On Wednesday March 17, I testified before the House Financial Services Committee at their second GameStop hearing. You can read my written testimony in full here, and watch the hearing here. Below are my topline takeaways.
Whose fault is it that Robinhood prevented GameStop buy orders? (Probably Robinhood's)
One of the themes that many Republican lawmakers hit on throughout the day was this idea that it perhaps wasn't Robinhood's fault that they (and other brokerages) prohibited purchasing GameStop stock on January 28. Many Republicans seemed to echo the excuse made by Robinhood in a blog post – blaming the lack of realtime settlement of trades for its trading freeze. I think this is likely a red herring.
Long before Robinhood faced issues raising capital to meet clearinghouse requirements, it had a track record of outages, and design failures with tragic consequences. Over the series of several days in late January and early February, Robinhood drew down “at least several hundred million dollars” from its bank credit lines and then raised some $3.4 billion dollars from investors. Bloomberg reported that Robinhood was going to use the bulk of the funds as collateral at DTCC’s clearinghouse. (Bloomberg’s Matt Levine said that Robinhood’s investors got a "substantial desperation discount" for their emergency investment.) Separately, Robinhood is in talks with banks to raise another $1 billion of debt.
In a blog post on Feb 2, four days after Robinhood halted trading in GameStop, Vlad Tenev wrote “T+2 settlement exposes investors and the industry to unnecessary risk.” To me, this seems like it may be an attempt to blame what may be a failure to manage Robinhood’s own internal risk on industry-wide settlement standards.
While there are certainly reasons to move to settle trades faster (which I discuss below), I think it’s safe to assume that most broker-dealers have many employees dedicated to estimating what amount of capital they’ll need to provide to their clearinghouse on any given day. Proper planning, and ensuring you have enough capital to give the clearinghouse in times of volatility, is a part of running your business!
It would be helpful for the Committee to ask Robinhood how many employees, including how many quants, were building and monitoring their internal capital models prior to January 2021. I suspect the number might be significantly lower than other firms.
Sidebar: What's a clearinghouse? What's capital?
A clearinghouse is an entity that sits between brokerages, and acts to mitigate the risk of any one individual broker failing.
There's a helpful discussion of this in the Committee's memo for the hearing, if you'd like to learn more!
The Depository Trust & Clearing Corporation (DTCC), a member-led holding company that is responsible for clearing and settling much of U.S. stock trades, facilitates the clearing process by serving as a centralized clearinghouse for more than 50 exchanges and equity platforms, processing trillions of dollars in securities transactions daily.
Because there is a two-day period between trade date and settlement date (T+2), there is a risk that a broker may not be able to complete its end of the transaction by the settlement date (e.g. the buyer fails to deliver the cash, or the seller fails to deliver the security) due to potential changes in market or financial conditions, including price fluctuations in the transacted security.
To safeguard against a potential default by either the buyer or seller, the National Securities Clearing Corporation (NSCC), a subsidiary of DTCC, maintains a multibillion-dollar clearing fund which is funded by member brokers, including Robinhood, in the event of such a failure. The clearing fund deposit amounts are calculated at least once daily pursuant to a formula, established by NSCC’s rules, designed to cover the fund’s exposure to a given member’s risk based on the riskiness of that particular member’s portfolio that includes, among other factors, a “member’s concentration in volatile stocks, the volume of trades occurring, imbalances in buying and selling, and the [member] firm’s financial condition.” As a member broker’s risk profile grows, the NSCC may demand that it deposit more money in the fund.This is a free post from Markets Weekly. If you appreciated it, please consider signing up here for premium access to all posts.
The Democrats are concerned about potential conflicts inherent in Payment for Order Flow
I believe it's important for regulators and lawmakers to consider how to make the true costs of trading more transparent. Payment for Order Flow (PFOF), an arrangement where a market maker pays a retail brokerage a pre-set fee for every trade they execute, obscures this cost in many ways. And many Democrats asked about the potential for conflicts in PFOF, beginning with Chair Maxine Waters:
Here is the 2016 memo the SEC wrote to its Equity Market Structure Advisory Committee, asking a series of questions about PFOF. The Commission pointed out that PFOF can “create potential conflicts with a broker’s duty of best execution.” (Best execution is a legal mandate that requires brokers get the most advantageous order execution for their customers.) Brokers must conduct regular and rigorous reviews of its execution quality against competitors to evaluate if it’s obtaining the best terms reasonably available for customer orders.
