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House Financial Services Committee Hearing on GameStop

House Financial Services Committee

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

Thursday, February 18, 2021

Witnesses

Opening Statements                   

Chairwoman Maxine Waters (D-Calif.)

In her opening statement, Waters questioned how the witnesses and their companies contributed to the historic trading events in January. She noted the events illuminated potential conflicts of interest and the predatory ways that certain funds operate and demonstrated the enormous potential power of social media in the markets. Waters claimed that the events also raised issues involving gamification of trading, potential harm to retail investors, and the business models of apps used by retail investors. She noted that many of the retail investors appeared motivated by a desire to “beat Wall Street at its own game,” and given many retail investors’ losses, there are many who had their beliefs that the financial system is “rigged against them” reinforced. Waters concluded that the role of the committee is to ensure fairness in the financial system, robust protections for investors, and accountability from Wall Street.

Ranking Member Patrick McHenry (R-N.C.)

In his opening statement, McHenry argued that Americans are far more sophisticated, informed, and capable than many give them credit for. McHenry said that a fundamental change is happening because everyday investors can communicate, access more information, and act collectively to move markets, all in real time. McHenry stated that current regulations allow for the wealthy to be “good to go” while the poor are deemed too “dumb” to be trusted with their own money; in the eyes of the government, he claimed, retail investors need to be protected from their own decisions, their own money, and opportunity. He called on the committee to seriously consider issues of equity and ownership in the American economy. McHenry concluded that instead of shutting out retail investors through new regulations, new forms of taxation, or so-called protections, the committee should use this opportunity to side with them.

Rep. Brad Sherman (D-Calif.)

In his opening statement, Sherman questioned short-selling, market participants who buy or short for the purpose of influencing price, payment for order flow, and the difference between best execution and enhanced best execution. He argued the committee needs to examine why it takes two days to settle a transaction and why it is the broker’s capital, rather than customer’s, that is posted during the two-day period. Sherman concluded that the committee should examine the gamification and glorification of high-frequency trading and pass legislation to solve these issues this year.

Rep. Al Green (D-Texas)

In his opening statement, Green noted that Citadel Securities has paid over $100 million in penalties. He questioned whether the committee can allow a market maker’s cost of doing business to include penalties from misleading clients and improperly trading ahead of clients. Green concluded that the risk of punishments for violations must always exceed the rewards in order to deter the activity.

Testimony

Vlad Tenev, Chief Executive Officer, Robinhood Markets, Inc.

In his testimony, Tenev stated that Robinhood’s purpose is to democratize finance for all and make investing more accessible; most of Robinhood’s retail clients, he asserted, invest for the long-term. Tenev noted that Robinhood offers hundreds of free educational resources on its app and that the business model works for everyday Americans. Tenev argued that, during the volatile trading in GameStop and other companies, Robinhood Securities, the clearing broker, had to “hold the line” and post additional firm capital as collateral to support clearinghouse deposit demands. Robinhood Securities, he said, then imposed temporary trading restrictions on certain securities. He argued the restrictions were put in place to meet increased regulatory deposit requirements, not to help hedge funds. He also stated Robinhood immediately secured additional funds through capital raising and additional measures to increase liquidity to cushion against increased collateral requirements and related market stress in the future. Tenev apologized to his customers and ensured that this type of event will not happen again. He concluded that the two-day settlement cycle exposes investors and the industry to unnecessary risk and urged that capital and resource should be deployed to make the settlement period happen in real time.

Kenneth C. Griffin, Chief Executive Officer, Citadel LLC 

In his testimony, Griffin, acknowledging the important role of retail investors, noted that Citadel executes more trades on behalf of retail investors than every other firm. He emphasized that Citadel played no role in Robinhood’s decision to limit trading in GameStop and other meme stocks, saying he learned of the limitations only after they were publicly announced. Griffin stated that Citadel was able to provide continuous liquidity every minute of every trading day during the period of frenzied trading, even when others were unable or unwilling to handle the heavy volume of trading. Griffin concluded that Citadel is committed to ensuring the interest of retail investors were served during the extraordinary period.

