The US House Committee on Financial Services convened its third hearing last Thursday on the GameStop saga, examining whether new legislation around short selling was needed to protect retail investors from themselves
First came the hedge funds and trading apps. Then the academics and retail brokers. Now it was the turn of the regulators. The US House Committee on Financial Services convened its third hearing last Thursday on the GameStop saga, examining whether new legislation around short selling was needed to protect retail investors from themselves.
‘Game Stopped? Who Wins and Loses When Short Sellers, Social Media, and Retail Investors Collide, Part III’ heard testimony from representatives at the Securities and Exchange Commission (SEC), the Financial Industry Regulatory Authority (FINRA), and the Depository Trust and Clearing Corporation (DTCC).
Committee chair Maxine Waters, who called the trilogy of hearings to address “predatory short selling” by hedge funds, in the wake of the ongoing GameStop saga said: “It is critical for our cops on the block at the SEC to protect investors and ensure that our markets are transparent and fair.”
But short sellers seemed to quietly slip off the committee’s radar, as a whole range of issues — including gamification of trading apps, payment for order flow and system-wide risks — were also on the agenda.
Giving his testimony, newly minted SEC chair Gary Gensler said he thinks the events of January — the GameStop saga and associated trading of meme stocks — are part of a larger story about the intersection of finance and technology.
“These forces have had a symbiotic relationship since antiquity. One thing that I’ve come to believe is that technology can bring greater access to our capital markets,” Gensler stated.
But regulatory hawk Gensler also testified that new technologies can “change the face of finance” and when it does, “how do we continue to achieve our core public policy goals and ensure that markets work for everyday investors?”
Despite Gensler touching on several areas in his testimony, he said that at its core, January’s events were driven by the significant short selling of a number of meme stocks. “While FINRA and the exchanges currently publish or make available certain short sale data, Congress directed the SEC under the Dodd-Frank Act to publish rules on monthly aggregate short sale disclosures,” Gensler said, and that Dodd-Frank provided authority to the SEC to increase transparency in the stock loan market.
Gensler is referring to dormant sections of the 2011 Dodd-Frank Wall Street Reform and Consumer Protection Act, brought in after the financial crisis, which would oblige firms to record and publicly disclose short selling data at a minimum of once a month.
The SEC was meant to revisit the requirement after Dodd-Frank but the reporting rules were instead left to gather dust.
“I’ve directed SEC staff to prepare recommendations for the Commission’s consideration on these issues,” Gensler added.
Gensler also touched on Archegos, particularly the significant losses incurred by several global financial institutions that provided prime brokerage services to the beleaguered asset management firm. Significantly, it was Archegos’ use of total return swaps based on underlying stocks, Gensler said, and “the significant exposure the prime brokers had to the family office” that caused the firm to implode.
Referring again to Dodd-Frank, Gensler explained congress gave the SEC rulemaking authority to extend beneficial ownership reporting requirements to total return swaps and other security-based swaps. “Among other things, I’ve asked staff to consider recommendations for the Commission about whether to include total return swaps and other security-based swaps under new disclosure requirements, and if so how.”
DTCC CEO Michael Bodson said that extreme market volatility and “short squeeze” events are not new phenomena. “What was unusual was that activity in the volatile meme securities was more concentrated in the portfolios of firms that primarily support individual investors,” Bodson said.
Bodson went on to say that the concentrated retail interest in purchasing “meme securities” and the related spike in the prices of those securities was a substantial factor in generating the near-peak aggregate clearing fund requirements at NSCC earlier this year on 28 January.
“The impact of that increase was more concentrated in the clearing members whose clients drove that activity. The impact of the March 2020 market volatility and the related increase in NSCC clearing fund requirements, by contrast, was more evenly distributed across clearing members,” Bodson explained.
FINRA’s Robert Cook noted that in light of January’s events, the brokerage firm and exchange market regulator is considering whether its rules should be updated to better support the overall approach established by the Commission. “For example, the Commission has primary responsibility for establishing rules relating to short selling — Regulation SHO — as well as the transparency around short selling and the stock lending market that supports it,” Bodson commented. FINRA rules require periodic reporting by its members of open short interest.
“We are considering potential enhancements to our short interest reporting rules, particularly around the frequency and content of reporting [and we] would also welcome the opportunity to explore with the SEC the potential for greater transparency for regulators and, potentially, the public with respect to the securities lending markets,” Bodson concluded.
Although there was much to discuss outside of short selling, many house members wanted to query the regulatory bigwigs on whether rules around short selling need to be tightened.
California representative Brad Sherman argued that there was a need to look at short sale disclosures. “Right now, disclosures are filed with the SEC quarterly — that is so 1977.” Sherman said that one would expect reports to be filed far more often. “And we have to discuss what reports should be made public.”
Meanwhile, Florida representative Bill Posey suggested that some people believe current short selling practices drive down share prices below fundamentals. “What does your experience tell you and what should we or could we do about it?” he asked Gensler.
Gensler highlighted that short selling has been part of the market structure for many decades, “even before the securities laws,” and economists have conducted many studies and had many debates on short selling. Gensler went on to say that although shorting a stock may mean that individual securities are not aligned with fundamentals, it’s important to remember that the SEC’s “remit is to ensure that the markets are fair, orderly and efficient and that they’re free of fraud, manipulation”, but Gensler added, “we do think that there’s a need for greater transparency in the short selling side”.
South Carolina representative William Timmons asked Gensler whether increased short selling disclosures would constitute regulatory overreach.
“Congress anticipated and gave authority to the SEC to require aggregate short selling information on a monthly basis,” Gensler said, referring to the moribund Dodd-Frank legislation that would require enhanced short selling disclosures. “FINRA publishes some information on a bi-weekly basis”, Gensler added, “and I think that amount of transparency is positive to markets”. Gensler said that had instructed staff at the SEC to consider enhanced disclosures. “We’re gonna lean in and follow Congress’ mandate from 12 years ago.”
Timmons then asked whether Gensler believes short sellers play a role in creating fair, orderly and efficient capital markets.
Commenting on this, Gensler concluded: “Short selling is as old as capital markets and does play a role in capital markets and price formation — the important tenet for the SEC is to make sure the market is free of fraud and there is the appropriate transparency.”