The SEC’s concerns about PFOF’s potential conflict with best execution now seem prescient! Robinhood has already faced regulatory enforcement actions for past failures on best execution:
- In December 2020, the SEC charged Robinhood with failing to disclose that it was using this Payment for Order Flow model at all. The SEC also found that Robinhood was failing to provide "best execution" to its clients, thus costing them over $34 million due to "inferior trade prices," even when factoring in zero commission trading.
- FINRA fined Robinhood in 2019 for “best execution violations related to its customers’ equity orders and related supervisory failures.” Robinhood paid a $1.25 million fine.
In 2016 the SEC also noted that without PFOF, market makers could have “incentives to quote more competitively,” leading to better prices for their customers. The SEC suggested that if PFOF were prohibited, market makers might need to lean harder on the competitiveness of their quotes in order to gain the business of brokers.
Ending PFOF would not necessarily end commission-free trading
By contrast, many Republicans in the hearing either brushed off concerns about PFOF, or implied in that it would also end zero commissions. But as I mentioned in my written testimony, there are brokerages like Public who ended PFOF in February, but still offer commission free stock trades. And Fidelity doesn't use PFOF for its stock trades, and also offers commission-free stock trades.
Robinhood has simultaneously argued that the PFOF amounts are low — an average of $0.0023 per equity share. If that’s the case, it seems reasonable to expect that, should Robinhood’s revenue stream of PFOF end, the commissions it charges to clients would also be in the $0.0023 per equity share range. Yes, in the past, most discount brokerages used a flat-fee model, with a price-per-order rather than a price-per-share executed. But there's no reason they couldn't use a price-per-share commission model if that's what potential customers were interested in seeing.
Republicans seemed excited to give the SEC lots of enforcement work!
Typically, Republicans are more skeptical of the Securities and Exchange Commission (SEC) doing, well, much. But throughout the hearing, they kept asking former SEC Commissioner Michael Piwowar things like "isn't the SEC already enforcing best execution obligations" for brokers, and highlighting the other ways that the SEC already has authority to look for wrongdoing. Which is of course true!
What's interesting is how hard Republicans seem to want to lean on the SEC, when historically at least, they have been in favor of cutting the SEC's budget, or at least opposing the budget increases the SEC has requested. So I hope (but don't expect) that this is a new era where they will support a well-funded SEC!
Democrats are interested in bringing more transparency to short selling
Rep. Nydia Velazquez pointed out that while large investors like hedge funds must disclose certain long positions, no such disclosure is required for short positions. This means the public doesn’t know what amount of stock hedge funds are shorting; it's not disclosed on the Form 13F hedge funds have to file. The reason we knew that Melvin Capital was short GameStop is because they were short put using put options – and options are disclosed on Form 13F.
To address this, the SEC could move to implement a piece of the Dodd-Frank law that was never implemented: Section 929X(a) required the SEC to write rules to ensure there is monthly, public disclosure of short sales. In 2015, the NYSE petitioned the SEC for them to implement this rule. But it remains unfinished.
Many lawmakers see certain hedge funds as a potential systemic risk
Multiple lawmakers, including Reps. Al Green and Jesus "Chuy" Garcia, asked about the potential risks to the financial system that hedge funds might be creating.
This was discussed at length in the Committee's hearing memo:
The market dominance of some capital market participants raises concerns about systemic risk and, in particular, correlated risks arising from the relationship between financial institutions. For example, Citadel LLC is a multi-service hedge fund and financial services company, and its subsidiary, Citadel Securities LLC, is one of the largest market makers and, according to its website, executes “approximately 47% of all U.S.-listed retail volume.” Citadel Securities also, reportedly, handles almost as much trading volume as Nasdaq. Further, Citadel Securities along with market maker Virtu Financial, “account for more of the overall equity market than the New York Stock Exchange.” With respect to Citadel, some have raised concerns about a single market maker managing such a large volume of retail order flow, and what that means in terms of pricing. Others have questioned whether Citadel has such dominance in our financial markets that it poses a systemic risk to the entire U.S. financial system.