Gabriel Plotkin, Chief Executive Officer, Melvin Capital Management LP

In his testimony, Plotkin noted that many investors on all sides experienced losses. Plotkin also emphasized that Melvin Capital played no role in decisions of the trading platforms to limit trading; Plotkin closed all positions in GameStop days before the limitations were enacted. Plotkin said that Melvin Capital was not bailed out during these events, and explained that Citadel proactively reached out to become a new investor as an opportunity to buy low and reap returns for their investors if and when Melvin Capital’s funds increased. Plotkin argued that most investments are long; after extensive research, the firm occasionally might short certain stocks for the long-term because when markets go down, Melvin Capital has a duty to protect their investors. He asserted that none of Melvin Capital’s short positions were an attempt to artificially depress or manipulate the price of stock, and that Melvin Capital complied with all securities laws surrounding shorting stocks. Melvin Capital, he noted, has had a short position in GameStop for six years. During the frenzy, Plotkin argued, he did not believe that the increase in share price had any relationship to the intrinsic price of GameStop business. Plotkin concluded that Melvin Capital closed their position at a loss, but not because the investment thesis changed, and noted that he needed to take steps to protect his investors in the future.

Steve Huffman, Chief Executive Officer, Co-Founder, Reddit

In his testimony, Huffman explained Reddit’s moderation system, which involves platform-wide content policies against hatred, illegal activity and bullying. He explained that each moderator, such as the moderators for WallStreetBets, can also set their own rules. Huffman stated that WallStreetBets is a higher-risk, higher-reward investment community whose traders banded together at first to seize an investment opportunity not usually available to retail investors, and later banded together to defend all retail investors against the criticism of the financial establishment. With increased attention, Huffman argued that Reddit increased their infrastructure, helped resolve conflict and the moderation tools were working as expected. Huffman concluded that the events in January raised important issues about fairness and opportunity in the financial system.

Keith Gill

In his testimony, Gill noted that he does not have clients nor does he provide investment advice in either his personal or employment capacity. He explained that he works at MassMutual, but his job is to help develop financial education classes for other MassMutual employees to present to prospective clients. Gill said that in June 2019, his own research suggested that GameStop declined below what he though was the fair value. The market, he argued, was underestimating the prospects of GameStop’s legacy business and overestimating the likelihood of bankruptcy. He also argued that GameStop has the potential to reinvent itself as the ultimate destination for gamers and has the unique opportunity to pivot toward a technology-driven business. Social media platforms, he noted, have leveled the playing field for retail investors. He concluded that his posts on social media did not cause the movement of billions of dollars into GameStop shares, and the events in January demonstrated that investing in public securities is extremely risky and demonstrated how alarmingly little Americans know about the market. Gill concluded that retail investors should be able to invest in what they want when they want.

Jennifer Schulp, Director of Financial Regulation Studies, Cato Institute

In her testimony, Schulp noted the increase in retail investor participation in public equities, which provides a path to wealth for retail investors. This, she argued, should be welcomed and expanded, not restricted. With respect to GameStop, Schulp stated that the temporary volatility in the market did not present a systemic risk to market function. The fact that prices were trading above fair market value is not a reason for concern, Schulp argued, and markets are no stranger to bubbles. Schulp also noted that short-selling works well to handle circumstances where the analysis is missing relevant information or the stock price is due for a correction. Schulp argued that the Securities and Exchange Commission (SEC) has the tools to address any harmful misconduct because the SEC has access to much more information. Schulp concluded that she believes that no more regulations are warranted and that no steps should be taken to limit retail investors’ access to the markets.

Question & Answer

Trading Restrictions and Capital Requirements

Throughout the hearing, several committee members asked about the restrictions Robinhood placed on trading. In response to questions from Reps. Bryan Steil (R-Wis.), Barry Loudermilk (R-Ga.) and McHenry, Tenev explained that the decision to restrict trading in certain securities was driven by deposit and collateral requirements imposed by clearinghouses. Tenev also pointed out they were not the only brokerage putting limitations on buy orders for these stocks. In response to a question from McHenry, Tenev confirmed that Robinhood was not pressured to do so by any of the other witnesses. Rep. Madeleine Dean (D-Pa.) asked when customers were informed of the trading restrictions, to which Tenev replied that Robinhood communicated with its customers that opening further options in certain securities would be restricted, as well as published a blog explaining the rationale behind this decision.

