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Senate Banking Committee Hearing on GameStop

Senate Committee on Banking, Housing, and Urban Affairs

Who Wins on Wall Street? Gamestop, Robinhood, and the State of Retail Investing

Tuesday, March 9, 2021

Witnesses

Opening Statements                   

Chairman Sherrod Brown (D-Ohio)

In his opening statement, Brown said that the COVID-induced plummet of the stock market, followed by the fastest recovery in history, demonstrated that the markets are detached from the economy and the reality of most Americans’ lives. He questioned who benefits from the stock market, arguing that the beneficiaries are a tiny sliver of people, often at the direct expense of American workers. Brown said the development of fintech and financial services, such as Robinhood, claim to democratize markets, but also demonstrate the serious risks. He said that as busy Americans cannot make sense of the market, they will lose faith in the market and hedge funds will reap the majority of the profits. Brown noted that Robinhood tried to blame its decision to cut-off its customers from being able to purchase certain stocks on industry-wide standards for processing stock purchases, but that Robinhood violated the law, refused to respond to customers, and cut off customers to save itself. He said the SEC should cut the time it takes to complete stock purchases. Brown argued that Wall Street treats the market as a game which they always win at the expense of everyone else, stating that the system is set up to funnel more wealth to the already wealthy. Brown concluded that the economy and market should work for everyone with broadly shared prosperity and a growing middle class, saying this will promote confidence that the markets work for people, not just for Wall Street.

Ranking Member Pat Toomey (R-Pa.)

In his opening statement, Toomey said Congress should not impose unnecessary restrictions and burdens on investors, which could limit investors’ access to and choices in the stock market. He said it is a great time to be a retail investor because of zero-commission trading platforms with no minimum account balance required and user-friendly trading technology such as mobile apps. Toomey noted that 2020 was a record year for new individual accounts, which allows everyone to share in the gains of the market. He said that some people believe the market is rigged against retail investors, but questioned if the market is rigged as some hedge funds lost “their shirts” shorting GameStop and some retail investors “hit pay dirt” buying it. Toomey argued that retail investing does not need to be expensive, miserable or difficult, and more American households should have the opportunity to benefit from the financial gains available through the stock market. He said the average American does not need big government limiting their access to, and choices in, the stock market. Toomey said risk is a fundamental aspect of the market, but over time long-term investors investing in US stocks “win.” He concluded that regulators should pursue a faster settlement cycle, such as same-day or even real-time settlement, which will reduce risks and require less collateral for clearing agencies which may reduce margin charges and other fees that are inevitably passed on to investors.

Testimony

Gina-Gail S. Fletcher, Professor of Law, Duke University 

In her testimony, Fletcher said the capital markets exist to channel capital into its best uses, including providing investors with reasonable returns, but argued that recent trading activity seems to be divorced from this essential purpose. She said that as a company’s price “yo-yos” back and forth, it is clearly not a good faith reflection of the fundamental value of a company. Fletcher noted that financial innovation has made it easy for retail investors to trade more complex, leveraged, and risky activities which leads to more retail participation. She argued, however, that recent market events have raised questions about the integrity and long-term stability of the markets. She argued that, to the extent that asset values are subject to wild swings and are divorced from fair-market values, market participants will view the markets as rigged and unreliable, which will deter investment and harm the economy. Fletcher said that Congress and regulators should act to ensure that those who deliberately distort prices may be subject to regulatory or prosecutorial discipline. Fletcher said Congress and regulators should address the incentives and market structures that have created the modern trading markets, including the proliferation of payment for order flow practices, the segmentation of retail orders, and the overall impact on trading costs for all investors, including retail and institutional investors. She said Congress and regulators should review whether and how investors should access complex leveraged products, such as call options, saying that some investors do not fully comprehend the products they are trading or the risks they are taking. She said that Congress and regulators must acknowledge that events such as GameStop are no longer outliers but are instead regular features of the current system. She argued that brokers need to be better prepared to stand behind their customers’ risky trading and to the extent they cannot, the answer ought not lie with limiting retail participation. She also said regulators should shorten the settlement cycle.

