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House Financial Services Committee GameStop Hearing Pt. 3

House Financial Services Committee

Game Stopped? Who Wins and Loses When Short Sellers, Social Media, and Retail Investors Collide, Part III

Thursday, May 6, 2021

Witnesses

Opening Statements
Chairman Maxine Waters (D-Calif.)
In her opening statement, Waters said that in previous hearings, the Committee has discussed market volatility and scrutinized payment for order flow (PFOF), gamification of trading, the settlement process, and the evolution of trading. She outlined this third hearing will focus on the regulatory response to the events and testimony from the Securities and Exchange Commission (SEC), Financial Industry Regulatory Authority (FINRA), and the Depository Trust & Clearing Corporation (DTCC). Waters continued it is critical to protect investors and ensure our markets are fair. She particularly noted her interest in hearing from Gensler and others about clearinghouses and the settlement cycle. Waters said the Committee is focused on developments in our capital markets and plans to “put Wall Street on notice” that Congress is watching closely.

Ranking Member Patrick McHenry (R-N.C.)
In his opening statement, McHenry said throughout the past few hearings, the Committee has learned that everyday Americans have a newfound interest in the markets, “Reddit is powerful,” and that Congress still only knows as much as was known at the time of the first hearing. McHenry said they keep seeing the same policy solutions and argued that proposals from his Democratic colleagues will just reduce access to investment opportunities. He said if Congress wants to respond, they need to expand the accredited investor regime rather than shrink it and find solutions that allow more people to invest in businesses they support. Along those lines, McHenry highlighted the reintroduction of the Gig Worker Equity Compensation Act to expand the category of workers that can benefit from equity compensation. He said there is still a lot to learn about the January events. McHenry was not in support of “forcing folks to start paying to make trades again.” He concluded by urging Congress to stand up for everyday investors, tear down barriers, and stand up for true equity and ownership of the American economy.

Testimony
Gary Gensler, Chairman, U.S. Securities and Exchange Commission
In his testimony, Gensler opened by saying the policy issues raised by the GameStop, Melvin Capital, Reddit, and Robinhood related market volatility are part of a larger story about the intersection of finance and technology. Gensler said he has come to believe that technology can bring greater access to our capital markets, adding that there should be a focus on technology changing the interface of finance and how to continue to achieve public policy goals and ensure markets work for everyday investors. Gensler said his responsibility is to protect investors as well as maintain fair, orderly, and efficient markets, and facilitate capital formation. In doing so, he highlighted seven factors that were at play in these volatile events: gamification and user experience, payment for order flow, equity market structure, short selling and market transparency, social media, clearance and settlement, and system-wide risks. He said he cannot comment on ongoing examinations but assured the Committee that SEC staff is expected to publish a report assessing the market events over the summer and are vigorously reviewing for any violations. He said he is not concerned about retail investors stating their opinions online, but more concerned with the “bad actors.” In shortening the settlement cycle, Gensler said he believes it could reduce risks and costs in our markets and has directed SEC staff to put together a draft proposal for the Commission’s review.

Michael Bodson, President and CEO, the Depository Trust & Clearing Corporation
In his testimony, Bodson spoke about the important role of the DTCC in facilitating prompt and accurate clearance and settlement of securities transactions. Bodson said they do not know the identity of the customers who execute or direct the trades, nor the customers’ reasons for trading or what other positions customers may hold. He explained if a clearing member defaults on settlement obligations, clearing corporations guarantee the delivery of cash and securities to its non-defaulting members. He said clearing is essential to facilitate the high-volume trading and that without clearing, investors could not trade in the accessible, transparent and highly efficient securities markets that they do today. Over the past year, and as a result of the January market volatility, Bodson said DTCC has been in collaboration with the industry to explore the benefits of moving to T+1 or T+0, and has conducted pilot projects to look at new technologies that could be employed in accelerated settlement or even real-time gross settlement (RTGS). Bodson believes the industry is prepared to move to T+1 and noted that DTCC’s analysis suggests that T+1 settlement could reduce volatility charges by as much as 40 percent, which could save clearing members upwards of $6 billion per day in margin requirements during periods of extreme volatility. As such, Bodson said an acceleration of the current T+2 settlement cycle will benefit clearing members and securities investors alike and looks forward to continuing their work with SIFMA and ICI on this important initiative.

