🔴 Watch: Leaders Of Robinhood, Citadel, and Reddit Testify In “Game Stopped” Hearing…
The full Committee Chairwoman Waters and Ranking Member McHenry host a virtual hearing entitled, “Game Stopped? Who Wins and Loses When Short Sellers, Social Media, and Retail Investors Collide.”
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Witnesses for this one-panel hearing:
- Keith Gill
- Kenneth C. Griffin, Chief Executive Officer, Citadel LLC
- Steve Huffman, Chief Executive Officer, Co-Founder, Reddit
- Gabriel Plotkin, Chief Executive Officer, Melvin Capital Management LP
- Vlad Tenev, Chief Executive Officer, Robinhood Markets, Inc.
- Jennifer Schulp, Director of Financial Regulation Studies, Cato Institute
In January 2021, retail investors on social media site Reddit’s “WallStreetBets” subchannel (“subreddit”) collectively executed an investment strategy to induce a short squeeze in stocks such as GameStop, AMC and KOSS, as well as other securities they identified as being heavily shorted by hedge funds. Meaning, social media users collectively drove the stock prices up, forcing short sellers who bet the stock price would go down, to purchase shares at an increased price. Reddit user, Keith Gill, notoriously discussed GameStop stock on Reddit under the username “DeepF*ckingValue.” Initially, this squeeze led to heavy losses for some short sellers, particularly hedge funds, and led to substantial financial gain for some retail investors. Robinhood, and other broker dealers, placed restrictions on transactions in these stocks, which received public and regulatory scrutiny. Eventually, the stock prices started to decline and many investors were faced with steep financial losses. For some, the January short squeeze raises questions regarding whether legislators and regulators should take a closer look at existing rules governing short sales and related disclosures, as well as the conflicts between the practice of payment for order flow and firms’ best execution obligations. It also raises important questions about the efficacy of anti-market manipulation laws and whether technology and social media have outpaced regulation in a manner that leaves investors and the markets exposed to unnecessary risks.
II. Short Selling
When an investor shorts a stock, they borrow the stock, typically from a broker, and then sells it to another investor. When the time comes for the borrower to return the borrowed stock, the borrower will purchase the stock in the market and return the stock to the lender. In a successful short sale, the market price of the borrowed stock will fall below the amount it costs to borrow the stock. When this happens, the borrower is then able to purchase the stock in the market at an amount lower than it cost the borrower to borrow the stock, return the stock to the lender, and keep the difference as profit. Some investors, such as hedge funds, engage this trading strategy when they are betting that the price of the securities will decline and expect they can profit from that decline. Others use this strategy to hedge against other market risks. The U.S. Securities and Exchange Commission (SEC) has repeatedly noted that short selling provides liquidity and price efficiency. The SEC has, however, implemented various rules to curb abusive short sale practices. These are discussed below, in detail.
III. Short Sale Rules and Laws Against Fraud and Market Manipulation
A. Regulation SHO
On July 28, 2004, the SEC adopted a new Regulation SHO, under the Securities Exchange Act of 1934 (Exchange Act), which implemented changes in how short sales are regulated. One important function of Regulation SHO is that it restricts short sales that are referred to as “naked short sales.” Generally speaking, a naked short sale refers to selling short without having first borrowed the stock.
It is important to note that naked short selling does not always violate Regulation SHO. In fact, the SEC has noted that, in certain circumstances, naked short sales may contribute to market liquidity. For instance, broker dealers that are market makers provide liquidity to the market by being ready to buy or sell a security, even in the absence of a buyer or seller, and even when there are market shortages. Due to the time it can take to buy or borrow a security, a market maker may short a security without first making arrangements to borrow it.
Later, in 2010, the SEC amended Regulation SHO to include the alternative uptick rule. The alternative uptick rule places restrictions on short selling during periods where a stock’s price significantly declines. More specifically, the rule restricts short sales on certain securities that experience a 10% or more price decrease in a single day. In these cases, short sales are only permitted where the price is above the current best bid.
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