Not long ago, the name “GameStop” referred only to a struggling bricks-and-mortar tech company catering to video gamers. Today, it has come to be used as a catchall for an abrupt shift in stock market dynamics, enabled by technology and driven by retail investors, with substantial impacts on market volume, volatility, and public perception. Unlike many market changes, this one is occurring right at the intersection of Wall Street and Main Street and, for that reason, it stands to shape regulatory priorities just at the moment when new leadership prepares to take the helm at Wall Street’s top regulator.
Awaiting the Arrival of Gary Gensler
On March 2, the Senate Banking Committee held the confirmation hearing for SEC Chair-Nominee Gary Gensler. The controversy over the retail-driven trading in GameStop and other “meme stocks” has added pressure to quickly confirm the new Chairman, and based on comments Sherrod Brown, the Chair of the Committee, made at the hearing, the Senate seems poised to do so. That raises the possibility that Mr. Gensler could be in place by the end of the March.
Predicting how the nominee’s leadership will shape the SEC agenda requires a fair amount of speculation, but we can gain insight by understanding his background as well as his comments at the hearing. His experience in financial markets is multi-faceted: former co-head of finance at Goldman Sachs, Treasury Department official, adviser to Senator Paul Sarbanes, and Chairman of the CFTC from 2009–2014, where he led government efforts to reform the derivative markets after the financial crisis. He also substantially energized the CFTC’s enforcement division, notably in the prosecution of cases involving manipulation of Libor interest rates. Most recently, he has taught at the MIT Sloan School of Management, focusing on the intersection of finance and new technology, including use of the blockchain and cryptocurrencies.
In short, the incoming Chairman has an extraordinary and nuanced knowledge of financial markets and a proven determination to use governmental authority to remove inefficiencies and curb fraud and manipulation, even in the face of intense resistance. And he made clear in his remarks at the hearing that the overriding focus of SEC-driven reform will be the protection and welfare of investors.
Equity Markets Regulation
The agenda for reform of the equity markets will also be impacted by the unfinished agenda of the previous SEC regime, particularly on the topic of market data. Even more, it will hinge on the extent to which market participants agitate for action on long-simmering debates over the diminution of trading on-exchange, conflicts of interest, and best execution, among others. None of these issues are new, but all of them have acquired more urgency as a result of the market changes that have accelerated over the last year. The following list describes some of the more conspicuous areas for reform. While action in all these areas is not assured, it seems a safe bet that all of them will be on the table.
Under former Chair Jay Clayton, the Commission sharply ramped up scrutiny of new fees and required more justification for data and connectivity fee increases. It also pushed through sweeping changes to overhaul governance of the securities information processors (SIPs), expand the content of consolidated data, and move away from the monopoly SIP model in favor of competition by independent companies. The large exchange companies have filed court challenges to these changes, but it is worth noting that all of them were adopted by unanimous votes, and it seems likely the SEC will vigorously defend these changes and continue to closely review market data fees imposed by exchanges.
Accelerating a long-term trend toward less displayed liquidity, since the end of the year, we’ve seen some days when, for the first time, more than half of total share volume was conducted off-exchange. According to various industry studies, this trend has increased trading costs and made it harder for institutional investors to access liquidity. In response, the SEC might consider bringing more “light” to dark trading. For example, the agency might require more immediate trade reporting that identifies trades occurring in specific venues as opposed to all activity being grouped under a generic off-exchange moniker. The SEC is also likely to continue to be open to proposals for new types of incentives to trade on-exchange.
The Rise of Retail
The rise in retail trading raises a host of investor protection issues, which will be more acute in the event of a market correction that exposes the new legion of on-line retail traders to substantial losses. Concerns about the “gamification” of the markets was a recurring theme at a recent House committee hearing as well as at the Gensler confirmation hearing. The focus of these concerns is not whether retail investors should have access to the latest technology, but how they are being induced to use it, and whether the choices being made by the firms that enable it serve investors’ interests.
The SEC is unlikely to restrict access of investors to platforms like Robinhood, but it may well consider, at the least, higher customer protection and disclosure standards for this segment of the industry.
Routing Conflicts of Interest
The SEC moved in the last two years to enhance disclosures about broker routing performance, but it may look to do more to reexamine routing incentives. Last May, a federal court negated the SEC’s Transaction Fee Pilot, which, among other things, would have prohibited rebate payments for a group of pilot stocks. Still, concerns about how rebates impact trading persist, and the Commission may consider whether to craft another approach. In addition, the ongoing Robinhood and GameStop saga has placed a spotlight on the role of payment for order flow arrangements in directing retail orders, including how those payments affect brokerage commission structures and how they may affect execution outcomes for retail investors.
This is a perennial topic that perennially seems to lead nowhere, resulting in a state of opaque FINRA interpretations and widely divergent market practices, but this time may be different. Both outside commentators and some Commissioners have voiced the need for reform, or greater clarity, in recent years. What form that might take is anyone’s guess, but to be meaningful, it would seem to require at least sharper and more enforceable guardrails defining minimum standards that apply in common routing scenarios.
Expanding Security and Operational Safeguards
Some SEC Commissioners in the past have pushed for tougher substantive requirements, especially around reliability, security, and integrity, on both automated trading systems and other trading centers that account for a substantial share of trading volume. Those proposals may receive renewed consideration.
This has become a hot topic in recent years, involving questions about the proper use of corporate funds, and whether and how buybacks benefit ordinary investors. It is unlikely the SEC would seek to dictate or substantially restrict how companies can use their capital, but it is certainly possible it would consider tightening the conditions in its existing rules on how buybacks have to be conducted to avoid claims they are being used to manipulate prices. The Commission might also consider further restricting the ability of corporate insiders to trade in corporate shares timed close to the announcement of a buyback.
The financial transactions tax proposal floated last year by the New Jersey legislature (to apply a per transaction fee to trades matched in the New Jersey data centers) appears to have been forestalled for now, but it could rear its head again in the future. More recently, some in the New York legislature have proposed eliminating the current “rebate” that applies to the New York State stock transfer tax (in effect, applying it for the first time in 40 years) to help close the New York state budget gap. Industry participants have so far been able to identify logic gaps in these proposals (IEX is a member of a coalition working for that purpose), but exchanges and other firms are actively considering alternative data center locations as a fallback if the New Jersey tax were to pass. The New York tax would apply differently to trades that are considered to have a nexus to New York and, if applied, it could potentially accelerate the movement of financial services firms out of the city, which is one good reason it may fail to gain traction.
A U.S. House-sponsored bill would impose a federal tax of on all stock, bond, and derivative trades. The proposal is sure to receive heavy opposition, but its introduction makes clear that market participants will need to be prepared to address financial transaction tax proposals at both the federal and state levels.
Equity Markets Stay Front and Center
Equity markets have always been a primary focus of regulators, not least because they represent the part of the capital markets that most visibly impacts the lives of ordinary Americans. Considering the many important subjects that will command the SEC’s attention in the next several years, there may come a time when it pays less attention to the rules governing equity investing and trading. But, considering the recent expanded participation by retail investors, and popular attention to the related risks and benefits, it seems likely 2021 will not be that year.