: Best Interest or Full Service.)
None of this is to say that the report's recommendations are not worth consideration. They are. But they ought not to be accepted uncritically.