Quick Recap
Assuming you are broadly aware of this issue here is a brief recap:
Investors getting together on internet message boards (mainly on Reddit) and buying up stocks where they perceive short sellers have interest. This has resulted in some amazing price action, for example GameStop (GME) has traded north of $400 a share in the last week but before this had never traded above $63 since listing in 2002 and had been trading more around the $5 mark through most of 2020.
Whilst a lot of the narrative has been parsed in terms of the plucky Reddit investors taking on the Wall Street hedge funds the reality is likely somewhat different, as this blog from the CFA suggests we have moved quickly to a situation where retail investors are buying from and selling to other retail investors, all the institutional money has left town. In turn those retail investors still invested in these stocks are relying on the Greater Fool Theory whereby valuations are not driven by any assessment of intrinsic value but instead that someone else caught up in the euphoria will come along and buy the shares from you.
One of my favourite websites is called Visual Capitalist who I would recommend if you have not looked at before, they have published a great infographic on this story.
What questions should senior managers and compliance professionals be thinking about?
The regulators have been wary about taking sides in this issue but have issued warnings instead. For example, the FCA warned retail investors about the dangers of buying in volatile markets and the probability that losses would not be covered by the UK compensation scheme (adverse market movements are not linked to regulated firm failure).
Are markets in these becoming dysfunctional or disrupted in a way that impacts regulation?
Whilst prices seem dislocated from reality, markets have generally continued to function despite remarkably high volumes. The exceptions have been some of the low-cost brokers, such as Robinhood in the US, who needed to restrict trading in these stock for prudential reasons and have since raised more capital, for example brokers need capital to cover the risk for the period between execution and settlement which is heightened in volatile stocks. As such this does not look like a clear case of market manipulation.
An area regulators might look at is whether wider stock indices fell as a result of this activity. One suggestion posited is that hedge funds were forced to rapidly sell out of other stocks to pay their margin calls, with most equity indices roughly back to where they started the year, this might not be a priority for the regulators.
Has some other form of market abuse taken place?
Users on message boards have focussed on stocks where public information indicated there were large, short positions held by investors. So there does not appear to be any misuse of confidential or inside information.
Where this becomes more interesting from a compliance perspective is the motivation for those sharing ideas on message boards. Is this just retails investors sharing ideas? A co-ordinated plan to take on the hedge funds? Or something more sinister like a ‘pump and dump’ scheme?
The first situation should be fine as I discuss in the next question. It is the second idea that has caught a lot of imagination in the ‘David vs Goliath’ narrative and might take some unpicking.
The idea on some of the message boards was, by heavily buying these stocks and ‘attacking the shorts’ they would force the funds to also buy in the market to cover the shorts and hence drive the price up further. This is more problematic.
It might be politically unpopular to go after the retail investors however, there is an argument that actions to drive prices away from the natural level could be seen as manipulation as it could be seen as creating a misleading impression.
The third option: pump & dump, is the one that could be clear cut. Are more sophisticated individuals encouraging retail to investors to invest in some of these stocks? This is particularly concerning if these sophisticated traders already had positions in the stocks as has been suggested about some of the ‘Reddit gurus’. In the classic version of this scheme those who have ‘pumped’ the stock to retail investors then ‘dump’ their positions when the price rises and take a profit.
What's the implications of compliance with the financial promotions rules for people "tipping" stocks on platforms like Reddit?
In the UK, the rules on financial promotions are focussed on protecting the less sophisticated. Mainly retail investors.
Usually, to qualify as a financial promotion someone needs to be selling a product or service by way of business. If I give a friend some financial advice as a favour, I should be fine. If I start doing this more broadly and receive some sort of ‘consideration’ for this (broadly payment) then the financial promotion will need approval by a regulated person who will check it meets the Clear, Fair and not Misleading tests.
As such most of those commenting and cheering on stocks on Reddit and other platforms are unlikely to fall into a regulatory perimeter due to the lack of consideration. However, those who benefit from this and/or work in regulated financial services might find the regulators look more closely at them. It would certainly be very unwise for a regulated firm or individual to encourage this speculative activity.
What happens if retail investors lose significant funds and what about offering leveraged trades?
Thanks to Fela Bankole for this question. This has always been the area that concerns me most.
As we have started to see this week some of these stocks are now falling heavily from their highs (GME closed on 2nd February at $90). This is where the Greater Fool Theory really starts to bite. The pool of new retail investors willing to buy the stock begins to dry up, and previous investors start to take profits (sell their stock) then prices will fall heavily. For example, anyone who bought GameStop on Monday morning market open is now sitting on a paper loss well north of 50%.
Most brokers operate on an execution only basis for simple buy and sell business and make it clear that no advice is being offered. The electronic nature platforms and hence lack of human interaction should make this easier to prove.
