The SEC Crackdown and Equity Trading
Back in June 2021, US Securities and Exchange Commission chair Gary Gensler laid out his proposals for new rules and regulations for the financial market in what could be the biggest change to the market in decades.
The main motivation for this change occurred in January of the same year when Wall Street was rocked by the so-called Reddit Rally. In this event, "meme stocks,” most notably GameStop Corp popular in online communities surged to massive highs after coordinated heavy trading on apps such as Robinhood and other commission-free retail brokerages.
The fallout from the event was big losses for those hedge funds which had bet against those stocks and a reduction in market confidence. The intense volatility prompted by the event led to Robinhood restricting trading of those stocks, much to the chagrin of investors who had engaged in the rally.
Gamification
The main beef the SEC has with the current state of the trading marketing in relation to the Reddit Rally, is that commission-free trading apps are creating a generation of young gamblers who are becoming intoxicated by some of the marketing tricks used by said applications.
"The SEC has been very concerned that many younger investors, many of them too young to legally drink alcohol, are instead getting intoxicated by digital engagement in the market," said Howard Fischer, a partner at law firm Moses & Singer, adding the industry is likely to push back hard. "It is likely to have a war on its hands."
The gamification of trading apps is the main culprit for this trend according to SEC Chair Gary Gensler. These apps use notifications, leaderboards, and numerous other bells and whistles to stimulate the same reward pathways as video games – which makes these techniques particularly effective on the aforementioned young people.
In a subsequent consultation, the SEC has put forward the idea that these digital gamified prompts may constitute an investment recommendation which is covered by the 2019 Regulation Best Interest rules which require a broker-dealer making any investment recommendation to act in the best interests of the customer and highlight any conflicts of interest which may exist.
"Some experts worry digital engagement practices are growing so sophisticated that they may generally increase trading without obvious individual prompts. That could mean the Regulation Best Interest approach may be insufficient,” the SEC's internal investor advocate, Rick Fleming, has warned.
This would force firms which are using these kinds of tools to make extensive new disclosures, adding increased compliance burden and making them more vulnerable to potential lawsuits.
Other Issues
Gensler has also criticized payment for order flow and proposed a total ban on the practice.
With PFOF, commission-free brokers generate revenue by sending customer orders to wholesale market makers in return for payments, rather than to exchanges, which raises potential conflicts of interest by providing brokers with incentives to encourage customers to trade more frequently to maximize their payments.
The Reddit Rally has also highlighted the small number of market-makers which dominate the retail trading space and has raised concerns regarding competition and the creation of a level playing field for trading.
As a result, the SEC is now proposing changes which will modernize these rules and aim to ensure that equity market structure such as those relating to order routing, conflicts of interest, best execution, market concentration, and the disclosure of best execution statistics, are as fair and equal as possible.
Because most of the stocks in the Reddit Rally were shorted, the saga has brought a sharper focus onto the transparency of hedge funds. The SEC has now proposed changes which would boost hedge fund disclosures on material events and extraordinary losses. Gensler also added that, while there was no evidence of foul play in the event, greater transparency of short selling may be in order.
The SEC also plans to finally implement a rule created by the 2010 Dodd Frank Act which would expand the current investment position reporting requirements to include details on short sales.
Final Thoughts
The Reddit Rally has sent serious reverberations throughout the trading world of that there is little doubt. The SEC has a difficult task ahead as it must work to make sure the democratization of trading is maintained and it doesn’t return to the days as an elite only market, while ensuring retail customers are protected from some of the worst excesses of the gamified gambling world.
Making sure the trading industry is a fair and level playing field should be a priority of all brands in the industry and we’ll all be keeping a keen eye on these proceedings as they continue to develop.
The SEC crackdown is sure to be a hot topic at Equities Leaders Summit 2023, taking place in January at the Eden Roc Miami Beach, FL.
Download the agenda today for more information and insights.