The inner workings of the stocks trading industry will receive a public airing on Thursday when Washington lawmakers grill the key protagonists in January’s amateur trading frenzy.
Hedge fund managers, professional investors and specialists in the more arcane corners of trade processing are clearing their diaries and checking popcorn supplies for a session that could determine how regulators deal with an explosion in trading by amateurs for years to come.
Here is what to look out for.
First, a recap. Non-professional investors have been a growing force in US stock markets for almost a year, swept along by free trading apps, lockdown boredom and in many cases, spare cash.
Co-ordinating their trades in online chat rooms such as r/WallStreetBets, they succeeded in firing up the share price, crushing hedge funds that had been betting against it. But shares tumbled back down to earth after retail brokers such as Robinhood clamped down on new positive bets on GameStop and other favoured bets.
Many retail traders were outraged by the restrictions, which they felt were aimed at limiting their success. US politicians from both sides of the aisle weighed in, leading ultimately to Thursday’s hearing.
Who is testifying?
The hearing held by the House financial services committee is scheduled for midday in Washington on Thursday (5pm in London).
Here is a list of witnesses:
Robinhood CEO Vlad Tenev
Reddit CEO Steve Huffman
Gabe Plotkin, whose hedge fund Melvin was forced into a rescue after retail traders crushed its bets against GameStop
Ken Griffin, chief executive of Citadel, whose securities trading arm executes Robinhood clients’ trades, and whose hedge fund helped to bail out Melvin
Keith Gill, a longtime cheerleader for GameStop shares, variously known online as Roaring Kitty and DeepFuckingValue
Why did Robinhood and others restrict trading on stocks such as GameStop and cinema operator AMC?
This is Robinhood’s chance to cool down customers’ conspiracy theories but also to demonstrate a solid grasp of its regulatory obligations. Both are crucial to its success as it gears up to list its own shares on public markets.
Robinhood has long suffered outages and had attracted rising regulatory scrutiny for the alleged “gamification” of investing even before January’s drama, but champions itself as a force for democratising markets. It has said it clamped down on clients’ trades last month only because it faced margin calls from the clearing house, run by the Depository Trust and Clearing Corporation.
The DTCC is one of the pillars of global market stability. Last year it settled $2,150tn of US securities deals. It stands between a buyer and a seller, ensuring that assets are legally transferred from one to the other — a process that takes two days. In between, it demands its members deposit margin to cover risks in case the trade fails.
As trading grew frenetic in late January, the DTCC’s demands from the industry rose from $26bn to $33.5bn. Robinhood’s own requirements increased 10-fold. It needed to find $3bn within hours — a figure it negotiated down to $700m.
Margin calls are based on the performance and volatility of assets, not the status of the broker. The size of the call is based on the amount of business a broker is doing, the direction of positions in the broker’s trading book and the historic moves and volumes of shares the customers are trading.
One electronic market maker told the Financial Times it knew exactly how much the DTCC was going to ask for in advance.
Robinhood, it appears, did not. It quickly raised $3.4bn in two capital infusions to get through the turbulence. Lawmakers will probably want to know why.
Robinhood has called for shares to be settled instantly. Would that prevent further restrictions?
Since the trading surge, Tenev has repeatedly called for the “antiquated” two-day settlement period to be done in real time.
DTCC says it has the technology to settle on the same day but “the industry isn’t aligned”. That is not a euphemism. A shift like this would have a knock-on effect to other financial markets activity, from options trading to securities lending and cash borrowing.
Besides the vast expense to the industry, customers would have to pay for their deals in advance. Market makers would also lose the ability to combine all their positions and take their net exposure at the end of the trading day. That would effectively take US markets back to pre-1891 standards, the DTCC says. Griffin may be called on to explain.
Is short selling the core problem?
Tenev argues it is central, complaining publicly that “it should not be possible to sell more shares than are out there” — a point he links to two-day settlement.
In blogs, Robinhood has also argued that the plumbing behind markets is faulty. “The market mechanisms behind short selling, securities lending, and clearing are complex. This complexity can lead to the perception that the game is rigged to benefit certain market participants at the expense of others,” a recent blog read. “Although this isn’t necessarily the case, abuses do happen and at a minimum perception can become reality for some.”
Cutting “excess short selling” would help market stability, it says, since the broker in the middle will not be as exposed if the plumbing clogs up.
But Robinhood itself makes money from the stock lending essential for legal short selling. Like some other brokers, it allows investors to trade on margin accounts, in which a customer borrows part of the purchase price of a stock from the broker, rather than stumping up all the money in advance. In that scenario, Robinhood still owns the shares and can lend out the securities in the customer’s account, earning a profit on the trade.
Tenev may need to explain why he objects to the practice.
Are untrained investors fully aware of the risks?
Some Redditors were big financial winners from the meme stocks frenzy. Others lost savings in the collapse, or even borrowed money to take on bets that quickly soured.
Lawmakers will want to know what responsibility Huffman and Gill take here, and how they seek to protect small investors.
Has short selling changed for ever?
Plotkin is likely to be called on to explain what useful function short selling performs, how Melvin got its bets so wrong, and whether Redditors have permanently changed the game for supposedly sophisticated speculators betting against stocks. Griffin is also likely to face questions over how Citadel Securities avoids potential conflicts of interest when it completes Robinhood’s trades and the Citadel hedge fund bailed out one of the industry’s biggest victims.