What the GameStop Congressional hearing will reveal to retail investors – Yahoo Finance

One month after GameStop (GME) shares surged to record levels due to Reddit-fueled trading, Wall Street, online brokerage Robinhood and Reddit are facing probes by the Department of Justice (DOJ), the Commodity Futures Trading Commission (CFTC) and both chambers of Congress.

During GameStop's two-week meteoric rise, the S&P 500 dropped a whopping 5% from peak to trough. Wall Street felt the full brunt of the chaos. Hedge funds endured a gut-wrenching de-risking event comparable to the global financial crisis as retail investors banded together to short squeeze institutional investors. Fortunes were made and lost in hours, as the now-infamous hedge fund Melvin Capital Management became the poster child for Wall Street's self-help bailout machine.

Suffice to say lawmakers and regulators are paying attention. The incident has also caught the eye of Treasury Secretary Janet Yellen and the U.S. Securities and Exchange Commission (SEC). Now what?

A House Financial Services Committee hearing about the GameStop trading frenzy, scheduled for Feb. 18, will shine a light on the extant secular trends that allowed the capital markets to become farcical caricatures of themselves.

"We're still learning things new about what went on every single day... [T]he financial markets can move quickly," Andy Green, senior fellow for Economic Policy at American Progress and former SEC counsel, told Yahoo Finance Live. "So I think that's why it's really important for investors to be prudent, to be looking for the long term, to be aware of the basics about not borrowing on margin and taking risks that they can't afford."

Robinhood will have to field tough questions. It will have to explain why it temporarily banned investors from trading GameStop and other stocks. Robinhood will also have to disclose how it assesses whether its customers are suitable to trade options (even if they're only call options that have defined risk). Exploding call option volume and the leverage embedded therein are accounting for a big chunk of a recent run-up in stock prices. Simply handing out leverage to inexperienced traders can be very dangerous.

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Last year, Robinhood beefed up the educational section of its website but only after a U.K. college student committed suicide after misinterpreting his account statement and financial loss (a lawsuit, filed by the student's family, against Robinhood is pending). With the flood of new retail traders opening new accounts, it would be useful to revisit how brokers industry-wide assess customer risk and suitability and whether or not brokers are actually sticking to their written controls and procedures.

Green compares Robinhood's no commission trading to the free services offered by Big Tech that aren't really free. "The cost is hidden. And they're passed on to ordinary users of the big tech sites or other parts of society. So there are hidden costs to a lot of these platforms and free services that we're going to pay for and we need to think about more carefully." he said.

Robinhood will also have to explain the margin calls it got from Citadel Securities, which is an institutional broker that is a distinct entity from the affiliated hedge fund Citadel. Like most retail brokers, Robinhood sells its users' order flow to wholesale market makers like Citadel, which is how brokerages make money.

This practice, called payment for order flow (PFOF), is coming under scrutiny. Wall Street market makers, like Citadel, paid brokers, like Robinhood, $2.86 billion for customer orders in stocks and stock options in 2020, according to Bloomberg data. The business model needs to be thoroughly investigated to determine how retail investors are indeed being affected by it. There's huge money in this, so the stakes are high.

Robinhood and other brokerages claim they improve the fill price of customer orders when they're matched internally at firms like Citadel, Susquehanna International Group and Virtu Financial. But last December, Robinhood paid a $65 million fine to the SEC, in part, for providing "inferior trade prices" that cost customers $34.1 million. Assuming Robinhood has cleaned up its act, it should still break down its order price improvement statistics across different classes of stocks particularly by stock price and market capitalization.

Doug Cifu, the CEO of Virtu Financial (the only public company that pays for order flow), recently defended the practice on an earnings call. He said he'd never seen a shred of data that validates the assertion that PFOF distorts the marketplace.

Traders are concerned about PFOF because it reduces overall market transparency (as do all off-exchange transactions) by definition, as the details of those internally matched trades dont make it to public data feeds. In addition, theres a reason why those orders are so valuable, which needs to be sniffed out and put in the record. Traders will want firms that buy customer orders to disclose if they trade ahead of such orders or otherwise seek to profit off the data.

Finally, the very structure of trading stocks will likely be explored. The term pump-and-dump (whether fair or not) will likely emerge during the Congressional committee hearing. That is, questions will arise whether or not there was a concerted effort to artificially raise prices of stocks with the intention of selling them at a profit.

Hedge funds pay billions of dollars every year for high speed exchange data that's far more useful than the slower feed that retail investors get. And it's that slow, retail data feed called the National Best Bid and Offer, or NBBO, that is used as the benchmark to determine if customers are getting a better price at Citadel et. al.

If the NBBO was faster and not so archaic, retail traders would presumably get better fills. But that would impinge upon the profitability of PFOF, and therein lies the rub. The NBBO provides a de facto structural safe harbor for brokers to deliver fills at inferior prices at the expense of retail traders.

A 2014 study compared the retail NBBO to the direct feed that hedge funds buy, looking for price dislocations. Its findings: "Price dislocations between the NBBOs occur several times a second in very active stocks and typically last one to two milliseconds. The short duration of dislocations makes their costs small for investors who trade infrequently, while the frequency of the dislocations makes them costly for frequent traders. Higher security price and days with high trading volume and volatility are associated with dislocations."

High trading volume and volatility were hallmarks of the GameStop saga, so it would be helpful to quantify exactly what price dislocations occurred and how much they cost investors.

"I'm not going to propose ... a comprehensive reform of payment for order flow because you have to look at the whole market. But I am of the view that conflicts of interest are not good for investors. They're not good for our financial markets. We need to be reducing them, not ... permitting them to increase," said Green.

Jared Blikre is a correspondent focused on the markets or Yahoo Finance Live. Follow him @SPYJared

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What the GameStop Congressional hearing will reveal to retail investors - Yahoo Finance