Rep. Andy Barr (R-Ky.) asked if clearinghouses are supervised by federal regulators, which Tenev confirmed. Rep. Ann Wagner (R-Mo.) asked about the purpose of the capital requirements that caused Robinhood to restrict trading and if there were failures in these functions. Schulp said the requirements are in place to provide security for the stock and that the market functioned correctly. Rep. William Timmons (R-S.C.) asked Tenev to explain how the volume of trades ordered by customers affected Robinhood’s required collateral, to which Tenev replied that Robinhood’s deposit requirements increased tenfold from January 25th to 28th. Timmons argued that the Dodd Frank Act imposed these requirements, to which Schulp said that the capital requirements established by the Dodd Frank Act could be seen as responsible, saying it is important to evaluate them as well as examine settlement times and modernization of the system more broadly.

Asked by Rep. Anthony Gonzalez (R-Ohio) what would have happened if there was forced liquidation as a result of missing the capital call, Tenev said that customers would have experienced a total lack of access to the markets.

Liquidity Concerns

Reps. David Kustoff (R-Tenn.) and Waters asked Tenev if Robinhood misjudged its capital requirements. Tenev said they did not misjudge the requirements; it was simply an unforeseeable event with limited options on how to address the situation. Members implied that Robinhood’s problem might have been liquidity-related, leaving them undercapitalized to properly serve their customers. Tenev said the company felt comfortable with its liquidity, and the additional capital it raised was not to meet its capital or deposit requirements. Reps. Gregory Meeks (D-N.Y.) and Michael San Nicolas (D-Guam) expressed concerns that the capital infusion benefitted the company rather than investors. Tenev said that Robinhood was in compliance with its deposit and capital requirements, and the additional capital raised was to prepare for future events and to remove restrictions on trading. He added that Robinhood has improved in risk management which will improve the customer experience.

Payment for Order Flow and Best Execution

Reps. Brad Sherman (D-Calif.), Frank Lucas (R-Okla.), Bill Huizenga (R-Mich.), Joyce Beatty (D-Ohio), Andy Barr (R-Ky.), Bill Foster (D-Ill.), McHenry and Waters asked questions about the relationship between Citadel and Robinhood, the purpose of paying for order flows, and how it impacts the quality retail investors receive. Touching on the purpose of pay for order flow and how the process benefits the everyday investor, Tenev said payment for order flow enables commission free trading. Schulp said this feature has largely benefited customers and industry competition which helps drive innovation. Griffin said that Citadel has vigorously advocated for execution quality, saying the company plays by the rules of the road regarding payment for order flow. Tenev noted that payment for order flow is a legal practice and is disclosed to customers in multiple instances.

Reps. Ritchie Toerres (D-N.Y., Barr, Foster, Beatty, Sherman and Waters all agreed that Citadel’s role in the event and their roughly 47 percent share of Robinhood orders raises questions for policymakers. Beatty noted that Citadel paid online brokerages like Robinhood $700 million for their order flows and asked if Robinhood can serve the best interest of their users when they sell order flows to Citadel. Similarly, Rep. Juan Vargas (D-Calif.) asked Citadel how they balance best execution requirements while profiting from order flows. Tenev and Griffin both ensured that routing order flows to Citadel is in the user’s best interest because Citadel provides a better price and quality of execution than the exchanges, who have a one cent minimum tick size. Rep. Chuy García (D-Ill.) asked Citadel, based on their claim to be the largest destination for retail trading, if they consider themselves a systemically important financial institution (SIFI), but Griffin said he does not view Citadel as part of this category. Foster asked Robinhood if they would support a mechanism allowing customers to compare execution quality statistics. Tenev and Griffin explained the difficulty in comparison because the quality naturally varies based on size and channel of the order. Tenev said he is generally supportive of greater transparency.

