Did GameStop Put Congress on the Right Track to Improving Trading Regulation?

Correction: An earlier version of this article incorrectly attributed a statement to Citadel CEO Kenneth Griffin. The full quote, "When your broker is being paid for order flow, you get a worse execution," was said by Rep. Brad Sherman, D-California, during the U.S. House Financial Services Committee hearing last month. (March 28, 2021)

The hubbub around GameStop GME has given politicians an opening to define a problem that can best be solved by their preferred market reforms.

At a U.S. House Financial Services Committee hearing last month, lawmakers examined whether the market volatility and subsequent trading halt warranted policy reform. And at a more recent Senate hearing, where former SEC Commissioner Mike Piwowar testified, senators dug deeper into some of the policy proposals.

We believe that some policy ramifications of the GameStop/Robinhood uproar are likely. Here's a look at some of the possibilities and trade-offs.

Real-Time Transaction Clearances

Robinhood CEO Vladimir Tenev suggested in his congressional testimony that instantly clearing securities sales could promote more activity and possibly liquidity in the market than with the current T+2 system. In this system, trades are settled within two days from the initial transaction date. A financial system with the infrastructure to support instant clearing has less risk of system outages and trading halts, which means investors can be spared the types of losses sustained during the GameStop trading halts.

That said, faster trading clearance allows no time for recoverability and no room for error, giving all transactions a degree of risk that's similar to blockchain transactions now--that is, they're irreversible.

Moreover, it would take years for U.S. trading settlement infrastructure to handle real-time transactions because of the technical complexity of getting every party in a transaction to perfectly sync their clearing systems, as Citadel CEO Kenneth Griffin said during the House hearing.

However, a recent Depository Trust & Clearing Corporation, or DTCC, report notes that one-day settlements could consolidate the costs of a firm's daily trades to a single net debit or credit. This intermediate change could smooth out the market risk that brokerages see on especially volatile days, as Robinhood experienced with GameStop. The focus on this area in the Senate hearing, in addition to the report by DTCC, makes it likely that some reform will occur.

Standardizing Treatment of Cash Versus Margin Accounts

Robinhood defaulted investors into margin accounts, but not all brokers do. Why not have the default brokerage account be a cash account with the choice to switch to a margin account? Further, margin accounts could be subject to greater restrictions, like the possibility of halting trading depending on market conditions, whereas cash accounts need not face such restrictions unless the halt is marketwide, for example, initiated by an exchange.

The clear advantage of such an approach is that not all retail investor clients of a broker need to halt trading when volatility increases--only those purchasing on margin would. Since those buying on margin cause an externality to the market by borrowing from the broker and thereby making it more difficult for the broker to meet its obligations at the clearing house, distinguishing between margin and cash clients seems appropriate.

As a downside, increased margin requirements could create barriers to entry for retail investors to participate in the market, including through a standard margin requirement (as opposed to one based on wealth). Robinhood's appeal has been to make such types of trading accessible to retail investors, and clearly an appetite for such risk-taking exists. Such standardization and ease of trading on margin, however, raise the question of whether defaulting clients into margin accounts might constitute a recommendation to purchase on margin under Regulation Best Interest, and whether such a recommendation is in line with Robinhood's best-interest obligations under this regulation.

Payment for Order Flow Regulation

This policy solution appears unrelated to GameStop volatility--as far as we can tell--but was a topic of great interest to Congress during the hearing. As Rep. Brad Sherman, D-Cal. stated (and Citadel CEO Ken Griffin did not refute), "When your broker is being paid for order flow, you get a worse execution."

One simple way to look at it is that Robinhood clients paid no commission but paid slightly higher prices in exchange. The irony here is that those investors who might have benefited most from such an arrangement--those who purchase ETFs and hold them for the long term, making the commission savings outweigh the slightly worse execution--are not Robinhood's target market. The GameStop investors, who trade more often than the long-term investor, are impacted negatively by paying commissions or getting a worse execution, making the net effect of the economics of their relationship with Robinhood ambiguous without an in-depth analysis of their trading activity.

It is unclear whether and what regulation may come out of GameStop in this area, but certainly those who oppose payment for order flow will use this opportunity to make their case.

A Financial Transaction Tax on All Securities Trades

Congress also discussed the possibility of a financial transaction tax, or FTT, to discourage day trading. During the House hearing, Rep. Alex Mooney, a West Virginia Republican, floated the idea of a 0.10% FTT as part of the proposed Wall Street Tax Act.

One advantage of an FTT is that transaction costs on trades have been falling for years, so a tax would not likely cause significant market distortion. FTT revenue could be used to fund broader social programs.

Morningstar tested the impact of a 0.10% FTT on returns in active and passive versions of three large, small, and mixed-cap ETFs, and found that returns on a $10,000 investment decreased by $200 to $500 over 20 years in both passively and actively managed funds. The passively managed funds took smaller losses than their actively managed counterparts, even with the same stock holdings. Thus, an FTT would still cause some distortions to investing in general and might distort incentives to choose between passive and active funds.

Congressional Action Should Be Targeted

Whatever Congress or the regulators decide to do, it should be targeted to the actual problems GameStop brought to the forefront. The pros and cons of any reform should be carefully considered. In general, a specifically targeted regulation, for example, one that standardizes default brokerage accounts to be cash accounts instead of whatever the broker chooses, are likely to attract broader political support and may be more effective than significant restrictions on retail access.