Two issues emerged from a congressional hearing on the volatile trading of GameStop Corp. shares: Lawmakers and regulators need a greater understanding of how technology helped foster the frenzy, and regulators need systems to understand such events — and possibly to manage them.
House Financial Services members and witnesses spent most of their time at the hearing last week focusing on the role of short-selling in the GameStop trading frenzy in January. They specifically looked at the source of securities used to take short positions, and they looked at how a bunch of retail investors seemingly were able to outmaneuver the professionals.
Both areas raise questions about technology. The securities lending that is part and parcel to short selling may demand more disclosure, as even the chief operating officer of the New York Stock Exchange acknowledged, but systems to do so aren’t currently available. And the retail investors made savvy use of social media platforms that raise questions about market manipulation.
“With GameStop, groups of individual investors acted in concert, at a speed and size unimaginable without social media in its current form,” Alan Grujic, founder and CEO of All of Us Financial, a San Francisco-based online broker that launched last year, said in submitted testimony. “Social media can empower individuals, but also influence them.”
He said market participants need to upgrade risk models to reflect this new reality, in which quick collective action “at scale” can cause risks to spike.
In the case of GameStop, those investors noticed that short positions were greater than the available number of its shares. Short selling involves an investor borrowing shares, selling them in expectation of a lower price, then buying them back to return to the broker who lent the shares in the first place. If the price falls, the short seller pockets the difference as profit; if the price rises, the short seller takes the loss.
Rep. Blaine Luetkemeyer, R-Mo., said short positions in GameStop amounted to 140 percent of its shares. That’s possible because some shares can be lent more than once. “You have more stocks shorted than there is stock available,” Luetkemeyer said at the hearing. “You’ve got a situation that’s ripe for musical chairs with your money.”
In the case of GameStop, one of those left standing when the music stopped was a big hedge fund that needed to be bailed out after being caught short. As the retail investors piled into the shares, pushing up the price, the shorts were forced to join the buying, creating demand that pushed up the price more.
Michael Blaugrund, the COO of the New York Stock Exchange, told the lawmakers that they should demand more disclosure of securities lending. He and others came to the defense of short selling but said the securities lending business needed more transparency.
“Short selling is an essential practice for liquidity price discovery and risk management, but the securities lending market on which it depends is opaque and inefficient,” Blaugrund said. He said the Securities and Exchange Commission should establish a public data feed that would track securities lending.
“A system that anonymously published the material terms for each stock loan would provide the necessary data to understand shifts in short-selling activity while protecting the intellectual property of individual market participants,” he said. The agency, if it were better informed about the practice through new technology, could even place limits on how many shares can be lent.
Michael Piwowar, executive director of the Milken Institute and a former SEC commissioner, said regulators should look “upstream” at securities lending before placing hard limits on short selling.
“Right now in that securities lending market, the SEC could go in and gather up information on an ad hoc basis and try to piece together what it looked like in the past, but it doesn’t have real-time information,” he said. “Before we start directly looking at limitations on short selling, we need to address the opacity issues in the securities lending market, and the SEC does have authority there to do that.”
Dennis Kelleher, president of Better Markets, said SEC rules are too vague to prevent a share from being borrowed more than once by a short seller. The SEC requires brokers to have a “reasonable belief” that investors borrowing shares can return them by the delivery date.
“People can have a lot of reasonable beliefs, and we have massive failures to deliver GameStop stock in January,” Kelleher said. “The publicly available information certainly indicates that there’s a very high likelihood of some abusive short selling by somebody.”
In some cases, the same share is loaned out multiple times, Kelleher said in response to questions from Rep. Ed Perlmutter, D-Colo., about how it was possible to sell short more stock than is actually available.
“It’s almost a house of cards,” Kelleher said. “You have short sellers having a reasonable belief at a period in time that that’s the security that they could reasonably deliver at the delivery date. The problem is that that security has now moved to somebody else who has a reasonable belief that that very same security is the one he can deliver.”
Transformative social platforms
The GameStop volatility was an illustration of a new technological phenomenon. Social media platforms enabled ordinary investors to organize quickly and in sufficient numbers to catch short sellers flat-footed. But watching them are big financial institutions that have their own agendas.
“Technology is transforming the finance industry in ways that increase access for retail investors,” Vicki Bogan, associate professor at Cornell University’s SC Johnson College of Business, said in submitted testimony. “Increased access is beneficial, but the manner in which investors access financial markets must be carefully managed to avoid deleterious consequences for retail investors.”
Hordes of investors are able to essentially pool their money and organize online in forums like Reddit or Twitter to act on so-called meme stocks. It’s not clear how lawmakers could limit this organizing — or if they should. Big financial institutions have the capacity to monitor this part of the market, and possibly to exploit what they learn in it.
One element of this stock trading involves using technology to make it more appealing, in what is sometimes called the “gamification” of investing that some brokerages are using.
Sal Arnuk, co-founder of Themis Trading, said online broker Robinhood Financial LLC does something novel: It combines investing trading tools with a social media experience targeted to young people “complete with trading addiction, and a herding effect.” The user base’s orders tend to be small, with an average account size of about $5,000, compared with TD Ameritrade’s $110,000, he said.
Alexis Goldstein, a senior policy analyst for Americans for Financial Reform, said Wall Street is watching those market moves playing out in public forums. She told lawmakers that thousands of Reddit users post their positions and their future plans are being mined for information by big firms.
“Many will likely have created software to extract and analyze the content of the posts and make trading decisions based on it,” she told lawmakers in her testimony.
Caitlin Reilly contributed to this report.