T+2 Settlement Cycle

Reps. Blaine Luetkemeyer (R-Mo.), Warren Davidson (R-Ohio), John Rose (R-Tenn.), Loudermilk and Kustoff asked if a T+0 settlement cycle in this situation would have solved the problem and what unintended consequences we could see from reducing the settlement period to real time. Griffin pushed more for T+1, saying T+0 would require every bit of the workflow to be synchronized across all parties and would leave them with no time for recoverability. He added that certain market participants rely on next day settlement to take advantage of intraday netting and run up larger one-sided positions in certain stocks with the knowledge that they could close those positions or reduce them by the time settlement happens. He said that T+0 would be a limitation to the trading activities of some of these institutions. Tenev expressed his belief that real time settlement would have prevented this situation and will lead to a reduction, perhaps even elimination, of overall clogging in the system.

Financial Transaction Tax

Reps. Alex Mooney (R-W.V.), Rashida Tlaib (D-Mich.) and Hill asked about a potential financial transaction tax (FTT). Mooney and Hill argued it would do more harm than good for smaller retail investors. Mooney said instead of making trading more burdensome with a tax, we should aim to empower retail traders. Members asked how a 0.1 percent tax on the sale of securities would affect trading platforms and retail investors, and if there’s reason to believe it would help prevent fraud, market manipulation, or market volatility. Tenev said a FTT would eat into the returns of their customers who are largely small investors. Schulp said FTTs often fail to raise money and distort trading. She said an FTT might initially seem like a small imposition, but the taxes often hurt individual investors and their long-term retirement goals and would do nothing to address market volatility.

Short Selling

Luetkemeyer questioned how short selling a stock is not considered manipulation and if there should be a limit on this. Plotkin said any time they short a stock, they locate a borrow, ensuring they always short stocks within the context of all the rules. Rep. Steve Stivers (R-Ohio) asked Plotkin if Melvin is a frequent short seller and has ever engaged in short selling of Tesla, mentioning Elon Musk’s tweet about purchasing stock in GameStop. Plotkin said Melvin runs a long and short portfolio with the majority being long investments. and Melvin has some short investments to hedge out market risk. Plotkin said they have been short Tesla in the past but cannot speculate as to whether Musk’s tweet had an impact or was purposely done to target them. Asked by Barr if their short positions exceeded float, Plotkin said they did not. Rep. Vincente Gonzalez (D-Texas) asked what is in place to prevent Citadel from taking advantage of a short selling situation and profiting off retail investors. Griffin said Citadel takes pride in their duty of best execution and the quality they give traders.

Data Security

Reps. Lee Zeldin (R-N.Y.) and Stephen Lynch (D-Mass.) raised concerns about national security. Zeldin said the increased use of trading apps could involve more sharing of user data with Chinese companies. Zeldin asked Schulp about the potential for Chinese entities with ties to the CCP to receive personally identifiable information (PII) or other user data from their broker dealers. Schulp agreed it is a potential national security concern, arguing that PII and other material data rules should be applied equally to both on and offshore companies. Lynch asked if it would be appropriate to put some of these trading platforms under the same regulations as FINRA, to protect the integrity of the system. Schulp agreed there needs to be integrity on the platforms but not necessarily through Regulation Systems Compliance and Integrity.

Retail Investor Protection
Reps. Nydia Velazquez (D-N.Y.), Jake Auchincloss (D-Mass.), Cindy Axne (D-Iowa), Torres and Meeks expressed concern about the “gamification” of investing on the Robinhood platform. Tenev said that Robinhood does not “gamify” investing, but rather gives people access to the markets in a responsible way. He noted that the company is investing in educational and customer support tools to support customers’ investing journey. Tenev clarified that only three percent of Robinhood’s users borrow on margin, 13 percent monthly perform an options transaction, while most use it to engage in buy and hold activities to build a portfolio over time. He explained that the company makes numerous disclosures and that Robinhood is a self-directed brokerage that does not make recommendations about how a customer should or should not invest. Asked by Huizenga if investing is like “casino gambling,” the witnesses agreed it is not, with Griffin noting that the vast majority of retail investors are “saving to meet their dreams.” Asked by Rep. Emanuel Cleaver (R-Mo.) what improvements have been made to the Robinhood platform, Tenev explained that Robinhood has clarified the display of buying power in the app, added the ability to instantly exercise options positions, and added an options education specialist and live phone-based customer support for acute options cases.