Rachel J. Robasciotti, Founder & CEO, Adasina Social Capital 

In her testimony, Robasciotti said there are three groups to consider – hedge funds, “Redditors,” and everyday Americans. She argued that the first two groups are fast-moving, high-risk speculators with more skills and tools than the average person. Robasciotti said that the domination of these two groups leads to market disruptions which are a problem because extreme stock price volatility has the potential to expose investors to rapid and severe losses and undermine investor confidence. She argued that everyday Americans’ only option to provide for their future is to invest in the stock market, requiring them to “play” against sophisticated, high-risk hedge funds and Redditors. For everyday Americans, Robasciotti said that sustaining significant losses, or even the perception of losses, is devastating and makes them lose confidence and want to opt out altogether. Robasciotti concluded that we need to maintain fair, orderly, and efficient markets that serve as a reasonable place for the average American to invest their life savings and that we have a duty to protect these investors from the “cross-fire” of fast-moving, high-risk speculators.

Dr. Teresa Ghilarducci, Bernard L. and Irene Schwartz Professor of Economics, The New School 

In her testimony, Ghilarducci said that young investors are told to buy and hold stocks, but they do not absorb the second point to “hold” such stocks because trading on Robinhood is a “game” with psychologically powerful intermittent “rewards” that are disconnected from long-term wealth accumulation. She argued that the places where Americans really get their wealth are primarily home equity, Social Security and retirement, explaining that directly owned stocks and bonds comprise only a small share of most Americans’ wealth. Ghilarducci said that stock trading feeds a narrative about wealth, specifically the fiction that stock trading creates wealth, when in fact retail investors fuel bubbles. She argued that while some users of Robinhood did accumulate wealth, most Americans are being “left out” because they do not have access to retirement accounts, which are invested in diversified portfolios managed by institutional investors and professionals that can handle complex investment instruments. Ghilarducci concluded that we need innovations in public policy to give more Americans access to what we know works: professionally managed retirement coverage that allows everyone to benefit from the stock markets.

The Honorable Michael S. Piwowar, Executive Director, Milken Institute Center for Financial Markets 

In his testimony, Piwowar said that retail investors have “never had it better,” particularly because they have so many investment-related choices. He said that retail investors can make their own investment decisions, can seek a broker-dealer or investment advisor, can invest through mutual funds and ETFs, and have access to a wide availability of retirement savings accounts. Piwowar said that the January trading frenzy and its related difficulties highlighted a few areas that require immediate attention. He said the SEC is determining whether regulated entities have disadvantaged investors or otherwise unduly inhibited their ability to trade certain securities and the SEC is investigating whether abusive or manipulative activity occurred. Piwowar recommended the SEC should: 1) evaluate whether and how to move to a shorter trade settlement cycle; 2) study how payment for order flow is working in a zero-commission environment, with a focus on order routing and best execution requirements; 3) evaluate various alternatives to increase regulatory reporting and public transparency in securities lending; and 4) consider amending the “accredited investor” definition to achieve more equitable access to investing in private companies across all income levels.

Andrew N. Vollmer, Senior Affiliated Scholar, Mercatus Center 

In his testimony, Vollmer said that what we know so far about the GameStop events does not provide a sufficient basis for new legislation or regulation. He argued that based on public information, misconduct by the “Redditors” probably did not occur in the trading of GameStop because the main group of individuals did not make material false or misleading statements and were not deceived by others. He also said that securities manipulation, which requires trading that is artificial and not genuine, did not occur because the Redditors actually bought the stocks. He said that the effects on the secondary markets do not appear widespread or severe. Vollmer discussed the role of Robinhood, arguing that criticisms of the platform fail to give the appropriate weight to the benefits of its business model, which is innovative and makes significant positive contributions to society and the economy. Vollmer concluded that the information currently available has not revealed a problem of sufficient severity to justify Congress imposing new regulations, arguing that during any deliberations about possible additional legal restrictions, Congress should give weight to and respect the personal liberty interest involved.

Question & Answer

Market Structure and Inequality

Brown asked about the fairness of our financial markets and suggested that fixations on Wall Street performance have distracted us from the economic reality of most American families. Robasciotti said there is an increase of people in younger generations choosing to not participate in the markets because they do not see them as fair or efficient. Fletcher said the U.S. capital markets are some of the best in the world, though not fully efficient and have room for improvements around investor protection.