One quick win for transparency into the sorts of risks that hedge funds might present to the financial system would be for Treasury Secretary Yellen to re-start the Hedge Fund working group at the Financial Stability Oversight Council.
Should we push to settle trades faster than one day (T+1)
Another question asked repeatedly by many Republican lawmakers in the hearing was about the potential move to settle trades either same-day (T+0) or instantaneously (realtime settlement). A couple of lawmakers even mentioned, you guessed it, blockchain. (One funny exchange happened when former SEC Commissioner Piwowar noted that a lot of people ask him about blockchain and realtime settlement, and when he tries to respond, they just respond by saying "blockchain" louder.)
I discussed one operational difficulty with moving to settle trades faster than T+1 in response to a question from Rep. Van Taylor:
I also elaborated on this question in my written testimony:
While there are many reasons to consider moving to T+1 settlement, challenges remain that make moving to T+0, or even real time settlement, difficult at this time. As one example, T+0 would eliminate flexibility some market participants rely on, and prohibit netting — which allows transactions to be “netted” together even if the trades execute over tens, or hundreds, or thousands of separate orders. As the Depository Trust & Clearing Corporation (DTCC) wrote, “Allowing trades to ‘net’ settle reduces the total amount of cash and securities that have to go back and forth throughout the day, and eliminates a significant amount of operational and market risk.” Losing the benefit of netting would create significant new operational costs.
Rather than pushing to move to T+0 or real time settlement before the industry has even made it to T+1, Congress and the regulators should instead examine if broker capital standards as they are today are adequate to withstand periods of extreme market stress.
Data gaps and public blindspots
Another question I have is: what was the "over the counter" options trading activity in GameStop on the most volatile days. While some of this information is likely available through (expensive) proprietary data tools like the Bloomberg terminal, this isn't information easy for the general public to access.
From my written testimony:
Major Wall Street institutions may choose to trade equity options “over the counter” — when large broker-dealers trade bespoke options with each other, instead of through the standardized options available on exchanges. But Wall Street firms typically still “hedge” their positions by buying or selling listed stock. “Hedging” is a way to minimize the risk of large losses by trading an offsetting position. While doing so limits profits, it also limits losses. When trading options, many Wall Street flow trading desks employ a technique known as “delta hedging,” where options traders try to insulate their portfolio’s value from moves up or down in the price of the stock; they do so by purchasing or selling stock against the options they trade. Having a sense of the volume of over the counter options trades in “memestocks” like GameStop, Nokia, Blackberry, Koss, and AMC from January 21, 2021 - February 4, 2021 would provide a bit of a window into the role large institutions played in GameStop’s volatile run up (and down) in price.
Thus, regulators should examine the trading volumes that institutional players made in over the counter equity options markets and dark pools (which are venues unavailable to retail traders) during the period of extreme volatility in GameStop trading. In addition, lawmakers should evaluate if there are data gaps or points of friction in current reporting regimes, and if so, work to bring more transparency and speed of reporting to over the counter options. The SEC should also work to finalize the Consolidated Audit Trail, first proposed after the 2010 “Flash Crash” (where in just ten minutes, the Dow Jones Industrial Average index lost 1,000 points, nearly 9 percent of its value, only to recover shortly thereafter) and now long delayed.
The Big Picture
In my oped for the NYTimes, I tried to put GameStop in a larger perspective. Yes, many retail traders have done extremely well this year! Others have unfortunately likely bought at the top of GME, and realized some losses since.
While apps like Robinhood proclaim they want to "democratize finance," I think a better solution is to rebalance our economy so no one is left behind, especially not during a pandemic. Instead of creating policies that benefit the wealthy, or large corporations, we could guarantee shelter, provide baby bonds, make higher education free, and cancel existing student debt (which President Biden has the authority to do without needing Congress). Or...we can all try and chase the latest goldrush play. Sometimes it works! But I think there are less risky ways to organize our society, and I think it's worth pursuing public policy that lifts up everyone.