Where things could get more difficult for firms is when a stock is getting bubbly like this and it seems retail investors are taking outsize risks. In this situation there is risk for firms that regulators and courts decide in hindsight that such brokers should have done more to warn retail investors about the risks they are taking. This is possible because brokers owe a fiduciary responsibility or appropriateness obligation to those retail investors owing to the broker having greater knowledge than the retail investor. We have already seen evidence of brokers mitigating this hindsight risk by taking action both in terms of risk warnings and practical measures like preventing new purchases or requiring higher margin for certain stocks.
The riskier area is where brokers are offering leveraged trading. This basically allows investors to buy stocks without paying the full cost of them, with the balance lent by the broker. Whilst this leverage helps magnify gains, it can of course magnify losses and lead to retail investors losing more than their original investment. Similar risks exist with CFDs and spread betting.
Brokers can try and mitigate this with margin requirements but the risk of some retail investors making heavy losses remains. Best practice is to make noticeably clear to investors about the risks they are taking and only allowing leverage to more experienced retail traders. That said with situations like GameStop et al it might just be wiser not to offer leverage to retail investors at all.
What is the position for platform providers receiving claims from individuals that had failed trades or who were restricted from trading?
This follows on neatly from the previous question and has caused a great deal of angst from some of these retail investors when brokers like Robinhood suspended or limited trading. Generally speaking, the regulators are heavily focussed on operational resilience so expect brokers to maintain their service as much as possible and have some contingency for high volumes. However, regulators also see valid reasons for firms to suspend or limit service. FCA has clearly said the volumes caused by GameStop provides a valid reason.
“Broking firms are not obliged to offer trading facilities to clients. They may withdraw their services, in line with customer terms and conditions if, for instance, they consider it necessary or prudent to do so. Firms are exposed to greater risk and therefore more likely to need to take such action during periods of abnormally high transaction volumes and price volatility.”
As such where brokers can show they had valid reasons for limiting service this is likely to be OK with regulators in the UK. The situation might be more complex in the US where both the left of the Democratic party and the right of the Republican party appear to see this as an opportunity to put pressure on Wall Street.
What about the role of Payment for Order Flow (PFOF)?
This part of the story has been less reported on though the Economist wrote a good article if you have a subscription. The model of zero commission brokerages like Robinhood is interesting. They can charge no commissions by putting in place PFOF with brokers such as Citadel.
How this works is that when retail investors place an order with Robinhood these orders are then passed to Citadel for execution. Citadel pays Robinhood for this privilege. Why?
Well, Citadel can make money on the bid offer spread and benefits from the information this flow provides. These are not insignificant sums either as The Economist reports that Robinhood received over $270 million from such payments in the 1st half of 2020.
This approach has attracted the scrutiny of the SEC in the US who received a settlement from Robinhood of $65 million in December last year in relation to impacts of this PFOF. Most notably the SEC charged that clients were not always getting best execution due to this approach and that their clients were not receiving adequate disclosure about this order routing.
This is likely to stir more interest from Congress in the US on clamping down on PFOF. In the UK it is very unlikely that this arrangement would be allowed (and I note that Robinhood do not operate here yet) as the FCA have been clear about their concerns on PFOF as have ESMA. Whilst there is not an outright ban it needs to be considered very carefully and only for ECPs in certain situations. Please see our previous blog on PFOF.
If you are operating on an online platform like Reddit, what are your regulatory and legal obligations?
This is a difficult question and is really part of wider debate as to what are the compliance responsibilities for platforms like Reddit, Facebook and Google for content that users share on these platforms. In recent years much of the focus has been on content in relation to offensive content, dangerous content, copyright infringement and debates around ‘fake news’. Whilst some of these platforms have cranked up their efforts to remove such content, they are also reluctant to act as police for their platforms for a variety of reasons including free speech and cost. Adding the policing of investment ideas will add to this burden.
In the UK there is a draft Online Harms Bill that will likely further regulate these platforms; however, it currently does not cover economic harm caused by content on these platforms. We are aware that the FCA are pushing parliament hard to reconsider this and retail investors crystallising their losses from this whole GameStop saga must be giving them added ammunition in that debate.
If you are a compliance officer should you approve a PA Dealing request to trade a stock such as GameStop?
Most personal account dealing policies discourage speculative trading activity, and this is definitely best practice. Doing so helps avoid any perceptions around conflicts of interest – that your trading activity is somehow based on you having information others do not. It is also good practice because speculative, short term positions require time and focus, which distracts from the day job.
This is done via minimum holding periods (for example 1 month) and not allowing leveraged trading like CFDs or spread betting.
If your policy does not have such restrictions it might be time to revisit it!