Sen. Bob Menendez (D-N.J.) asked about the consequences of disproportionate participation by minority families in the stock market and if their lack of stock ownership impedes their ability to build wealth. Ghilarducci said they need social security, home equity, and access to financial instruments with professionally managed funds, not through trading on their phone. She said not having access to retirement plans at work also holds these families back from being able to build wealth. She said we need to expand retirement coverage to all workers and include innovative pensions for all plans.

Sen. Jon Ossoff (D-Ga.) raised his frustration with inequalities surrounding the total national wealth held in stock and asked what benefits we could see from policy that gets money in the hands of investors. Robasciotti said when you give money to those who are more in need, they are more likely to spend it and circulate it which creates a multiplier effect of benefits throughout the entire economy.

Toomey asked about the benefits of more affordable access to investing, and if a retail investor puts their savings in a broad, diversified portfolio would they see substantial returns on those investments or see a loss if the stock market operates like a “casino.” Piwowar said that on average the stock market tends to go up, so retail investors who hold diversified positions in low-cost mutual funds over long periods of time will do well in increasing their wealth.

Financial Education

Sen. Bill Haggerty (R-Tenn.) said that many investors were caught off guard when restrictions were placed, but as a result this has caused people to learn more about the financial markets. Haggerty asked if the SEC accomplishes more by focusing on investor education than stricter regulations, and what actions can be taken to support retail investors. Piwowar said the SEC has all the regulatory authority it needs, but in terms of investor education, there is always room for improvement. He cited making sure disclosure information is understandable by a regular investor not just securities lawyers as an example.

Sen. Jon Tester (D-Mont.) asked what improvements the witnesses would make to the system to ensure it works better for retail investors. Fletcher responded that investors would benefit from better information about what the true costs are for their trades and transactions so they can better evaluate costs and risks. Ghilarducci agreed, and Piwowar added that better disclosures can arm investors with the information they need to make better decisions, calling particularly for better information on order routing and best execution. In response to a question from Sen. Catherine Cortez Masto (D-Nev.) about whether broker dealers currently provide enough education and disclosure to consumers, Fletcher said that not enough education is currently being provided to allow retail investors to maximize their wealth.

Payment for Order Flow (PFOF)

Sens. Mark Warner (D-Va.), Brown and Menendez raised concerns about the use of PFOF and potential conflicts of interest. Brown asked why these conflicts can be so problematic. Menendez asked how PFOF affects the customer’s best interest and the quality of execution. Fletcher said PFOF allows some firms to say they are offering zero commission, but the model undermines the relationship between a broker and their client. She said the PFOF model creates a conflict of interest because brokers are incentivized to put their own profit seeking interests above the interest of their client. Fletcher said we need better disclosure obligations to provide the retail investor with information on price improvement when routing between different wholesalers.

Warner agreed that PFOF is extraordinarily not transparent. He disbelieves the argument that a PFOF model is necessary to increase liquidity, citing that large enterprises like Fidelity and Vanguard do not use PFOF and still provide quality execution to their customers. Fletcher said PFOF is not needed for liquidity. She said we have a deep financial market and pointed to the UK experiencing no decline in liquidity without PFOF, saying there has been better execution for investors because of little conflicts of interest.

Cortez Masto asked if the PFOF model should be banned. Robasciotti said it should be. Piwowar said it should not be banned without proper study, calling on the SEC to look into the issue. He noted that banning PFOF will likely bring back commission-based trading, saying this just shifts any conflicts of interest rather than eliminating them. Vollmer added that those providing important services in the capital markets deserve compensation and PFOF is one method, saying if it is banned another mechanism for compensation for those services will need to be found.

Settlement Cycle

Brown and Toomey asked if moving to a T+0 settlement is realistic and what challenges could occur as a result. Piwowar said he supports the SEC moving to T+1 to remove some risk from the system, but the move towards T+0 is a bridge too far because it would increase operational risk. Piwowar referred to the last decision when moving from T+3 to T+2 instead of T+1 which had added challenges and costs. He said if we want to reach T+0, the answer must involve blockchain technology but noted that we are not there yet. He suggested the SEC put this topic out for public comment.

