On February 18, 2021, the House Financial Services Committee held a virtual hearing to examine the recent market volatility involving GameStop Corp. and other "meme" stocks that have been prone to high volatility due to, among other things, comments on social media. The individuals who provided testimony before the Committee were:
- Vlad Tenev, the co-founder and CEO of Robinhood Markets, Inc.;
- Steve Huffman, the co-founder and CEO of Reddit Inc.;
- Kenneth Griffin, the founder and CEO of Citadel LLC;
- Gabriel Plotkin, the founder and chief investment officer of Melvin Capital Management LP;
- Keith Gill, a GameStop investor and trader who goes by the online handles "Roaring Kitty" and "DeepF—ingValue"; and
- Jennifer Schulp, the Director of Financial Regulation Studies at the Cato Institute.
Chairwoman Maxine Waters (D-CA), who led the proceedings, explained that the hearing was called to examine the roles of the various parties in last month's trading events, when Robinhood temporarily paused buy-side trading of GameStop and other stocks as a result of an internet-driven frenzy of purchases. The trading went "viral" after a group of Reddit users, inspired by Mr. Gill's argument that GameStop was undervalued, bought up GameStop stock. This buying, along with other purchases, squeezed several short sellers, including Melvin Capital, which resulted in the covering of short positions and further increases in the stock price. Lawmakers also wanted to know whether Citadel, which pays to receive Robinhood's order flow (known as "payment for order flow") and executes its trades, had any role in Robinhood's decision to halt purchases, which both Mr. Griffin and Mr. Tenev flatly denied.
The hearing lasted more than five hours and covered many topics, ranging from Robinhood's decision to suspend trading to the future of clearing and settlement. Several themes emerged from the hearing. Lawmakers assessed whether further regulation, including additional rules regarding capital requirements, might be necessary in light of the investment firms' importance to the financial system. They also considered whether retail investors were adequately protected in the wake of last month's events. In addition, throughout the hearing, lawmakers probed the witnesses about whether a legislative or regulatory response would be prudent.
The Consideration of Legislative or Regulatory Responses
Several Committee members discussed whether too much or not enough federal regulation contributed to these events. Rep. Bryan Steil (R-WI) emphasized that retail and institutional investors should have fair and equal access to the market, but additional federal regulation of these markets would be a mistake without further investigation and input from the SEC and the Biden Administration. Rep. Andy Barr (R-KY) and Rep. Barry Loudermilk (R-GA) identified regulatory requirements as the reason that Robinhood had to pause trading in the first place, with Rep. Barr observing that, if "anyone has a problem with [Robinhood's] decision to halt trades, it's fair to say that their frustration should be directed toward federal regulation." This is consistent with Robinhood's prior explanation for why buying was temporarily halted, which stated that the firm has "many financial requirements, including SEC net capital obligations and clearinghouse deposits" and that "some of these requirements fluctuate based on volatility in the markets and can be substantial in the current environment."
Robinhood's suspension of buy-side trading led to questions about whether capital requirement rules should be adapted to this type of event. Rep. William Timmons (R-SC-4) and Rep. David Kustoff (R-TN) questioned whether capital requirements for retail trading platforms should be increased. Mr. Tenev of Robinhood answered that changes are not necessary given the "1 in 3.5 million chance" of this type of market volatility.
Rep. Rashida Tlaib (D-MN) proposed a financial transaction tax to "discourage risky and high-frequency trading," but Mr. Griffin of Citadel, Rep. Alex Mooney (R-WV), and Rep. French Hill (R-AR) argued against this type of tax. Rep. Mooney stated that any tax on transactions would not prevent a GameStop-type event from recurring and would make trading cost-prohibitive for retail investors. Notably, Sens. Elizabeth Warren (D-MA) and Bernie Sanders (I-VT) have pushed for a financial transaction tax in the past, so far without success.
Committee members also were interested in the benefits of real-time clearing and settlement. Under the current structure, once a trade is executed, there is a two-day process (T+2) in which the transaction is cleared and settled. Rep. Kustoff asked Mr. Tenev whether the GameStop situation could have been prevented had trades been settled in real-time or one day (T+1) after execution. Mr. Tenev noted that, if stock clearing were to occur in real-time rather than over a two-day period, many of the problems Robinhood faced in the last several weeks could have been avoided.