Robert Cook, President and CEO, Financial Industry Regulatory Authority, Inc.
In his testimony, Cook thanked the Committee for the opportunity to discuss the important role FINRA plays in the regulation of broker-dealers and to share their response to the January market volatility. He said the review of these events has raised important investor protection concerns that warrant further investigation. Cook outlined the tools that FINRA has at its disposal to investigate and respond to such incidents, including surveillance over member firm trading activities, risk monitoring, examination, and enforcement when appropriate. Cook said market participants are constantly developing new technologies, which often benefit investors but can also often present unintended risks. He said one important resource to assess this is FINRA’s Investor Education Foundation and would be happy to provide the Committee with their current research on investor trading behavior. Cook said FINRA is reviewing member firm conduct during the recent market events to assess compliance with investor protection and market integrity rules, and they will take disciplinary action as warranted. Cook mentioned a number of topics that will be discussed during the hearing, including payment for order flow, best execution, the settlement cycle, and gamification, and stated that FINRA continues to support SEC guidance around these issues and will take action regarding those found in violation of related rules and regulations.

Question & Answer
Regulation Best Interest
Rep. Ann Wagner (R-Mo.) asked if the SEC plans to make any amendments to Regulation Best Interest. Gensler said the SEC will ensure that rule is fully complied with as written. He later followed up to clarify that if the Commission determines the rule is not working or needs to be revised, they will do so.

Family Offices
Rep. Anthony Gonzalez (R-Ohio) asked about the Archegos event and what it means for systemic risk. Gensler said the SEC staff is preparing recommendations for the Commission. He said there are systemic implications that mean the rules need to be adjusted.

Regulatory Enforcement
Rep. Blaine Luetkemeyer (R-Mo.) noted that regulators issued an interagency statement clarifying the difference between supervisory guidance and laws and regulations. He acknowledged that the SEC operates differently from these regulators, but asked if distinguishing between guidance and rules is essential for sound regulation. Gensler said there is a difference between rules that have gone through notice and comment versus staff guidance. Luetkemeyer asked if Gensler will commit to issuing a final rule that clarifies the role of guidance and ensures enforcement actions will only be based on law. Gensler said he understands there is a difference and would like to meet with staff to discuss further.

Market Makers
Reps. Chuy Garcia (D-Ill.) and Waters outlined concerns regarding systemic risk originating from firms like Citadel, and how “big players” impact pricing and best execution. Waters asked Gensler what his approach will be to mitigating risk related to market maker concentration. Gensler said the heart of well-functioning markets and the mission of the SEC is promoting competition. He said this can be done through transparency but also by ensuring the rules inspire more competition rather than concentration. He said there has been an increasing concentration in market making and in brokerage, particularly around retail order flow. Gensler has asked SEC staff to give the Commission a view of what to think about in our market structure to address this. He said more concentration can lead to more fragile and costly markets. 

Rep. Al Green (D-Texas) asked about the proposal to prohibit market makers trading ahead and if Gensler agrees with disallowing major firms to do so. Gensler said the current rules are civil, but if a market maker takes a customer order and trades ahead of that, it should not be allowed. Bodson said DTCC is not a regulator of the markets on the trading side but noted they do not endorse the practice of trading ahead.

Rep. Rashida Tlaib (D-Mich.) asked if Citadel is supervised by the Federal Reserve and is considered a systemically important financial institution (SIFI), arguing they have used their classification as a hedge fund to evade regulatory scrutiny. Gensler said Citadel is registered at the SEC and that they are not designated as a SIFI. Gensler said he would like to work with the Committee on more rigorous oversight of all significant brokerage firms and clearinghouses.

Reps. Andy Barr (R-Ky.) and Roger Williams (R-Texas) asked Bodson to describe how DTCC communicates with brokers regarding their collateral requirements and if there is potential to improve this communication. Bodson said their margin calculation reflects the risk that the firm is presenting to the DTCC and it gets calculated overnight. He said Robinhood’s margin requirement was in excess of their capital which is what caused problems and extra margin charges. Bodson said transparency is always needed but believes the DTCC currently has good tools to provide said transparency.

