Outreach Blog

Tuesday, May 11, 2021

Live by the Sword. Die by the Sword. Part 1

How the Online Gamestop Crowd Missed the Big Picture


Author: David Schwartz J.D. CPA

January's GameStop frenzy, where amateur online retail traders took what they hoped would be a rollicking joyride through the world of high finance, has left regulators scratching their heads about what to do next and the retail buccaneers themselves with quite a hangover. The newly minted SEC Chair, Gary Gensler, told the Senate Banking Committee in testimony last week that the Commission is still trying to figure out what the GameStop drama meant and what, if anything, the market regulator should do about it. However, some of the online buccaneers have made their next move clear and filed a class-action lawsuit against seemingly everyone who's anyone in the world of retail and wholesale securities trading. The GameStop episode demonstrates that the online buccaneers failed to appreciate the workings of the markets they opted into, and may even hold some lessons for the more experienced participants, particularly when it comes to the complicated dynamics of leverage.

The heart of the suit is an allegation that the Wall Street Goliaths conspired to protect themselves and shut out the little guy. But were the markets' reactions truly the product of some vast conspiracy between thirty-some-odd brokers, hedge funds, and clearinghouses? Or had the online investors just relied on incomplete models and failed to comprehend a complex and dynamic securities market with checks and balances that are well-understood by the major players?  

 

Retail and wholesale securities markets, though heavily regulated, have developed risk mitigation and management systems through the natural evolution of commerce. These structural and economic guard rails and circuit breakers act as a sort of a market immune system triggered to respond to disruptive or chaotic market conditions. One might say that the habitués of the retail and wholesale securities markets have the complete picture of the markets in which they operate every day. Their understanding of their exposures and models is complete. 

 

On the other hand, the online investors overlooked or were not fully aware of these critical circuit breakers. Margin and collateral requirements and the clearing and settlement processes evolved over decades of retail and wholesale trading activities in good markets and bad. Based on years of accumulated lessons learned, these self-correcting mechanisms kick in during periods of stress, as they did for the GameStop frenzy. 

 

Fair or Foul?

 

Overconfidence may also have played a factor for the online investors. Judging from their class action complaint, the illusion of understanding or superior market foresight may have made them overestimate their market insight and caused them to overlook some critical restrictions on their trading activities.[1]  For example, the online investors did not factor into their trading strategies that institutional investors had access to after-hours trading while the online investors did not.

 

Whether the online investors were treated unfairly vis-à-vis institutional investors, as the class action complaint alleges, is a question of "what duty, if any, did the brokerages owe their online platform clients versus their institutional investor clients?"  Brokers generally owe a duty of best execution (i.e., timely execution at the market price). But does this extend to policing the activity on their own ostensibly free platforms? What do the contracts between brokerages and online investors say? The online investor plaintiffs allege that "RobinHood does not warn users of any situation where it could prevent users from buying stock out of its own volition." [2]  But is this true? It seems unlikely that the terms of service omitted restricting client trading opportunities during volatile market conditions or in response to abusive or disruptive trading. Ultimately, with the help of industry experts, the courts will decide if the treatment of the online investors departed from standard industry practices.

 

The lesson to take away from the GameStop frenzy may be that structures, securities finance markets, and participants reacted to the online investors' disruptive and provocative activity as they should have. Collusion or conspiracy was not necessary to prompt the built-in guardrails and circuit-breakers to engage. They could not have been expected to react otherwise. The online buccaneers have perhaps learned that what you don't know can, indeed, hurt you. And when you live by the sword, you die by the sword. 

 

In part 2, we'll discuss how market forces served to counteract the pressures from the options-leveraged online GameStop investors and eventually shut down the system. 

 


 

 

[1] The illusion of understanding or superior market foresight may have made them overconfident.

    • "Retail Investors correctly deduced that GameStop was undervalued because large financial institutions had taken large short positions" [Class-action Complaint p. 14] 

    • "The Fund Defendants, Clearinghouse Defendants, and unnamed co-conspirators predicted incorrectly." [Class-action Complaint p. 14]

    • "Institutional investors, holding large short positions in GameStop's stock and other Relevant Securities began to push back and attempted to message on media and elsewhere that the Relevant Securities were not as valuables the Retail Investors thought." [Class-action Complaint p. 17]

    • The online investors believed the Fund Defendants' short positions were "highly speculative bets"rather than soundly researched investment decisions made as part of an investment strategy.

      • "Rather than use their financial acumen to compete and invest in good opportunities in the market to recoup the loss in their short positions the growth in the Relevant Securities' prices represented, or paying the price for their highly speculative bad bets, Defendants instead hatched an anti-competitive scheme to limit trading in the Relevant Securities." [Class-action Complaint p. 25]

 

[2] Clapp v. Ally Financial et al. Case 3:21-cv-00896, U.S. District Court for the Northern District of California, Class-action Complaint p. 27

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The CSFME’s Regulatory Outreach Programs

Regulatory reform has become a collaborative process. Where once market supervisors promulgated rules without regard for input from practitioners, today’s reform process has evolved into a dialogue of mutual respect for the opinions of all stakeholders in the capital markets. The process of regulatory outreach has become embodied in virtually every developed markets in the world.

