Treasury head Yellen calls regulators together to discuss market volatility

The meeting will include leaders from the Securities and Exchange Commission (SEC), the Commodity Futures Trading Commission (CFTC), the Federal Reserve Bank, and the Federal Reserve Bank of New York.

“Secretary Yellen believes the integrity of markets is important and has asked for a discussion of recent volatility in financial markets and whether recent activities are consistent with investor protection and fair and efficient markets,” said Treasury Department Spokesperson Alexandra LaManna, via email.

The first step for regulators would be to launch an investigation into potential market manipulation by retail investors swapping stock tips and investing strategies in online forums and social media. Both the SEC and CFTC have said they are monitoring whether market manipulation is driving market volatility.

Stock for GameStop, a video game retailer, was worth about $20 in late January. Several large hedge funds held significant short positions on the stock, meaning they would benefit if the stock fell below a certain price. A group of retail investors, egging each other on in Reddit message boards and social media, started buying the stock in late January; hedge funds that held short positions had to buy stock to shore up their bad bets, sending the stock price higher still. The price of GameStop crested at $347 per share on Jan. 27 and had fallen back under $100 during trading Wednesday.

Regulators will struggle to prove hundreds or even thousands of individual retail investors crowdsourcing their investment advice on social media conspired to manipulate the market, experts say. Individual retail investors likely didn’t know for sure if their comments would lead enough fellow investors to a particular stock to actually move the market. There’s also the wrinkle that some retail investors may not have been solely motivated by money. They have claimed their purchases of formerly moribund stock like GameStop was a political statement intended to punish hedge funds that held short positions on the stock.

“It’s going to be a challenge for the SEC to build enforcement cases. If they identify that there are institutional money managers playing a part in fueling the frenzy, that’s where I would expect the SEC to focus its resources.”

Michael Abbriano, Director, ACA Compliance Group

Robert Litan, a former federal prosecutor and now a partner at the firm Korein Tillery, says Yellen wants to hear from regulators whether recent market volatility caused by retail investors in small stocks like GameStop could threaten the stability of the whole market. He says it hasn’t, at least not yet.

“I don’t see anything that has risen to the level of a systemic concern,” he said. “These are like a bunch of mini-bubbles.”

But David McGill, attorney with Kobre & Kim who has represented hedge funds, said what happened with GameStop and social media may be “the tip of the iceberg” as far as the market is concerned.

“The role that social media has played in forming public sentiments, and how that can be manipulated, there’s no reason why that same playbook couldn’t be brought to bear on the markets,” he said.

More likely is an investigation by the SEC that focuses on the actions of institutional investors, either those who piled onto the buying frenzy started by retail investors or others who somehow took advantage of the situation. The CFTC could launch a similar investigation into retail investors pumping up the value of silver in the commodities markets.

“It’s going to be a challenge for the SEC to build enforcement cases. If they identify that there are institutional money managers playing a part in fueling the frenzy, that’s where I would expect the SEC to focus its resources,” said Michael Abbriano, director of ACA Compliance Group, a compliance vendor. “Those firms need to act now to make sure their employees aren’t engaged in any activity that the SEC could perceive as market manipulation. Otherwise, I don’t see an obvious way for them to pursue a case against the collective action of hundreds of thousands of retail investors.”

Litan said it will be interesting to see where the SEC focuses its investigation. He said Robinhood gave a legitimate reason for halting trading in GameStop and other stocks—it did not have enough money to meet the margin requirements posed by such intense trading.

Where the SEC might focus its attention is on the actions of hedge funds like Citadel, which may have benefitted from Robinhood’s pause in trading.

“The question for the SEC to answer is whether Citadel knew in advance that Robinhood was going to shut the door and used that knowledge to short the stocks,” Litan said.

At the time, a Citadel spokesman told Fox Business in a Jan. 28 story the firm “is not involved in, or responsible for, any retail brokers’ decision to stop trading in any way. Citadel Securities has not instructed or otherwise caused any brokerage firm to stop, suspend, or limit trading or otherwise refuse to do business.”

Beyond the issues of Robinhood’s trading pause and Citadel’s potential benefit from that pause, McGill said there’s a possibility that other forces—a block of employees from the same broker-dealer or hedge fund, for example—could have been part of the same online wave that whipped up the buying frenzy for GameStop and other stocks. McGill said he could imagine a scenario where the SEC, as part of its investigation, would pore through Reddit chat rooms and social media posts, trying to figure out who was promoting what and when.

“There needs to be some accountability,” he said. Regulators should be looking at “whether this was coordinated by somebody on the other end who’s benefitting.”

There are other avenues for regulators to pursue in terms of rulemaking, but rulemaking takes time. The market is spasming now, and new rules take a year or longer to promulgate.

That said, the SEC may consider making short selling less attractive, as the short positions on GameStop held by several hedge funds was the impetus for Reddit retail investors to act in the first place.

“I would expect rulemaking efforts to focus on making it harder/less attractive for hedge funds to run up huge short positions–e.g., additional reporting requirements, requiring short sellers to meet additional capital or other suitability requirements, capping short interest, or restricting trading in heavily shorted names,” Abbriano said.

No matter what regulators and the Treasury decide to do, there are several compliance takeaways from the GameStop market insanity, experts say. The main area of concern for broker-dealers and investment firms is the behavior of their own employees, whether they participated in the frenzy by trading certain stocks or placed messages in chat rooms or on social media meant to affect a stock price one way or the other.