Payment for Order Flow (PFOF)
Reps. Bill Posey (R-Fla.) and Gregory Meeks (D-N.Y.) asked if PFOF means investors are subject to unfair trades. Torres asked about conflicts of interest and if the costs outweigh the benefits. Gensler said the nature of PFOF, paying a broker for order flow, can conflict with the interest of customers. He said the SEC found a case in December where there were communications between the wholesaler and broker saying “you (the broker) can get more or your customer can get more.” Gensler said he has asked staff to look at this in the context of the overall market structure and noted there are “other pieces of this puzzle” like exchange rebates. He said he wants to support more transparency and competition around the issue. Cook agreed that PFOF can create a conflict of interest and said the DTCC’s role involves evaluating why PFOF is being routed to certain market makers and if it is in the best interest of the customer.

Rep. Sean Casten (D-Ill.) argued there is a total conflict of interest in the structure of the PFOF agreement and that it puts the interest of brokers and wholesalers directly at odds with that of the investors. Gensler said he would like to take a holistic view of market structure and address the increasing concentration in the markets.

Rep. Josh Gottheimer (D-N.J.) asked Gensler if he thinks the conflict of interest is too significant to be addressed by legislation. Gensler said the SEC found that conflicts do exist, but whether or not it can be addressed through more disclosure needs additional thought and attention.

Rep. Bill Foster (D-Ill.) asked what the feasibility would be for providing retail investors with an estimate of the quality of their order execution and allow them to choose what is in their best interest. Gensler said there is a conflict if a broker only has two or three arrangements for PFOF and if that really fulfills best execution requirements. Gensler said he is interested in looking further into the concept of trade-by-trade information. Cook said we need to determine a benchmark and then how to ensure consistency against such a benchmark. Cook said it would require more reporting from firms themselves or through a centralized process.

Rep. Barry Loudermilk (R-Ga.) asked how banning PFOF would impact investors. Bodson said it varies across firms and is based on their business model. He said for those that rely heavily on it, there would be passthrough effects on investors and affect guaranteed and prompt execution.

Many representatives asked questions about possible solutions other than an outright ban. Gonzalez asked if PFOF is really an issue or if Congress is unnecessarily looking into something that has been around for years. Rep. Cindy Axne (D-Iowa) asked if Gensler is considering updating PFOF rules and what other options are there to address related conflicts of interest. Rep. Alex Mooney (R-W.V.) said banning PFOF is not the right approach and might lead to the end of commission free trading. Rep. John Rose (R-Tenn.) said he is not in favor of banning PFOF without the proper due diligence of studying costs and benefits and asked if a more granular Rule 606 offers a possible solution. Gensler said transparency is always helpful and the SEC is looking at what they should do in terms of overall market structure, whether that includes updating Rule 606 or going further.

Short Selling
Rep. Carolyn Maloney (D-N.Y.) raised concerns about the lack of transparency and asked if broker dealers should improve disclosures about how and when they impose trading halts. Gensler said access to markets, whether you are an individual or an institution, is a critical pillar of our capital markets. He said transparency is important to broker dealers and their customers, and the SEC has asked what the transparency looks like and under what circumstances, as well as if firms have the liquidity to meet collateral requirements.

Rep. Brad Sherman (D-Calif.) asked why FINRA does not disclose short selling information publicly but instead provides it to the exchanges. Cook said he asked staff to prepare a regulatory notice to solicit comment on changes to FINRA’s disclosure regime regarding short selling to make it more frequent and granular as well as how that information is disseminated.

Posey asked Gensler what should be done about short selling. Gensler said short selling has been part of the markets for decades, even before the securities laws. He said the agreement at the SEC is to ensure markets are free of fraud and manipulation and said sometimes individual securities are not aligned with those fundamentals. He said there is a need for greater transparency as it relates to short selling practices.

Rep. William Timmons (R-S.C.) asked if short sellers should have to disclose their short positions in 13F filings. Gensler said Congress anticipated and gave authorities to the SEC on a monthly basis to require aggregate information in the short selling market and believes that transparency benefits markets. Gensler continued that short selling plays a role in price formation, but added that it is important for the SEC to ensure it is done so without fraud or manipulation.

Rep. Alma Adams (D-N.C.) asked what reforms need to be made to 13F filings and if they should be expanded to include derivatives. Gensler said derivatives or total return swaps being included in those filings would be positive and has asked staff to prepare recommendations for the Commission. He concluded that there may be further additions going beyond just derivatives.