The CSFME has adopted a role of facilitating this collaborative dialogue at all stages of the professional contribution process. Starting with students’ contributions to published commentary letters, through panel presentation and webinars, right up to trade association initiatives, the CSFME provides assistance through education, data compilation, analysis and commentary for some of the most pressing issues in contemporary markets.

DLT and Preferred Securities Financing

We believe the widespread use of encrypted third-party ledgers, blockchains, and smart contracts (i.e., DLT) is inevitable in securities finance, and that those technologies will permit lending agents to offer new revenue opportunities to their clients. Among these, we believe that certain agents will use DLT to help their lenders expand their loan books by opening their lendable portfolios on a preferential basis to the hedge funds in which they've already invested, as well as to other trusted counterparties, a concept we have dubbed, “Preferred Securities Financing.”  

CSFME is openly soliciting participation in a research initiative to assess the potential benefits to securities lenders from the use of DLT and data sourced from new regulatory disclosures. Specifically, our research will focus on how DLT, blockchain, and smart contracts can facilitate Preferred Securities Financing.  Learn More about our DLT Securities Finance Initiative

Research and Analysis of the Effects of Financial Regulatory Reforms

Given the sweeping changes in financial market regulation following the financial crisis, CSFME has turned its focus to questions relating to to how these changes are affecting the risks and economics of bank activities. The purpose of the Center’s research in this area is to foster sound policymaking and effective regulation with minimal adverse and unintended consequences. CSFME studies supervision and regulation of global financial institutions, the effects of reregulation on the global financial industry, optimal roles and methods of regulation in securities markets, corporate governance at financial institutions, and the most effective metrics and methods of data collection for understanding and measuring the effects of regulations on the global financial landscape. 

Lately, in response to a call from the FDIC for research on financial sector policy and regulation, the Center submitted a paper modeling the indirect costs to markets of bank regulatory reform.  The paper critiques regulators’ models for assessing these costs, and provides empirically-based suggestions for a more complete dynamic model of the long-term effect of bank capital reform.  Mindful of the Basel Committee's ongoing reviews of modeling tools, i.e., May 2012 and March 2016, the Center's critique is intended as a constructive addition to the holistic conceptual base of the regulatory reforms.

The Center also continues to provide input on regulatory proposals.

In March of 2016, CSFME submitted a comment letter to the Bank for International Settlement's (BIS) December 2015 consultative document regarding step in risk.  While supporting generally the goals of the Basel Committee to minimize the potential systemic implications resulting from situations where banks may choose to provide financial support during periods of financial stress to entities beyond or in the absence of any contractual obligations, the Center expressed some concerns and offered some suggestions regarding the approach taken by the Consultation. Drawing on practical experience, the Center offered an example from the trade finance sector supporting its belief that the nature of step-in risk may be one example of an acceptable, non-diversifiable exposure, given the potential positives for the economy at large.

In February 2015, CSFME submitted a comment letter in response to the Financial Stability Board’s November 2014 consultative document, Standards and Processes for Global Securities Financing Data Collection and Aggregation. In its letter, the Center identified additional metrics that may be necessary to assess properly the risk of collateral fire sales associated with securities lending transactions.  In particular, CSFME asserted that FSB and sovereign regulators must expand the data initiative beyond position aggregates, to include risk mitigation resources as well as termination activity.

Students Learn to Evaluate and Contribute to the Reform Process

As the level of intensity surrounding the reform process continued to build in 2013, the CSFME began to bring a fresh perspective to the reform process. By working with finance students and the US regulatory agencies, CSFME hoped to challenge the settled views of stakeholder by introducing the views of those whose careers would be shaped by the outcome of the reforms.

In the spring of 2013, a select group of Fordham University economics students met in Washington with officials at the U.S. Treasury, Office of Management and Budget, Federal Reserve Board, and the Securities and Exchange Commission. The CSFME helped arrange the meetings and funded the logistics. By all accounts, the experience was very positive for students and regulators alike.

