GameStop Frenzy Is Tough Call for Regulators Focused on Transparency

By Paul Kiernan for the The Wall Street Journal

Washington was quick to react to the wild ride of GameStop Corp. GME 19.20% stock and the social-media-fueled trading frenzy that by some accounts pitted everyday people against Wall Street.

Barring evidence that people were trying to manipulate the market, regulators may not have much to do. One of the core principles of market regulation in the U.S. is transparency—give investors information and let them decide. The GameStop drama was nothing if not transparent.

“You can sell garbage to the public as long as you say to the public, 'This is garbage and you'd be an idiot to buy it, but would you like to buy it?'" said Harvey Pitt, a former SEC chairman.

What appears to have happened in recent weeks is that a massive wave of retail investors answered, "Yes," to that question, current and former policy makers say. Fueled by social-media platforms like Reddit and smartphone brokerage apps like Robinhood, the traders bid up the price of GameStop to $483 a share from less than $18 a share three weeks earlier. The struggling videogame retailer closed Friday at $63.77, down 87% from its intraday peak on Jan. 28.

"I do think there are a lot of people taking a lot of risk that they don't fully understand," said Rep. Jim Himes (D., Conn.), a former Goldman Sachs banker who sits on the House Financial Services Committee. "Sadly, the most effective remedy for that sort of thing is touching a hot stove."

One reason regulators may be stymied is a lack of political will to limit trading by small investors. When Robinhood temporarily blocked its customers from trading GameStop shares during the frenzy, a cry went up about market access. The big losses those little guys inflicted on some hedge funds by bidding up the stock was seen as a democratization of the market. Any effort to derail that could be criticized as protection for Wall Street.

"Most people believe that middle-class people, working people, should be able to take their chances on the stock market," Rep. Maxine Waters (D., Calif.), who chairs the House Financial Services Committee, said in an interview.

The consensus among regulators so far is that the episode didn't expose major problems with the market's plumbing. The Treasury Department said Thursday that regulators believe the market's "core infrastructure was resilient." The department said the SEC is reviewing "whether trading practices are consistent with investor protection and fair and efficient markets," and is expected to release a report on the factors that influenced it.

The SEC has stepped in before when it identified weaknesses. After the 2010 "flash crash," when trading in some stocks went haywire, the regulator worked with stock exchanges to implement new shock absorbers for the market, including circuit breakers for individual stocks that pause trading during bouts of extreme volatility.

Regulators also know that while the stock market does affect the economy, it doesn't have the same impact as debt markets, which spurred the financial crisis. The end of the dot-com boom of the late 1990s wiped out $6.05 trillion from U.S. households' stockholdings between the first quarter of 2000 and the third quarter of 2002, according to Federal Reserve data. The selloff spurred a recession, but it was relatively mild.

Regulators and lawmakers are likely to focus on two areas for scrutiny: the system that allows investors to trade stocks free of charge, and the gamelike apps and social-media sites that entice people to trade.

"The fact that our capital markets have this casino infection is something to fight against," said Rep. Brad Sherman (D., Calif.), who is chairman of a House subcommittee on investor protection and capital markets. He wants to put up regulatory obstacles to the sort of "psychic rewards" that the Robinhood app offers, such as a confetti graphic that celebrates some trades.

In just five days, GameStop's shares soared up to 500%. WSJ analyzed how Reddit posts, YouTube videos and tweets by personalities including Elon Musk spread online and fueled a trading craze that turned Wall Street upside down. Photo illustration: George Downs/WSJ.

The Financial Industry Regulatory Authority, an industry self-regulator overseen by the SEC, said this year it plans to scrutinize brokers that offer "gamelike" investing experiences. In a letter issued to brokerage firms about its examination plans, Finra said it would look at how brokers that use such tools disclose investing risks to clients and how they approve those customers for trading options, which are believed to have exacerbated GameStop's swings.

Ms. Waters said she plans to use a Feb. 18 hearing to examine payment-for-order-flow, the arrangement whereby market makers such as Citadel Securities pay Robinhood to handle its clients' trades. Critics of the practice say it warps the incentives of brokers and encourages them to maximize their revenue at the expense of customers. Brokers say it results in better prices for investors.

President Biden's pick to run the SEC, Gary Gensler, could try to put his stamp on the market by examining Robinhood's business and its payment-for-order-flow deals. Mr. Gensler has recently lectured on financial technology innovation at the Massachusetts Institute of Technology, which could shape how he treats the rise of low-cost and easy-to-use brokerage apps.

The SEC has repeatedly blessed payment-for-order-flow as good for investors. Congress has also examined the practice before, but little came from the oversight.

Citadel Securities, one of the main corporate beneficiaries of the model, has also become a major force in politics. Its owner, billionaire Kenneth Griffin, was the third-largest donor to Republican political campaigns in the 2020 election cycle, according to data compiled by the Center for Responsive Politics.

Sen. Pat Toomey (R., Pa.), the top Republican on the Senate Banking Committee, praised the system that enables free trading as "amazing" for small investors.

"If someone's got a better model in mind for how we get better execution at lower costs and maintain the liquidity, well I'm all ears," Mr. Toomey said in an interview. "But, boy, that'd be a hard thing to come up with given how well the markets function now."