Shortening the Settlement Cycle
Wagner and Posey asked if there are better solutions than the bills proposed and how shortening the settlement cycle would help address trading restrictions. Bodson said T+1 is a step in the right direction for lowering costs to members and beneficiaries. He said if we shorten the settlement cycle, the number of open transactions would decrease, and volatility charges would go down by 40 percent. Bodson said they are not proponents for real time settlement as everyone would lose all the benefits a clearinghouse provides. He said all transactions would have to be pre-funded which would in turn cause liquidity issues.

Rep. Van Taylor (R-Texas) asked Bodson about the DTCC’s whitepaper to accelerate the settlement cycle and the benefits of going from T+2 to T+1. He also asked about distributive ledger technology (DLT) and how it would work in this circumstance. Bodson said the move to T+1 will be based upon existing technology while also looking to see if DLT can be used to help solve the problem. Taylor asked if DTCC needs statutory authority to move to T+1. Bodson said he believes the industry itself will be able get to T+1.

Rep. Juan Vargas (D-Calif.) asked Gensler for his thoughts on moving to T+1 versus real time settlement. Gensler said technology exists to get to same day settlement, but it is still netted and there are transition costs. He said markets can get to T+1 or “T+Evening” but that it will take some time.

Adams asked if it was the settlement cycle or poor risk management to be blamed in Robinhood’s margin requirements issues. Bodson said shortening the settlement cycle would help reduce the margin charge as the number of open trades would be smaller.

Digital Assets and Cryptocurrency
McHenry outlined the need to collaborate on a regulatory framework for digital assets and cryptocurrencies, and he believes more concrete steps are necessary to further the crypto market. He asked Gensler what steps can be taken to bring more regulatory clarity. Gensler said the crypto market could benefit from greater investor protection. He said within the SEC’s current authorities, they put out a comment asking for feedback on custody in hopes to move forward and provide greater clarity. In terms of working with Congress, Gensler stated that it would be beneficial to consider whether to bring greater investor protection to the crypto exchanges, because trading in these assets does not currently have a regulatory framework.

Rep. Warren Davidson (R-Ohio) asked Gensler for his thoughts on blockchain technology and the regulation of digital assets, mentioning his Token Taxonomy Act. Gensler said there are things the SEC can do better if Congress desires to fill gaps in crypto exchanges and create an investor protection regime.

Rep. Ted Budd (R-N.C.) outlined his concerns that the U.S. has a lack of clear guidance as it relates to the crypto markets. He asked Gensler what he would like to work on in this area. Gensler said there are areas like bitcoin trading and large exchanges that are not really protected. In terms of using blockchain technology to speed up settlement, Bodson said distributed ledger is an exciting technology and in working with SIFMA and ICI, they plan to look at business processes and when the right time is for possible implementation.

Gamification, Social Media, and Trading Platforms
Reps. Emmanuel Cleaver (D-Mo.), Lawson and Axne asked what needs to be done in terms of guardrails to address the concerns around social media and manipulation. Gensler said it is important to be technology neutral and ensure they still stick to principles of investor protection. He said the SEC will lean into this issue and be a “cop on the beat” and “freshen up” the SEC rules to protect investors against social media bad actors. Gensler said he is requesting comments on this topic to better understand the risks and benefits to investors.

Rep. David Scott (D-Ga.) asked how Congress can ensure investors have equal market access and invest safely as inexperienced investors have been relying on unverified information from social media. Scott also asked how to regulate the impact of new technology and who is held accountable when trading advice leads to market volatility. Cook said FINRA does not regulate the social media environment and to look to the SEC for addressing concepts around manipulation. Gensler said the concern is not about free speech rights on social media, but when someone is trying to defraud the market, and that the SEC will vigorously lean in on individuals and companies and update their resources to be able to see those relationships.

Rep. Jim Himes (D-Conn.) asked Cook and Gensler if there is a point of complexity in which options or trading on margin should be restricted. Gensler said to open an options account, there is more discussion between an advisor and the investor. He said applications have made it easier to open accounts and we have lost the middleman to ask if the risk is appropriate. Cook said it is a matter of striking the right balance and the existing rules should reflect the change in technology that now lacks this middleman.