Stivers asked whether, if Robinhood users are harmed, they can recover through arbitration. Tenev said their arbitration is FINRA supervised, and believes it gives customers a fair and speedy resolution to their claims.

Reps. Ted Budd (R-N.C.), Stephen Lynch (D-Mass.), Tom Emmer (R-Mn.), and Auchincloss also pointed out the limited financial literacy that investors on Robinhood and similar platforms tend to have, making the argument for more investor protection and educational resource requirements. Auchincloss said many Robinhood investors who had been approved for options trading claimed they had limited to no investment experience, questioning if Robinhood would commit to a higher financial literacy threshold before quickly approving customers to trade options. Tenev said that while Robinhood has pioneered in options trading and helped make industry standards of zero commissions, no account minimums, and fractional shares, the market is still competitive, so he would only be open to implementing an options threshold if it was required across the board.

Market Manipulation
Rep. Al Lawson (D-Fla.) asked how retail investors were able to manipulate the market. Plotkin said the markets are changing and seeing a lot of new players who saw an opportunity to drive the price of the stock, and as a result, the industry will have to adapt. He continued that the markets are self-correcting, and firms will not want to be susceptible to these types of dynamics in the future. Rep. Alma Adams (D-N.C.) asked whether market volatility was driven at all by institutional investors looking to “ride the wave.” Schulp said it is likely institutional investors were involved, but they would need to look deeper into the data. She added that typically, retail investors have not been able to move markets as they did in this unexpected instance. Plotkin said he thinks the biggest driver was aggressive options activity and collective buying, not short covering.

Public vs. Private Markets

McHenry asked why investors utilizing the Robinhood platform are not allowed to invest in Robinhood. Tenev said Robinhood is a private company and Schulp explained that the SEC limits investment in private companies to accredited investors, who must earn at least $200,000 per year or have a net worth of $1 million.

Influence of Social Media
Reps. David Scott (D-Ga.) and Josh Gottheimer (D-N.J.) expressed concerns about the role of social media and what, if any, steps are being taken to address this. Tenev said Robinhood conforms to all regulatory requirements around monitoring and trade surveillance and they have educational resources available to investors and the general public. Huffman said that Reddit does not require users to reveal their identities but has a large team dedicated to ensuring the platform is as unmanipulated as possible, saying in this case they did not see any signs of manipulation or nefarious behavior.

Regulatory Next Steps
Reps. Ann Wagner (R-Mo.) and Rose said rather than new regulatory burdens that could have unintended consequences, Congress needs to reduce barriers to market participation to continue allowing main street Americans to invest better for their future.

In contrast, Reps. Trey Hollingsworth (R-Ind.), French Hill (R-Ark.) and Kustoff asked about areas in need of policy review or further investigation. Kustoff specifically mentioned amending Section 230; Huffman expressed support for the law initially created to protect internet forums talking about stocks.

Hollingsworth asked about the implication of increased trading off-exchange. Griffin said the more trading that happens on exchanges, the better price discovery we have, but unfortunately exchanges are handcuffed in their ability to be better competitors. He said much can be done by the SEC as the next step forward in Regulation NMS.

Hill asked if the SEC should investigate the WallStreetBets Reddit platform as it relates to Section 9(a)(2) of the Securities Exchange Act on inducing trading. Schulp said although the nature of this forum could lend itself to deceptive behavior, they have seen little evidence that would meet a test for manipulation.

Closing Statements
Rep. Blaine Luetkemeyer (R-Mo.)
In his closing statement, Luetkemeyer noted that committee Republicans stand ready to engage in oversight and investigations related to the activities examined in this hearing. He said protecting and giving more choice and access to everyday investors is of utmost importance.

Chairwoman Maxine Waters (D-Calif.)
In her closing statement, Waters said that the hearing has allowed the committee to assess what transpired during January’s market volatility and whether existing guardrails have kept up with the markets. She said the committee will continue to examine these issues, and subsequent hearings will feature securities market experts, investor advocates, and regulators as the committee considers legislative steps to protect investors and ensure Wall Street accountability.

For more information on this hearing, please click here.