May 06, 2021
Cadwalader’s Steven Lofchie, a Financial Services partner and founder and editor of the Cadwalader Cabinet, and former SEC Commissioner Robert J. Jackson, Jr., were featured speakers in last week’s webinar, “GameStop, Robinhood, and Regulation,” hosted by the Federalist Society. The discussion was moderated by Ronald J. Colombo, Associate Professor of Law at the Hofstra University School of Law.
In a lively conversation, the two financial services industry veterans, each of whom has achieved stature through different paths, engaged in an open exchange of ideas that were, in turns, both differing and aligned. Using the recent GameStop-Robinhood events as a springboard, Lofchie and Jackson presented their respective points of view and asked pointed questions about how financial regulators can effectively and appropriately educate and protect retail investors in a trading environment that’s increasingly smartphone application-driven.
In opening, Lofchie provided an overview of the circumstances surrounding the spike in GameStop’s stock price earlier this year, including the actions of retail investors, broader underlying changes in the broker-dealer landscape, and the ensuing legislative and regulatory reaction, including Congressional hearings.
On the widespread question of whether new rules should be created or other actions taken to prevent such future volatility, Lofchie emphasized the importance for regulators to develop a comprehensive understanding of such events: “If you don’t know why something happened, then anything you do in response to it is just randomness,” he said.
Against this backdrop, Lofchie next addressed Regulation Best Interest ("Reg. BI"), a rule adopted by the SEC in 2019, intended to expand and clarify the duties that broker-dealers owe to retail investors.
In reflecting on the disciplinary nature of Reg. BI, Lofchie proposed that regulators consider a different question: “How can brokers make money by providing recommendations to their clients?” He continued, “There’s a reason that regulators need to ask this question—if a service isn’t profitable to provide, then firms won’t provide it.” As an unintended consequence, he said, retail investors seeking investment guidance could increasingly be driven out of the regulated system and into informal online discussion boards and other such forums.
“It’s a very tough question but one that regulators need to start asking, as opposed to just what more regulation should we be adopting,” Lofchie added.
Next up, Jackson addressed some key takeaways from the GameStop trading frenzy, including the value and importance of trying “to learn from what the market is telling us.” He also questioned how the business models of modern-day online trading platforms, such as Robinhood, fit into a regulatory structure like Reg. BI.
“The hard question is, what does it mean for a broker who’s doing most of their work with a client on an app on one’s phone … what does it mean for them to act or not to act in that client’s best interest? I think we’re still learning the answer.”
While Jackson expects that Reg. BI will become more clearly defined in the coming years, he believes that certain game-like techniques employed by such online applications to acknowledge/reward a user’s particular actions (i.e., displaying digital confetti or balloons following a particular trade,) warrant “careful scrutiny” in the present.
“Providing [retail investors] with an answer as to why it’s in their best interest for app-based broker-dealers to be able to nudge them one way or the other … I think should be among the highest priorities of a federal securities regulator,” he said.
While Jackson questioned the allowance of broker-deals to provide app-based nudges to clients, he also surmised that enhanced regulation could introduce new risk. “I take seriously … Steven’s urging that the choice to regulate or not to regulate, itself, has implications, so to the degree that we make it more difficult for app-based broker-dealers to make recommendations of this kind, the more we’ll drive investors into the arms of other sources of investment advice which might be even more counterproductive,” he added.
Jackson also addressed how the GameStop situation revealed some important market realities that have critical implications for the exchanges: retail trading during the pandemic became a significant proportion of market activity in particular issues, with as much as 50% of trading in a given issue now occurring off-exchange. In response, proposals have recently emerged for how exchanges can attract increased volume.
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