Market Buying and selling Traits: Count on Regulatory Steering to Speed up

Gamification tactics and investment advice from social media influencers and chat rooms are just a few of the disruptive technologies and behaviors that will be drawing regulators’ attention in 2021, forcing them to take a closer look – and react. For the Financial Industry Regulatory Authority (FINRA) and the Securities and Exchange Commission (SEC) the question arises to what extent this new generation of traders can use these new tools, apps and free trades and which guard rails are needed to protect investors and market integrity to ensure? The consensus is that we can expect regulatory guidance to accelerate in 2022.

During the “Hot Topics” panel for market trading at Katten’s annual Financial Markets Litigation and Enforcement Symposium Series, Katten’s attorneys discussed developments in best execution and payment for the order flow, disruptive technologies, a new generation of traders and the highly controversial one Activity of the year, the GameStop trading frenzy.

Five takeaways to consider

1. A new generation of traders and the GameStop Frenzy

In 2020, a clearing firm announced the opening of six million new accounts, up 137 percent from 2019. One million of those new accounts were from Generation Z, with an average age of 19 years. With so many more people interested in market trading, a significant number of whom are guided by social media, it should come as no surprise that 2021 brought some unexpected developments. Among them was the GameStop trading frenzy, fueled by social media platforms and socio-economic undertones.

On the Reddit Internet chat board, WallStreetBets, retail investors wallow in the knowledge that GameStop, a dying breed of brick and mortar video game store, sold heavily in 2020 and was prone to a short squeeze. Wanting to hold onto hedge funds, Wall Street, and the “1%,” these new investors encouraged each other to buy the stock and keep going higher. The activity caused a massive price spike – 928 percent – in the early weeks of 2021, effectively forcing short sellers, including large hedge funds, to remove their short positions and buy stocks. The start-up in turn led to unprecedented market volatility and in some cases led to substantial losses for large investors.

In the course of the GameStop run-up, clearing houses and brokerage firms began to point fingers at each other. However, an October 2021 SEC report following Congressional hearings on the matter concluded that the price spike was actually caused by a large group of individual retail investors who turned to social media. Although the report did not make any specific policy recommendations, it is expected that regulators will eventually respond.

2. The dubious role of the “fin influencer”

With that in mind, 2021 saw a significant increase in the number of social media influencers entering the financial space. In general, social media influencers in a particular industry have gained credibility, have access to a large audience, and can convince others to act based on their recommendations. While influencers have been around for a while, financial influencers are fairly new.

Fin-Influencer’s social media activities range from showcasing stocks on the rise and how to get rich quick, to sharing educational materials or personal stories. On the flip side, some believe fin influencers are bridging a financial literacy gap, even though most lack formal qualifications. On the other hand, there is a lack of transparency regarding the risks associated with the products and investment strategies they recommend and the potential for pump-and-dump systems.

Additionally, as financial influence grows, more companies are adding them to their marketing mix. There is no better way to reach the new generation of traders than through social media. Firms and broker-dealers use (and pay) fin influencers to talk about stocks and services on their behalf. Regulators are now investigating the practices of brokers and traders and have made requests for information asking for a detailed history of relationships with influencers, how they first identified them, how they are compensated, and what referral agreements they may enter into. The inquiry letters also give several pages on privacy concerns related to the disclosure of customer information to influencers. This is certainly a ripe area for further regulation and guidance in the near future.

3. Gamification

Closely related to fin-fluencing and chat room investment advice is gamification, also known as digital engagement practices. Much like a fitness tracker, investment apps that use gamification tactics can track and encourage trading of the individual’s trading activity, send alerts, use a leaderboard, and reward the user with badges when they reach certain milestones. The related regulatory issues are numerous. For example, is an app that encourages an investor to trade a broker recommendation that falls under regulated activity? We expect FINRA and the SEC to issue further guidelines on gamification in the near future.

4. Best Execution Requirements

FINRA 2021 Regulatory Notice 21-23 provided specific guidance on Order Flow Payment (PFOF) and Best Execution requirements. One observation is that FINRA uses price as the main criterion for assessing execution quality before many other criteria. Meanwhile, SEC chairman Gary Gensler recently sent a directive to employees to review whether additional best execution requirements or guidelines are needed to promote investor protection, suggesting possible additional best execution requirements.

5. Payment for the order flow

PFOF, which has survived calls for the practice to be banned over time, has faced a new surge that would include rule changes or an outright ban on the practice in 2021. Calls for review followed the turmoil and market volatility caused by the GameStop episode. Though the connection between the GameStop saga and PFOF is not clear, SEC chairman Gensler said in October that the agency is actually looking into changing or banning PFOF with the aim of creating a more competitive market.

In 2021, the growth in payments related to the flow of orders in retail will be additionally examined. In the first three quarters of 2021, PFOF grew 41 percent compared to the same period in 2020. Much of that increase was due to options trading, which rose over 25 percent, largely due to the increased number of retail investor trading options. Regulators are concerned that brokers are encouraging retail investors to enter these risky complex derivatives markets without understanding the risk. Commissioner Gensler suggested that there could be two potential regimes in the near future, one for investment advisors and another for broker-dealers.

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