Regulators say GameStop rally ‘raises questions of market efficiency’

On Monday, the Securities and Exchange Commission published an official staff report on the GameStop rally earlier this year, calling for more scrutiny of both short-seller activity and broker-dealers like Robinhood. The report is particularly harsh on Robinhood’s “payment for order flow” system, which rewards the company for increasing the number of trades.

Released under the anodyne name “Staff Report on Equity and Options Market Structure Conditions in Early 2021,” the report is the SEC’s first full opportunity to weigh in on the confusion surrounding GameStop’s unlikely stock market rally, as well as some of the Robinhood features that critics say made the rally more chaotic.

In January, a cohort of online investors rallied around GameStop, driving up the share price of a company that had been on the verge of bankruptcy and spurring accusations of market manipulation from both sides. The SEC has been promising a full report on the situation for months — but the report delivered today will do little to quiet concerns.

The SEC report illustrates the sudden interest in GameStop by tracking the number of unique accounts that traded the stock each day. Over the course of January 2021, the number of daily unique traders increased from less than 10,000 to nearly 900,000. From January 13th to 14th alone, the number jumped by more than 50,000.

The SEC names a number of overlapping causes for the GameStop rally: Significant price shifts, large changes in the volume of trading, leveraged bets from short-sellers, and significant public attention driven first by online communities like /r/wallstreetbets and later by establishment media. The result allowed surges of investor interest to create wild swings in price, driving the stock up to nearly 20 times its original value.

The most controversial incident came when Robinhood, the stock trading app at the center of much of the hype, announced it would no longer allow users to purchase GameStop stock — a move CEO Vlad Tenev attributed to an inability to cover orders while meeting deposit requirements. But while the SEC report does not find reason to doubt Tenev’s explanation, it does raise significant new questions about other aspects of the company’s business model. In particular, the report calls for new scrutiny of Robinhood’s gamification efforts, as well as the company’s “payment for order flow” revenue model.

“Consideration should be given to whether game-like features and celebratory animations that are likely intended to create positive feedback from trading lead investors to trade more than they would otherwise,” the report concludes. “In addition, payment for order flow and the incentives it creates may cause broker-dealers to find novel ways to increase customer trading, including through the use of digital engagement practices.”

Payment for order flow has long been a controversial and complex practice. Explained by Michael Bolton here, it essentially allows Robinhood to charge market makers for early access to a portion of retail investors’ trades. But while financial experts have largely dismissed concerns around front-running, the model does create an incentive for broker-dealers like Robinhood to maximize the number of trades its users make.

Gary Gensler, the SEC chairman, has questioned whether payment for order flow is good business. In an August speech, he said that banning the practice was “on the table.” That would upend the business model for several of the mobile trading platforms that have sprung up, including Robinhood.

The report emphasizes that volatility in GameStop’s share price existed long before the company became an investment meme. The share price fell as low as $3 in April of 2020, and Chewy founder Ryan Cohen’s growing involvement had already inspired significant jumps in the company’s valuation. That made GameStop stock an attractive target for both short sellers and boosters even before the internet got involved.

The report also backs up claims that GameStop was an unusually heavily shorted stock, but it disputes the claim that short-sellers were the primary reason for the continued rally. “Whether driven by a desire to squeeze short sellers,” the report found, “or by belief in the fundamentals of GameStop, it was the positive sentiment, not the buying-to-cover, that sustained the weeks-long price appreciation of GameStop stock.”

Still, the report does find that the incident “raises questions of market efficiency that relate to short selling,” and the conclusion calls for improved reporting of short sales to allow regulators better visibility into the dynamics of the market.