Rep. Jake Auchincloss (D-Mass.) expressed his concerns around the gamification of options trading and asked where FINRA and the SEC draw the line between providing a good user experience and inappropriately inducing trading behavior. Cook said options bring greater PFOF and conflicts of interest, which combined all together creates a package that needs a holistic approach. Gensler said the gamification is inspiring people to trade more and believes the SEC needs to “freshen up” their rules.

Consolidated Audit Trail (CAT)
Loudermilk mentioned the CAT and outlined his concerns about including personal identifiable information (PII) and highlighted the Protecting Investors’ Personally Identifiable Information Act. He asked if Gensler will take action to protect investors’ personal sensitive data, arguing that even without PII, including any information still puts people at risk. Gensler said the SEC is committed to protecting investor data, and added that the SEC passed updates to the CAT, provisioning that a lot of PII will no longer be collected like birth date and social security number. Gensler also added that the CAT is being constructed together jointly under FINRA and the SEC.

Environment, Social and Governance (ESG) Disclosures
Rep. Frank Lucas (R-Okla.) asked about enhanced climate related disclosure and for Gensler to shed light on what this enhanced focus means. Gensler said he has asked staff to prepare recommendations for the Commission as to what disclosures in climate risk areas that investors want to take into consideration when making investment decisions.

Vargas mentioned his ESG Disclosure Simplification Act of 2021 (H.R. 1187) and asked if it is unfair that some companies disclose ESG when others do not. Gensler said he will look closely at the bill and plans to ask the public for comments as to what investors need as it relates to climate, human capital, and diversity. He said it is important and within the authority of the SEC to enhance these disclosures.

Financial Transaction Tax (FTT)
Wagner and Williams asked if an FTT would increase market volatility and what changes would most likely occur if one is imposed. Bodson said there are mixed results because some markets, like Hong Kong, have seen it be effective while other markets have shown that it can limit trading. He said he has not seen anything discussing FTT and volatility, but believes they are somewhat separated. In terms of who ends up paying it, Bodson said it flows back to the retail investors and would impact returns and wealth creation negatively.

Gottheimer asked Gensler if he supports an FTT and if there is concern with pushing markets overseas. Gensler said taxing questions are outside of the SEC’s jurisdiction. He said there are tradeoffs that would be more appropriately evaluated by Congress, Treasury, and the White House.

Arbitration
Maloney asked about “forced” arbitration clauses that issuers could insert into documents pertaining to corporate governance and by-laws and if the clauses violate federal securities laws. Gensler said he needs to be more fully briefed on the law, but the SEC has said consistently to issuers it would be best to not put this into corporate charters. He said the public needs to be able to have redress to their courts.

Huizenga asked what negative consequences could be if FINRA arbitration clauses were to be banned in customer contracts. Cook said that arbitration clauses in corporate governance documents and company by-laws is not something that FINRA imposes, but it happens as a matter of contract, and FINRA does not have authority to address that.

Diversity and Inclusion
Maloney, Perlmutter, and Meeks asked about diversity and inclusion efforts, and if Gensler will commit to promoting greater diversity in the agency, corporate, and advisory groups. Gensler said yes, that diverse views bring better solutions and he has asked staff to suggest ways to encourage diversity in corporate America as well as at the SEC.

Penny Stocks
Perlmutter asked Gensler if he agrees with concerns about the potential to manipulate low price stocks. Gensler agreed and said there is a risk with low price stocks for more manipulation and fraud. He said earlier this year, the SEC took action to delist about 30 entities that fall into these categories. Perlmutter asked if rules around penny stocks and exchange listings of these stocks should be updated. Gensler said he will ask his staff to look at the current rules and how they affect what happened in January.

Regulation Crowd Funding
McHenry said he is focused on the burdensome requirements of the original Regulation Crowd Funding (Reg CF). He said there have been some helpful changes made to Reg CF to boost trading and asked Gensler if he supports these streamlining efforts for small businesses. Gensler said small business entrepreneur efforts are the “backbone of American entrepreneurism” and that access to capital markets is a critical piece whether it is through loans or equities. He said he has not gotten a detailed enough briefing on Reg CF.

For more information on this hearing, please click here.