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GameStop Trading Mania: Next Steps by Financial Regulators

The last week of January 2021 unexpectedly turned out to be a wild week for stock markets and online forums focused on trading advice. It also cast an unlikely spotlight on a few previously anonymous day traders and their clashes with Wall Street. At the center of the story were volatile price movements of a few hot stocks such as GameStop and AMC.

Prices of these stocks surged wildly high on Wednesday, January 27th. GameStop popped 221%, while AMC soared 301% on Wednesday. Overall for 2021 through January 27th, GameStop spiked up 1,745% and AMC increased 839%. Put differently, GameStop’s stock went from $40 to $400 in the span of a week.

On Thursday, January 28th, GameStop’s share price dropped 44% and AMC fell 57%. In response to the downturn, on Thursday evening a number of online brokerages announced restrictions on the trading of highflying stocks including GameStop, AMC, and Blackberry. This move immediately backfired. Furious retail investors expressed their anger on the WallStreetBets Reddit forum and other social media platforms.

Robinhood Relents, Somewhat

Under pressure, the investing platform Robinhood greatly narrowed the list of restricted stocks from 50 to 8 companies. For the companies remaining on the list, Robinhood made the trading restrictions less stringent. Shares of GameStop finished the week with a gain of 400%.

Vladimir Tenev, co-founder and CEO of Robinhood, stated: “It was not because we wanted to stop people from buying these stocks. We did this because the required amount we had to deposit with the clearinghouse was so large—the individual volatile securities accounting for hundreds of millions of dollars in deposit requirements—that we had to take steps to limit buying in those volatile securities to ensure we could comfortably meet our requirements.”

Huge Losses from Selling GameStop Short

Some short-selling hedge funds suffered steep losses as a result of the action. Melvin Capital is a hedge fund that bought GameStop put options in anticipation of the stock price going down. It lost 53% in the month of January. Two prominent asset management firms, Citadel and Point72, came to the rescue with a $3 billion emergency loan.

GameStop Selling Short
Image credit: Grochim

Meanwhile Citadel Securities, a division of the hedge fund Citadel, has profited from the price rally as a so-called “market maker”. Market makers are electronic trading firms that execute the orders received from online brokerages such as Robinhood and TD Ameritrade. By processing order flows to buy and sell stocks, options, and other assets, Citadel Securities has benefited greatly from the surging volume.

Politicians Speak Out

A number of politicians have already voiced alarm at the situation that unfolded during the last week of January. Ted Cruz and Alexandria Ocasio-Cortez took to Twitter to outcry the trading restrictions Robinhood attempted to implement. The members of Congress alleged that the restrictions unfairly targeted retail investors. Chuck Schumer and other lawmakers have insisted on Congressional investigations and SEC review of potential market manipulation.

At the end of the volatile week, the SEC issued a statement vowing to monitor and review the GameStop saga. “We are aware of and actively monitoring the on-going market volatility in the options and equities markets and, consistent with our mission to protect investors and maintain fair, orderly, and efficient markets, we are working with our fellow regulators to assess the situation and review the activities of regulated entities, financial intermediaries, and other market participants,” remarked Allison Herren Lee, Acting Chair of the SEC.

The tumultuous events have been a call for regulators to step in. In particular, all eyes are on Biden’s pick to lead the Securities and Exchange Commission (SEC), Gary Gensler. Gensler previously served as head of the Commodities Futures Trading Commission (CFTC). Most recently he was an MIT professor who focused on studying fintech and cryptocurrency regulation. Prior to his government and teaching roles, he worked at Goldman Sachs for over two decades.

Weakened SEC Addresses GameStop

The SEC is running under an interim chair since the U.S. Senate has yet to schedule a confirmation hearing for Gensler. Amid various government distractions, it could take weeks or even months before he is finally confirmed.

Gensler is predicted to be a tough regulator of Wall Street. But no one knows yet how Gensler strikes a balance between encouraging market participation by smaller investors and curbing wild price volatility.

It’s possible that the SEC will bring a lawsuit against certain GameStop traders. The SEC has an affinity for taking action in high-profile cases. However, it may be difficult to prove that there was market manipulation. The GameStop volatility doesn’t show clear signs of securities fraud, meaning SEC regulators will have to use more creative arguments to prove manipulation occurred.

Market Manipulation?

Market manipulation is vaguely defined in case law. The general fraud provisions that the SEC relies on prohibit using a “fraudulent, deceptive, or manipulative device.” Federal courts have different interpretations on what behaviors constitute “market manipulation” and “deception.” One approach the SEC could take is to argue that certain members on the WallStreetBets forum provided verifiably false information about GameStop to compel collective trading of the stock. This may be a difficult line of attack to win because many investors bought GameStop stock openly and based on their views of the price momentum.

The legal consequences remain unclear under the existing regulatory framework. Given the limitations of existing market manipulation laws, the GameStop saga might spark a new wave of rules being imposed by financial regulators.

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