September 23, 2021

Volume XI, Number 266

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GameStopped? Regulators react to the “short squeeze”

While trading frenzies are as old as the markets themselves, the novelty of widespread retail trading in obscure US stocks fueled by Reddit chat forums has prompted recent interventions by regulators on both sides of the Atlantic.

Unfortunately the FCA’s terse 29 January statement on “recent share trading issues” gave little insight into how it viewed these events from a regulatory perspective. The FCA said only that buying shares in volatile markets is “risky“, and “unlikely to be covered” by the FSCS.

Several of the major online securities trading platforms responded to the volatility by stopping orders in affected securities. The FCA was supportive, noting that broking firms “are not obliged to offer trading facilities to clients“, and “may withdraw their services, in line with customer terms and conditions if…they consider it necessary or prudent to do so“.

The US Securities and Exchange Commission (SEC) US was only slightly more forthcoming, stating that it would “work to protect investors, to maintain fair, orderly, and efficient markets” and would “act to protect retail investors when the facts demonstrate abusive or manipulative trading activity”.

This brevity is perhaps understandable when regulators are responding to rapidly emerging issues. We hope they will comment further when time permits, because these events raise a range of regulatory issues.

Market manipulation

The first vexed question these events raise is whether the Reddit traders have done anything wrong.

The Market Abuse Regulation (preserved in UK law post-EU exit) proscribes behaviour which “gives, or is likely to give, false or misleading signals as to the supply of, demand for, or price of, a financial instrument” that falls within its jurisdictional scope, including by “disseminating information through the media, including the internet, or by any other means”While it appears some traders have profited enormously from encouraging trading, it is not clear if they have given false or misleading signals as to supply, demand, or price. The trading strategy being promoted was for enough retail investors to buy target securities to drive up prices, forcing short sellers to buy at those prices to close out short positions. The short positions are made public in regulatory disclosures: UK investors must make a public notification when short on 0.5% or more of a company’s shares; and similar requirements apply to US funds. The signals given were arguably therefore accurate and based on public regulatory filings.

MAR also proscribes “conduct by a person, or persons acting in collaboration, to secure a dominant position over the supply of or demand for a financial instrument…which has, or is likely to have, the effect of fixing, directly or indirectly, purchase or sale prices, or creates, or is likely to create, other unfair trading conditions“. This provision could be engaged, but it seems doubtful whether this ad hoc crowdsourcing amounts to collaboration or securing a dominant position.

US-traded GameStop’s shares are not within the scope of MAR, but other instruments that are within MAR (such as instruments and securities linked to silver prices) have been targeted using the same strategies. It would be helpful to know how the FCA sees these issues, given that we can likely anticipate copycat incidents in relation to UK/EU traded financial instruments sooner or later.

Market integrity

More broadly, whether crowdsourced trading strategies are legitimate or not under current law, they pose novel challenges for the FCA as a conduct regulator tasked with ensuring the integrity of UK financial markets, protecting consumers, and preventing financial crime. While the FCA monitors vast amounts of markets data, it cannot possibly monitor every online chatroom or forum that might be used by retail traders. It may be that market conduct rules will need to be reformed if it is concluded that the current regime cannot respond, and that the extreme volatility witnessed is not conducive to efficient market functioning.

Protection of consumers

Consumer protection is a key FCA focus. It is active in seeking to warn consumers of the risks of financial fraud and scams through ScamSmart and public awareness campaigns. The regulator has weathered recent criticism for high profile failures to protect ordinary investors from high risk investments marketed using social media and online advertising. That is reflected in the FCA’s focus on risks to retail investors and FSCS cover in its 29 January alert. There is growing debate over how regulators can protect retail investors from fraud and excessive risk in the digital age without having a chilling effect on consumer access to genuinely innovative investment opportunities.

Trading platforms

Online trading platforms are put in an immensely difficult position when markets become highly volatile. As the FCA notes, platforms will generally have the contractual right to suspend trading access. But that must be balanced with the need to treat its retail customers fairly, both in explaining clearly to customers that the power exists, and in deciding when and how to exercise it. The SEC, warned that it would “closely review actions taken by regulated entities that may disadvantage investors or unduly inhibit their ability to trade certain securities”. Class action claims have already been initiated in the US, where “stock drop” securities litigation is commonplace. US platforms are accused of suspending retail trading, while allowing more remunerative institutional clients to continue to trade. Similar claims may follow in other jurisdictions, although in the UK securities litigation is still underdeveloped. Platforms will want to review their policies for responding to abnormal volatility and trading patterns around particular securities and assess their exposure.

Institutional investors

Some hedge funds were caught out and suffered significant losses in closing short positions in affected securities. It is unclear to what extent any funds managed by UK-regulated managers have been materially impacted, let alone whether losses might reflect any failure of regulatory risk management requirements. However, fund managers deploying short selling strategies will need to ensure that their risk management processes for short trading are adequate to avoid exposure to losses of a magnitude that could put their viability in jeopardy.

Conclusions

Arguably these events are not anomalous, but are a symptom of wider trends. The democratizing effect of ready access to securities trading platforms, mass communications, and abundant data for retail traders, combined with the fragmentation of the financial services ecosystem, create growing challenges for regulators such as the FCA in ensuring market integrity, protecting consumers, and preventing fraud and financial crime. The regulatory framework and the approach of regulators will need to continue to develop to keep pace with rapid innovation in all forms in the financial markets.

© Copyright 2021 Squire Patton Boggs (US) LLPNational Law Review, Volume XI, Number 57
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About this Author

Partner

Chris Webber specializes in resolving financial services disputes and regulatory investigations. He represents clients including banks, broker dealers, corporate trustees, bondholders, issuers, mortgage servicers, borrowers, insolvency office-holders, regulatory bodies, investment funds, and individuals. He also acts for corporate clients in contractual, investment, and shareholder disputes.

+44 20 7655 1655
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