US watchdog mulls stricter rules after Archegos debacle, GameStop mania

WASHINGTON—Wall Street’s top regulator will study potential new rules related to two recent episodes of stock-market turbulence — the GameStop frenzy among small investors and the implosion of Archegos Capital Management.

In testimony prepared for the House Financial Services Committee, Securities and Exchange Commission Chairman Gary Gensler says applications that “gamify” trading—by using appealing visual graphics to reward a user’s decision to trade—might encourage frequent trading that results in worse outcomes for investors. Some Democratic lawmakers have blamed gamification for the boom in retail trading that helped drive the rise in GameStop shares.

Gensler, who is expected to appear on 6 May before lawmakers, also says in the prepared testimony that the SEC will study regulatory changes in response to the March blowup of Archegos, an unregulated family-investment vehicle of hedge-fund veteran Bill Hwang whose leverage-fueled bets led to more than $10bn in losses at top global banks.

In his remarks on gamification, Gensler suggests that many investor-protection rules were written before trading moved to online platforms that have grown more visually enticing and are sometimes blamed for encouraging investors to trade more. The hearing was scheduled after a boom in individual trading drove the prices of several stocks, including those of GameStop and AMC Entertainment Holdings, far above where they traded in December.

“Many of our regulations were largely written before these recent technologies and communication practices became prevalent,” Gensler is set to say. “I think we need to evaluate our rules, and we may find that we need to freshen up our rule set.”

Gensler, a former Goldman Sachs banker who led the Commodity Futures Trading Commission during the Obama administration, also is to say that the SEC is examining whether some large broker-dealers known as wholesalers have too much power in handling retail orders.

Wholesalers pay retail brokerage firms, such as Robinhood Financial and TD Ameritrade, for the right to trade with those firms’ customer orders.

The system, known as payment for order flow, has long been scrutinized for conflicts of interest, including whether retail brokers are encouraged to maximize their own revenue rather than ensuring their customers get the best price. Wholesalers say the market is competitive and that they don’t set the rates they pay to the retail brokerages. The system also generally yields better share prices for retail traders than they would get on stock exchanges.

Citadel Securities said it accounts for 47% of all individual trading of listed securities, making it the largest stock-market wholesaler.

Virtu Financial said it executes about 25% to 30% of those retail orders.

“Market concentration can also lead to fragility, deter healthy competition and limit innovation,” Gensler said in his prepared remarks. “I’ve asked staff to look closely at these issues to determine which policy approaches may be merited.”

Payment for order flow has swelled as more small investors have jumped into the stock market.

The 11 biggest US brokerages serving individual investors collected nearly $1.2bn in payments for order flow during the first three months of 2021, more than double the amount from the same quarter last year, according to an analysis of regulatory filings by Bloomberg Intelligence.

Robinhood alone generated about $331m for selling its order flow in the first quarter of 2021, more than triple the amount from the year-ago quarter.

The House committee’s Democratic staff has circulated draft legislation that would ban payment for order flow as well as some incentives offered by stock exchanges to attract orders. At a hearing in February, Democratic lawmakers pressed Citadel’s billionaire founder Ken Griffin on whether the system results in worse outcomes for individual investors.

Republicans oppose the draft legislation.

“It is unrealistic and a horrible idea,” said Rep. Patrick McHenry (R., N.C.), the top Republican on the financial services panel. “The idea that you’re going to have a mandate against something that has benefitted retail investors is really dumb politics and worse economics.”

Thursday’s hearing is set to include testimony from Robert Cook, the chief executive officer of the Financial Industry Regulatory Authority, and Michael Bodson, CEO of the Depository Trust & Clearing. Finra is a private regulator of brokerages that answers to the SEC, and DTCC operates clearinghouses that processes trades in US securities markets.

In his prepared testimony, Gensler says he has asked the SEC staff to prepare recommendations to increase public reporting on short-selling as well as the network of stock lending and borrowing that facilitates it. The Wall Street Journal reported in February that the SEC was studying the move. Short selling is the practice of borrowing shares and selling them on the expectation that they could be bought back later at a lower price.

Some of the gyrations in GameStop shares earlier this year were due to a so-called short squeeze, in which rising prices prompt bearish investors to cut their losses and buy back shares they had sold short, pushing the stock higher still.

Some of the investors who had bet against GameStop were hedge funds, and retail traders communicating on platforms like Reddit’s WallStreetBets boasted that their bullish trades were punishing establishment investment managers.

In his comments on Archegos, Gensler says he has asked SEC staffers to explore more disclosure of total return swaps, a type of derivative contract that played a key role in Archegos’s meltdown. Archegos — the family investment vehicle of hedge-fund veteran Bill Hwang — used such swaps to amass the equivalent of huge equity stakes in companies like ViacomCBS Inc. and Chinese internet giant Baidu Inc. Archegos effectively owned 25% of some companies, the Journal has reported.

By using swaps instead of simply buying shares, Archegos was able to place outsize bets while paying little money upfront and sidestepping SEC disclosure requirements on the stakes that large investors hold in companies. Some financial-reform advocates say expanding the disclosure rules to swaps could have helped prevent the Archegos debacle.

Write to Dave Michaels at [email protected] and Alexander Osipovich at [email protected]

This article was published by Dow Jones NEWSPLUS

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