For over a decade, hedge funds and other sophisticated traders have taken advantage of ordinary Americans who sought to share in the rewards of entrepreneurship and economic growth by investing in public companies. My research has identified tens of billions of dollars of transitory price crashes from short attacks aimed at retail investors on social media. Until last week, it appeared that GameStop was on its way to becoming yet another target of the activist short-selling machine. This was the week that investors decided to fight back.
“Negative activist” hedge funds mastered the art of driving down share prices via social media years ago – long before Reddit’s WallStreetBets forum became the home for the seemingly organic opposition that emerged this week. In fact, we have no way of knowing how much of the meteoritic rise in GameStop’s share price might have been the product of pump-and-dump manipulation by sophisticated traders. All will be revealed in time. Until then, we can identify three clear lessons from the events of the past week.
Lesson #1: The Urgent Need for SEC Rulemaking on Social Media and Market Manipulation
The GameStop short squeeze was a predictable consequence of the SEC’s failure to update its rules to protect ordinary investors from predatory hedge funds. The fact that Redditers decided to take matters into their own hands in the face of yet another short-seller onslaught shows the dangerous consequences of policy inaction when it comes to enacting rules that safeguard against manipulative short selling in the social media era.
While the free exchange of opinions about public companies is protected by the First Amendment, the law prohibits fraud and manipulation in connection with the purchase and sale of securities. Last year, I and 11 other academics filed a rulemaking petition asking the SEC to protect retail investors from manipulative short attacks by increasing transparency around those attacks. We asked the SEC to impose a duty to update promptly a voluntary short position disclosure that no longer reflects current holdings or trading intention. We also asked the SEC to clarify that rapidly closing a short position after publishing (or commissioning) a report, without having specifically disclosed an intent to do so, can constitute fraudulent scalping in violation of Rule 10b-5. The SEC has yet to respond to our petition.
More broadly, short seller Marc Cohodes and I have called for a mandatory 10-day holding period for both longs and shorts advocating positions on social media. While a cooling-off period for those advocating positions on Reddit and Twitter might require legislative intervention, even a highly politicized Congress could put forward a common-sense safeguard like this, which would go a long way toward protecting ordinary investors from manipulated bubbles and crashes.
Lesson #2: Wall Street Looks Out for Itself – At the Expense of Ordinary Investors
It is no secret that retail investors are systematically disadvantaged in our financial markets. Robinhood’s decision to suspend trading in GameStop and other high-volatility securities on Thursday was yet another example of the differential treatment that ordinary Americans face when attempting to compete with the pros on Wall Street. Robinhood’s explanation for blocking its customers from trading – a need to comply with SEC net capital requirements – rings hollow, as other large brokers had no need for such draconian measures. For many individual investors, this was just another example of how the deck is stacked against them.
As one might expect, the class action lawsuits have already been filed. One challenge for plaintiffs is that Robinhood’s customer agreement allows the company to “at any time, in its sole discretion and without prior notice to Me, prohibit or restrict My ability to trade securities.” But consider what might happen if a prime broker were to unexpectedly deny a hedge fund client the opportunity to trade. That broker would quickly find itself with one less client. The problem is structural: Retail investors are at a fundamental disadvantage in our markets. This should be a top priority for the SEC.
To take one example, SEC Rule 15c3-1 requires that brokers maintain sufficient net capital. But nothing in Rule 15c3-1 explicitly requires that broker-dealers proactively raise capital ex ante to ensure that a trading suspension would not be required to comply with these obligations. The news that Robinhood raised over $1 billion in new capital Thursday evening strongly suggests the company was facing a cash crunch earlier in the week. Yet Robinhood has given no reason why it could not have raised sufficient capital ahead of time. From the beginning of January through the end of the preceding week, GameStop’s share price nearly quadrupled in value. Robinhood had plenty of time to secure additional capital, restrict margin trading, or take other actions on a non-discriminatory basis to ensure that investors could freely trade GameStop and other high-volatility stocks last week. Doing so would have allowed the company to meet its capital obligations without locking ordinary investors out of the capital markets.
Of course, raising capital would dilute the share of corporate profits enjoyed by Robinhood executives and insiders. And that raises the question of whether Robinhood’s explanation is little more than a smokescreen. The SEC should outright prohibit ad hoc trading suspensions by individual broker-dealers or at least tighten Rule 15c3-1 to impose a severe penalty on brokers who sacrifice customers’ ability to trade as a way to meet regulatory capital obligations. Strict penalties – up to and including the “death penalty” of deregistration – would send a clear message that the SEC expects retail investors to be treated the same as hedge funds and other sophisticated players on Wall Street.
Lesson #3: The Technology Gap Between Industry and Regulators
The GameStop episode illustrates the urgent need for the SEC to make a far more fundamental investment in technology. Our federal securities regulator should be hiring top-notch data scientists and tech-savvy lawyers to navigate this brave new world. Ideally, SEC staff would be able to detect fraud and manipulation in real time and halt dangerous pump-and-dumps and short-and-distort attacks before they unfold. Unfortunately, just as in the years leading up to the financial crisis, industry seems one step ahead of the regulators.
Initiatives like the consolidated audit trail and market abuse data analytics are a good start. But it is time for the SEC to more fundamentally embrace the centrality of data science to modern-day market regulation and enforcement. That means situating data scientists alongside lawyers at regional offices and requiring tech skills like coding when hiring new staff. Greater data sharing by brokers and transparency into trading patterns would facilitate a more rapid response to market abuse.
In short, fintech is an exciting new field full of tremendous innovation. But as we saw in the financial crisis, innovation without safeguards that protect ordinary Americans can be a very dangerous thing. There is reason to be concerned that we are seeing something similar today at the intersection of social media and financial markets. As the events of this past week have dramatically illustrated, the dangers of policy stultification are real and present. It’s time for the SEC to make technology a top priority at both an organizational and policy level.
This post comes to us from Joshua Mitts, associate professor of law and Milton Handler Fellow at Columbia Law School.