Wall Street Worries About Regulatory Fallout From the GameStop Saga

Christopher Aluka Berry | Reuters

Wall Street is concerned about the Yellen regulator super summit, and with good reason, market watchers say.

"The Street should be worried," said Jamie Selway, former head of electronic brokerage at ITG and now an investment advisor. "There's clearly questions about gamification, and whether a lot of these approaches are suitable and inducing unnecessary trading activity. Regulators are starting to look at what kind of behaviors can be induced through those apps."

Treasury Secretary Janet Yellen has announced she will be meeting with the heads of the Securities and Exchange Commission, the Federal Reserve board, the New York Fed and the Commodities Futures Trading Commission to discuss "whether recent activities are consistent with investor protection and fair and efficient markets."

The meeting could take place as early as Thursday.

Was there market manipulation involved in the GameStop story?

Several of those regulators have already made preliminary statements.

The SEC has a three-fold mission: protect investors; maintain fair, orderly and efficient markets; and facilitate capital formation.

The commission already has put Wall Street on notice that it is concerned investors may not have been protected.

"We will act to protect retail investors when the facts demonstrate abusive or manipulative trading activity that is prohibited by the federal securities laws," the SEC said in a statement. "Market participants should be careful to avoid such activity."

Does the GameStop trade, largely instituted by the Reddit trading community, amount to abusive or manipulative trading? That may be difficult to prove.

"There may have been some bad actors, but the narrative in the media does not suggest a traditional pump and dump," said Philip Moustakis, former senior counsel in the SEC's Division of Enforcement and current counsel at law firm Seward & Kissel.

"There is no indication yet that the Reddit crowd was engaged in coordinated actions or disseminated false and misleading information," he added. "Those are not the elements of a traditional market manipulation case. There was certainly a lot of decentralized chatter, but it would be difficult to call that market manipulation."

Another issue regulators will be examining is the stability of the clearing system.

"The clearinghouses are nodes in our system that cannot afford to fail," former SEC Chair Jay Clayton said on CNBC.

What FINRA may be up to

The Financial Industry Regulatory Authority, which directly regulates brokers and broker-dealers, said in a recent report that one of its main focus for 2021 was the "gamification" of the markets.

"This focus includes risks associated with app-based platforms with interactive or 'game-like' features that are intended to influence customers, their related forms of marketing, and the appropriateness of the activity that they are approving clients to undertake through those platforms," it said.

Moustakis says this is a warning shot to the brokerage community.

"FINRA was putting those with game-like features on notice. These trading apps are marketing to a younger customer base, and I think FINRA feels that comes with increased know-your-customer obligations," he said.

A FINRA spokesman declined to comment, but the agency clearly has indicated it is concerned that the gamification may have caused investors to trade excessively or make investments not suitable for them.

A key feature of regulation of brokers is "suitability," the requirement that advisors place their clients in investments that are suitable for the risk they want to bear. FINRA clearly warns brokers and broker-dealers that certain features they offer may trip "suitability" requirements:

"If your firm offers an app to customers that includes an interactive element, does the information provided to customers constitute a 'recommendation' that would be covered by Reg BI, which requires a broker-dealer to act in a retail customer's 'best interest,' or suitability obligations under FINRA Rule 2360 (Options)? If so, how does your firm comply with these obligations?" FINRA said in the report.

"If your firm's app platform design includes 'game-like' aspects that are intended to influence customers to engage in certain trading or other activities, how does your firm address and disclose the associated potential risks to your customers?"

Eric Noll, CEO of Context Capital and now a board member of FINRA, said there were even broader issues for FINRA and other regulators to consider: "Regulators will ask, 'Do we have the risk metrics right around these broker-dealers, particularly those that have big concentrations around small numbers of companies?'"

"The most likely regulatory move is increased capital requirements around brokers," he said, stressing that he was not speaking on behalf of FINRA. "Robinhood needed to put up money they didn't have. They had a big concentration in a very small name. To preserve their business, they had to shut down taking longs in GameStop because that was the only way they could control their obligations."

Should regulators stop investors from doing stupid things?

A final concern is whether regulators will feel some obligation to encourage brokerages to be more vigilant protecting investors against engaging in what seems like foolish behavior, like trading stocks for prices divorced from any rational fundamentals.

Clayton cautioned against erecting what he called "blunt guardrails and blunt regulations." The former SEC chairman said it would be difficult to put up guardrails that would prevent investors from making investment mistakes, but added that certain guardrails like margin requirements were necessary. "I'm a believer in that and I believe those guardrails should be examined," he said.

Where's Gensler?

One key player is missing: Gary Gensler, former chair of the CFTC and now the nominee to run the SEC. His presence is greatly needed to preside over this difficult moment, but it may be months before he is confirmed.

"We would love to see his confirmation sped up and confirmed quickly," Selway said. "Doing this without him seems difficult."

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