Securities and Exchange Commission (“SEC”) Chair Gary Gensler announced recently that, given the recent explosion of skyrocketing demand for retail-investor-led “meme stocks,” the SEC will be examining market structure and considering rule changes to ensure transparency, fairness, and efficiency from online brokers and wholesaler high-speed traders who execute the majority of those orders.
Meme stocks generally see remarkable price increases that are primarily fueled by people on social media (typically Reddit, Twitter, or Tik Tok), and the stocks rarely have the company fundamentals to support the rise in price that follows and are often highly volatile. Once the upward momentum runs out and new investors stop purchasing the stock at higher prices, traders look to exit positions as quickly as possible, which can result in many unsophisticated investors – investors who are not well-versed in market dynamics and valuation – losing money.
This populist-investor uprising has been made possible, in part, by mobile applications such as the online brokerage Robinhood Markets Inc., whose claimed mission is to “democratize finance for all.” It offers zero-commission trading in stocks and cryptocurrencies by using, instead, payment for order flow (“PFOF”). With low barriers to entry, about half of Robinhood’s users are first-time investors with a median age of 31. Most of Robinhood’s revenue comes from trading volume, so the more an investor trades, the more the company makes. This incentive has led to criticism that Robinhood entices its investors to trade more and more through the “gamification” of trades, such as by allowing users to trade partial shares so that, it is argued, money spent seems inconsequential, with a similar appeal as that of a penny slot machine; offers free stock, which appears onscreen as a lottery ticket that a user scratches off; and shows digital confetti after placing a first trade, which could serve as a behavioral prompt encouraging more trading.
One of the most notable examples of a meme stock involved the struggling video game retailer GameStop Corp. (Ticker: GME). In mid-December 2020, GameStop was trading at approximately $14 per share. Several large hedge funds had borrowed GameStop shares and sold them short, betting that the stock would decrease in value and that the company might go out of business. By mid-January 2021, however, online chatter in a retail investing forum on Reddit called WallStreetBets hyped the stock and talk turned to squeezing the hedge funds. Subscribers to the forum quadrupled to more than five million, which was followed by millions of individual investors opting to buy shares of the seemingly faltering GameStop – not necessarily because they believed the company showed promise, but rather because they wanted to push the stock price up to trigger a short squeeze on the hedge funds, forcing the hedge funds to pay exorbitant amounts to buy the stock back. By January 27, 2021, the stock had risen to $380 per share, 2,600% higher than where it was trading in Mid-December at $14 per share. The next day, without warning or apparent justification, Robinhood announced that, in light of “recent volatility,” it was not allowing any users to purchase new shares of GameStop or other meme stocks. Retail investors were outraged by the unilateral action, particularly where hedge funds who had initially shorted the stocks stood to immediately benefit at those individual investors’ expense. While Robinhood’s knee-jerk action may have been spurred in part by the Depository Trust & Clearing Corporation requesting an enormous amount of additional collateral to match the new market value of the stock, retail investors saw conspiracy and a heavy hand on the scale of the established hedge funds.
As the story of GameStop illustrates, meme stocks can be wildly unpredictable. In addition, many meme stock trades are executed outside of public exchanges, and so information about those trades is scarce. The payment for order flow (“PFOF”) system, which online brokers such as Robinhood use behind the scenes instead of charging investors a commission, works as follows. Individual investors buy or sell shares with online brokers who then have the orders filled by high-speed traders known as “wholesalers,” “high-frequency-trading firms,” or “market makers.” A few high-speed trading firms – most notably Virtu Financial Inc. and Citadel Securities – dominate this field. These wholesale firms fill the orders by buying or selling the shares as investors requested and then using complex algorithms skims small amounts off the prices that those investors get, keeping that skimmed amount for themselves. In exchange for access to the orders, the wholesale firms pay rebates to the brokerage companies (for example, Robinhood) that routed the orders to them. The rebates and price skimming are invisible to the investors placing the trade order, who as a general matter see the brokers as offering them commission-free trades.
SEC Chair Gensler seemingly agrees, recently pointing out that “[b]rokers profit when investors trade…. [H]igher trading volume generates more payment for order flow. What makes the current zero-commission brokerage environment different is that investors do not see their costs as they’re executing trades, so they may perceive them as free.” In January 2021, nearly half (47%) of all trading was done with high-speed trading firms and broker-run trading venues known as dark pools, with the remaining 53% done on exchanges.
While PFOF is common, it is controversial because it can create an incentive for brokers to send investor orders to the high-speed trading firm that is willing to pay the brokerage the most in rebates, rather than to the one that provides the best deal for the investor (also known as “best execution”). The SEC requires that brokers disclose to investors that they are engaging in PFOF and insure that investors are getting the best terms for their trades. Brokers claim that PFOF results in investors getting better prices and faster execution; high-speed traders claim it increases liquidity and reduces costs to investors. However, several studies have shown that small investors would be better off without PFOF. Indeed, the United Kingdom, Australia, and Canada restrict PFOF. SEC Chair Gensler is among those skeptics who is concerned that individual investors might get better prices on public exchanges.
There are also transparency issues with PFOF. While public exchanges disclose their bids and offers and then compile the orders to publish a national best bid and offer for every stock, high-speed trading firms and dark pools do not reveal their pre-trade prices, making the public-exchange information incomplete. Off-exchange venues have to execute trades at prices at least as good as the national best price, which comes from exchanges. But the national best bid and offer might be a substandard benchmark because so many trades happen away from the exchanges that it may not adequately represent the market.
The SEC’s recent announcement is not the first time online brokers and high-speed traders and their business models have been scrutinized by regulators. In September 2020, the Wall Street Journal reported that the SEC was investigating Robinhood for failing to fully disclose that it was engaging in PFOF between 2015 and 2018. The SEC alleged that “Robinhood provided inferior trade prices that in aggregate deprived customers of $34.1 million even after taking into account the savings from not paying a commission.” In December 2020, the Enforcement Division of the Massachusetts Securities Division filed a complaint alleging that Robinhood had engaged in illegal practices, including using gamification to lure inexperienced investors into trading and failing to have adequate controls to keep the service functioning during large market swings. At the end of 2020, Robinhood agreed to pay $65 million to settle the SEC case. Further, at the end of June 2021, Robinhood agreed to pay nearly $70 million to resolve a regulatory action brought by the Financial Industry Regulatory Authority (“FINRA”) alleging that the brokerage misled customers, approved ineligible traders for risky options trading, and failed to oversee technology that malfunctioned and locked millions out of trading. Robinhood did not admit to wrongdoing in either the SEC or FINRA matters and disputes the allegations in the Massachusetts matter.
In making his announcement last month about considering rule changes to address these systemic issues, SEC Chair Gensler stated that the SEC’s current examination will be focused on ensuring that retail investors are getting the best prices on their trades. To determine whether regulations need to be revamped, the SEC will broadly assess PFOF, conflict-of-interest issues PFOF raises, and the lack of competition among high-speed traders in the retail market and the system-wide risks that presents. The SEC will also explore whether the national best bid and offer is being distorted by trading done off public exchanges, including as part of dark pools.
Time will tell whether changes will be made to the relevant regulatory structure and what those changes will be. But SEC Chair Gensler’s comments point to a critical issue worthy of scrutiny, and any changes eventually made would likely be positive ones that shed light and offer transparency to individual (and relatively inexperienced) investors trading in this highly opaque space.