Short selling was another popular topic for the lawmakers. Rep. Nydia Velázquez (D-NY) noted that, while "short selling can be used for legitimate purposes, too often I have seen abuse [which] ends up harming ordinary workers and families." Rep. Blaine Luetkemeyer (R-MO) also showed interest in legislative changes concerning short selling, asking Mr. Griffin of Citadel whether market rules that allowed "short selling a stock 140%" amounted to stock manipulation and if "there ought to be a limit on that?" Mr. Griffin said that he believed the recent interest in GameStop was exceptional, but he was "not sure whether it was worth delving into a legislative correction for an extreme situation." Ms. Schulp of the Cato Institute testified against additional regulation because short selling generally works well as a tool to circumvent bubbles in the market by allowing a stock's price to correct itself when out of alignment with its value.
Lawmakers directed short selling questions to Mr. Plotkin, whose firm Melvin Capital suffered losses as a result of its short position on GameStop. When asked by Rep. Velázquez if he supported additional disclosure regulations on short selling, Mr. Plotkin stated only that his firm will abide by the law regardless of how Congress chooses to proceed on the issue.
Throughout the hearing, lawmakers focused on steps Robinhood took to protect the interests of retail investors who use its platform. These included Robinhood's messaging about its decision to halt trading and its transparency during the trading activity of the last several weeks and more generally. For example, after Mr. Tenev explained that Robinhood halted buy-side trading to satisfy collateral requirements, Rep. Carolyn Maloney (D-NY) asked why Robinhood did not provide more disclosures concerning clearinghouse capital requirements on its website or otherwise. Several lawmakers tracked this line of questioning, with Rep. Gregory Meeks (D-NY) questioning Mr. Tenev as to whether Robinhood should disclose more information given its customers' ability to borrow on margin and trade options.
Payment for order flow also received significant attention during the hearing. This practice involves a broker, such as Robinhood, routing customer orders for execution to a third party, such as a wholesaler, and receiving compensation in return. Critics of payment for order flow contend that it potentially conflicts with a broker's duty of best execution.
Ranking Member Patrick McHenry (R-NC) asked whether payment for order flow was "legal, regulated, and disclosed to users" of Robinhood. Mr. Tenev testified that Robinhood discloses this payment structure in multiple places and emphasized its benefits to retail investors. Additionally, Mr. Griffin of Citadel testified that payment for order flow is an accepted practice within the industry, "expressly approved by the SEC," and has acted as an "important source of innovation in the industry."
Notwithstanding the legality and customary use of payment for order flow, Rep. Brad Sherman (D-CA) and Rep. Joyce Beatty (D-OH) questioned whether the practice has harmed retail investors. Rep. Sherman, for example, asked Mr. Griffin whether best execution enhancements are reserved for customers of institutional investors who do not take payment for order flow on trades, while Rep. Beatty asked Mr. Griffin whether payment for order flow distorts trading. Mr. Griffin, along with Mr. Tenev and several Committee members, praised the benefits of the payment for order flow model, explaining that the practice permits commission-free trading and opens the markets to retail investors. Mr. Tenev reiterated this point when queried by Rep. Alexandria Ocasio-Cortez (D-NY) as to whether Robinhood would pass along its revenue from payment for order flow to its customers, indicating that Robinhood's customers see the benefit through commission-free trading.
Access to Markets
Many Committee members were supportive of Robinhood's stated mission to "democratize finance" by opening the US capital markets to individual investors of modest background. But the extent to which Robinhood allows amateur investors to participate in the markets, including through transacting in potentially risky options trading, raised concerns among lawmakers. Rep. Emanuel Cleaver (D-MO) noted that some retail investors took over-leveraged positions on Robinhood. Rep. Jake Auchincloss (D-MA) pressed Mr. Tenev about what he thought the appropriate amount of financial literacy should be before an investor is allowed to trade options. Mr. Tenev detailed the steps Robinhood takes to educate investors on its platform and the small percentage of Robinhood users who trade options.
In her closing remarks, Chairwoman Waters announced that the Committee will hold at least two more hearings on this subject. One hearing will include securities market experts and investor advocates and another will feature officials from the SEC and FINRA to "inform the Committee's role and help us to determine potential legislative steps to protect investors and ensure Wall Street accountability." We also expect the Senate to revisit this subject in the near future, including during the nomination hearing for Gary Gensler to become Chair of the SEC, which is scheduled for March 2, 2021.
Whether there ultimately will be a public policy response to the GameStop saga remains to be seen, and future hearings may provide further clarity on this question. Certainly, issues such as the financial transaction tax were receiving attention prior to the recent market volatility, and it is unclear whether or to what extent the political landscape on such issues has been meaningfully altered. Be on the lookout for additional details about these hearings in future advisories from Arnold & Porter.
Originally Published by Arnold & Porter Kaye Scholer, February 2021
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