Trading Halts

Toomey asked if the claim by Robinhood that their trading restrictions were driven by margin requirements from the Depository Trust & Clearing Corporation (DTCC) is a plausible explanation and if it is optimal to have this opacity around how these rules work. Vollmer said the explanation by Robinhood’s CEO was reasonable, that the margin requirements truly took them by surprise. However, he said neither Robinhood nor the customer should have been as shocked as they were and urged the SEC to look into smoothing and improving the process for the benefit of both parties.

Sen. Richard Shelby (R-Ala.) asked whether Robinhood performed in a rational, thoughtful way during this time. Vollmer replied that they reacted rationally and their response was as thoughtful as it could be considering the great deal of time pressure they were under due to the sudden collateral call.

Regulatory Process

Shelby asked Piwowar to explain the process of conducting a cost-benefit analysis of a regulation at the SEC. Piwowar explained that current guidance enhances the role of the chief economist at the SEC, giving them more authority over the rulemaking process and involving them earlier in the process. He continued that the SEC must justify why they are proceeding with a given regulation, evaluate alternatives, provide economic analysis, solicit input from the public, and reevaluate, calling the rulemaking process “very robust.”

Financial Transaction Tax (FTT)

In response to a question from Tester about what the witnesses would change about the system to make it work better for retail investors, Robasciotti said an FTT would help prevent high frequency trading by serving as an “invitation for deliberation.” Ghilarducci agreed that an FTT would help the markets work better. Sen. Thom Tillis (R-N.C.) inquired further on this point, noting that studies have shown an FTT would reduce the value of a typical investor’s 401(k) by as much as 8.5 percent, saying they would have to work on average an additional 2.5 years to make up for that loss. Ghilarducci called that data out of date and distorted, saying that those studies were conducted on much higher taxes than those currently proposed, and would reduce savings in 401(k)s and pensions only if they traded “all the time.” Tillis continued that the Congressional Budget Office (CBO) projects that an FTT would result in a $43 billion first year net loss in tax revenues and would immediately lower the value of financial assets, asking what the “sweet spot” would be that would impact high volume traders but not others. Ghilarducci said it has to be done right and there is a number that works, committing to responding to the Senator later with an answer.

Sen. Chris Van Hollen (D-Md.) said he plans to reintroduce an FTT bill with Sen. Brian Schatz (D-Hawaii), and claimed the right FTT would generate billions of dollars to invest in opportunity and reduce volatility in the markets. He asked witnesses to evaluate the risks of high frequency trading and how an FTT could be a benefit. Robasciotti said she is happy to hear the bill will be reintroduced. She said the high frequency trading risks are systemic and that an FTT is a reasonable, small price to pay for slowing down the non-human high frequency trading that has caused so much damage. Ghilarducci said the associated costs and benefits have been evaluated for decades and an FTT that is too high or too low could have worse long-term savings effects or no impact at all. She said she believes the 0.1 percent tax is the right number and will reduce high frequency trading.

Market Access for Retail Investors

Sen. Kevin Cramer (R-N.D.) asked whether retail investors should have direct access to the markets or should have to rely on professional advice. Vollmer said retail investors greatly benefit from direct access to the markets but should be aware of the risks involved and recognize their limitations. Piwowar agreed, saying it is important for retail investors to have access to both options. Ghilarducci said that advice retail investors receive should be high-value and the benefits should outweigh the costs.

Gamification of Trading

Cortez Masto raised concerns about the gamification of trading, asking if the design features of trading apps should be regulated. Fletcher said that at a minimum the designs should be studied, saying there are behavioral economics at play. In response to a question from Tester, Ghilarducci said that economic analysis should include behavioral analysis, including how apps are designed to reduce the addictive aspects.

Piwowar said that while he has not used the Robinhood app and did not comment on it specifically, simulations and games can be an effective way to educate students.

Accredited Investor Definition

In response to a question from Tester about how to improve the markets, Vollmer noted that the differences between accredited and nonaccredited investors should be eliminated for private market transactions.

For more information on this hearing, please click here.