Robinhood CEO speaks to Cuomo after GameStop stock chaos

London (CNN Business)The cops on the Wall Street beat weren’t prepared for an army of day traders coordinating on social media to run up the price of stocks like GameStop (GME), BlackBerry (BB) and American Airlines (AAL).

Now, brokers are imposing restrictions on the fly, drawing huge backlash from traders who are crying foul and spreading unsubstantiated theories about nefarious corporate motives.
“To me, what is truly problematic about this is the regulators’ flat-footedness,” said Gina-Gail Fletcher, a Duke law professor who specializes in market regulation. “Right now, the integrity of the market is at issue,” she added.

The problem of asset bubbles, which have cropped up at least as far back as Dutch tulip mania in 1637, isn’t new. Neither is gathering online to speculate on stocks: Ahead of the dot-com crash in the early 2000s, Yahoo chat rooms were the place to be.
But this time, commission-free trading apps like Robinhood, which provide huge numbers of novice investors easy access to complex financial instruments from their phones, are having a significant impact on market dynamics. Social media, meanwhile, can accelerate the speed at which bubbles form.

That means when the GameStop saga ends, and tensions cool, regulators will have tough questions to answer.
“We’ve seen this before. We know how it ends,” said Joshua Mitts, a securities expert at Columbia Law School. “It doesn’t mean we can use the tools of yesterday to solve the problems of tomorrow.”
The US Securities and Exchange Commission, which regulates stock trading, said in a statement Wednesday that it was “actively monitoring” the situation. On Friday, it added that “extreme stock price volatility” has the potential to cause “rapid and severe losses” for investors and “undermine market confidence.” The Financial Industry Regulatory Authority, or FINRA, declined to comment.

What’s illegal?

The first order of business, according to experts, will be for the SEC to open an investigation to determine exactly who and what is driving up the price of stocks like GameStop, which has spiked more than 1,400% in the past month.

The dominant narrative this week has been of a rag-tag group of amateur traders coordinating on platforms like Reddit and Discord buying shares of distressed companies that had been targeted by hedge funds and short sellers who had bet that prices would fall.
That behavior, in and of itself, wouldn’t be considered illegal, Fletcher said.
“You would need to be able to show some kind of fraudulent activity — meaning [users] said something untrue in order to pump up the stock, or released some false or misleading information,” she said. Posting that you love GameStop shares and adding a bunch of rocket emojis likely wouldn’t qualify as a pump-and-dump scheme.
But the SEC will want to ensure that it has the full picture, and that there aren’t bad actors trying to capitalize on the moment.
“To me, it’s probable that people are pushing retail investors in one way or another when they have undisclosed positions that are being advantaged by those actions,” said Dennis Kelleher, CEO of financial reform group Better Markets. “That’s going to be classic market manipulation, and I don’t have any doubt that’s going on.”
The SEC said on Friday that it “will act to protect retail investors when the facts demonstrate abusive or manipulative trading activity that is prohibited by the federal securities laws. Market participants should be careful to avoid such activity.”

Brave new trading world

Then will come thornier issues, particularly about how to deal with the new technologies fueling the GameStop rally. Rep. Maxine Waters, chair of the House Financial Services Committee, has said she will hold a hearing, as has Sen. Sherrod Brown, a Wall Street critic and incoming chair of the Senate Banking Committee.
“This is not anything particularly new with people chatting up stocks and people becoming really exuberant — irrationally so,” Fletcher said. “What is new is the speed at which this can be done, and the intensity at which this can be done.”

Mitts is concerned there may not be enough necessary disclosures on platforms like Reddit, where anonymous users can say when they take a position but aren’t required to say when they sell. This tactic could be exploited both by hedge funds and individual investors in order to drum up a false sense of demand, he said.
The role of brokerages like Robinhood will also be in focus following the startup’s sudden decision Thursday to bar trading in certain stocks, setting off an avalanche of criticism from traders and lawmakers of both parties. Robinhood later clarified that the decision was made to meet certain regulatory requirements, and the company said it would resume limited purchases of those securities starting Friday. But the damage was done.
“We now need to know more about [Robinhood’s] decision to block retail investors from purchasing stock while hedge funds are freely able to trade the stock as they see fit,” Rep. Alexandria Ocasio-Cortez, a Democratic member of the House Financial Services Committee, tweeted Thursday.
Regulators may also be taking a look. The SEC said Friday it “will closely review actions taken by regulated entities that may disadvantage investors or otherwise unduly inhibit their ability to trade certain securities.”
How the app has changed trading — both for individuals and the market as a whole — will also come under the microscope.
Massachusetts regulators filed a lawsuit against the company in December, citing concerns that it has made trading resemble a game, luring newbie investors who may not understand the risks. Waters also said “gamification” would factor into the House hearing.
Commission-free options trading on the app is also in the spotlight due to its popularity among Redditors. They’ve proudly leveraged such powerful derivatives to gain exposure to GameStop, since they require less cash upfront and can offer bigger payouts.
“What Robinhood has definitely done uniquely to other brokers or innovations is make options trading accessible to the average American who signs up,” Mitts said.
Some will suffer steep losses, however. If an option doesn’t pay out, an investor is left with nothing. There are also questions about the broader systemic impact of the heavy options trading seen in recent days.

Who does Wall Street serve?

Broader conversations are also underway on how the GameStop frenzy has exposed cracks in financial markets.
Some think the saga demonstrates a need for greater consumer protections, with some inexperienced traders all but certain to lose a lot of money. Others see the democratization of markets as a positive trend, and think that with proper information, people should be allowed to take risks as they see fit. Money managers like hedge funds, they contend, have been gambling with stocks for decades.
“For years, the same hedge funds, private equity firms, and wealthy investors dismayed by the GameStop trades have treated the stock market like their own personal casino while everyone else pays the price,” Sen. Elizabeth Warren said earlier this week. “It’s long past time for the SEC and other financial regulators to wake up and do their jobs.”
Lawmakers have also promised to take a look at short selling, a tactic that lets investors profit when a stock goes down. Reddit investors have drawn attention to the practice in recent days, calling it immoral to intentionally try to drive shares in companies like GameStop lower.
James Angel, a professor at Georgetown University who specializes in market structure, said that while short sellers are often vilified — some rightfully so — they serve an important function in markets.
“You want the stock price to reflect reality, and that means the bad news as well as the good,” he said.

But once the GameStop dust has settled, there will be plenty of people demanding change — both to help protect investors, and to ensure markets are fair for everyone.
“We’re going to have to have a real conversation about the purpose of the stock market, our theory of how it should work, and for whom,” Fletcher said.
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