Buidling upon the success of the 2013 pilot program, in 2014, both Fordham and the CSFME decided to expand the outreach program and formalized the Regulatory Outreach for Student Education program as the ROSE program. Honor students in finance and economics were selected by the deans of four schools within the university: the Graduate School of Business Administration, Fordham College at Lincoln Center, the Gabelli School of Business, and Fordham College at Rose Hill. The students were organized into four teams representing their schools. The CSFME selected a contemporary issue of career significance, the Financial Stability Board’s Consultative Document on G-SIFI designation of non-bank, non-insurer financial institutions. Each team was charged with studying the issues in debate, then presenting their opinions in the manner of a formal comment letter to the FSB. Over four months, the students reviewed earlier opinion pieces, met with practitioners and regulators, and then submitted their opinions. Without influencing their opinions, the CSFME arranged access to research materials and opinion leaders, then reviewed their letters and, as appropriate, recommended submission on university letterhead. In April, 2014, the four teams’ letters were published by the FSB on its website. In recent memory, no university had ever had one letter, much less four, published on a regulatory website. To finalize the 2014 ROSE program, the CSFME arranged for all four teams to present their opinions to the key regulators at the Federal Reserve Board and the SEC in Washington, D.C. The day of meetings ended with regulators’ praise at the degree to which the students had understood the issues and presented their opinions clearly.

One student team even offered suggestions that regulators had not previously considered and praised for their creativity. “We always know what the trade groups will say, but you brought a fresh perspective.” That team, Fordham College at Lincoln Center, was awarded the 2014 ROSE Award for Analytic Excellence. In retrospect. each student completed the program with a credit that will not only endure on their resumes but also contribute to the evolution of the financial markets through the Twenty First Century.

In 2015 and 2016, Fordham formalized the ROSE Program as a for-credit course in their curriculum. The focus of the 2016 ROSE Program was the Bank for International Settlement's December 2015 consultative document proposing a preliminary framework for identifying, assessing and addressing step-in risk potentially embedded in banks' relationships with shadow banking entities.  Five teams of graduate and undergraduate students in economics, finance, accounting, management, and law researched and drafted comment letters on the consultation and submitted their letters to a panel of distinguished industry judges.  After reviewing each excellent submission, the judges then one winning letter to be presented at a visit to the Federal Reserve Bank on April 27, 2016. The winning team's letter was submitted in full to the BIS, along with a summary of the key ideas from the letters from each of the other four teams, and the submission was published on the organization's website with those of the consultation's other commenters.   All five teams of Fordham Scholars visited Washington, DC on April 27, 2016 and met with officials at the Fed, Treasury Department, and FINRA.  

Institutional Securities Lenders respond to Academic Criticisms

In 2006 the Center was created, initially for the purpose of testing academic criticisms of the securities lending markets. With funding and data support from the Risk Management Association, CSFME found “no strong evidence to conclude that securities lending programs have been used to any great extent to manipulate proxy votes or exercise undue influence on Corporate Governance issues.” Our study also found that “broker borrowbacks” had contributed to spikes in lending activity around record date – the same phenomenon that the academics had misinterpreted as evidence of hedge fund manipulation – due to the efforts of brokers to meet recall notices from securities lenders. In effect, the brokers were scrambling to acquire votes for their customers, not building positions to swing corporate elections. The academics had fatally misinterpreted their findings!

Ed Blount of CSFME testified at the SEC’s Roundtable on the results of the research in September, 2009. Then, the CSFME white paper, published in 2010, was submitted to the SEC as an attachment in response to a consultative document on the “Proxy Plumbing” process. As a result of the Center’s contribution to the collaborative process, the misguided call for reform of securities lending began to subside. Once again, securities borrowers were fairly recognized to be honest brokers in the corporate governance arena.

Securities Lenders consider new means to retain their Voting Rights

In a follow-up to the Empty Voting project (“Borrowed Proxy Abuse” as it came to be known), the CSFME responded in 2011 to requests by the participating securities lenders, by turning its attention to ways in which those lenders might be able to retain their corporate governance rights, while still benefiting from the income attributable to their securities loans. After all, as many studies have found, securities lending contributes significantly to the efficiency of market operations. Why should lenders be forced to choose between their loan fees and fiduciary duties to vote their shares, especially if they are contributing to market efficiency?? With independent funding, the CSFME retained attorneys from two prestigious Washington D.C. law firms, Stradley Ronon and Sidley Austin, to investigate the legal underpinnings to market practices which force pensions, mutual funds, insurers and other institutional securities lenders to give up their voting rights when they lend portfolio securities. In practice, margin customers of brokers also lend their securities, yet they usually retain voting rights -- and most of them aren’t even long-term beneficial owners. Both groups of beneficial owners retain dividend rights, so why, institutional investors asked, shouldn’t institutions also keep their voting rights? With the benefit of exhaustive legal research, CSFME filed a petition with the Securities & Exchange Commission to initiate a pilot program to test new market procedures by which recently-introduced efficiencies in market operations might permit lender to retain votes.  Learn more about Paradoxical Erosion of Corporate Governance

In 2013, the SEC approved that pilot program, largely in response to the encouraging recommendations of the International Corporate Governance Association, as well as the California State Teachers Retirement System and the Florida State Board of Administration.

That pilot was initiated in 2014. Simultaneously, the CSFME began to apply the results to new initiatives in Canada and Switzerland, where the pressure to meet fiduciary voting obligations was intensifying.  More about Full Entitlement Voting



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