GameStop fireworks are likely to bog down in a regulatory slog

Those who oversee the markets are not built to react quickly to disruptions within them. Theirs is a world of study and deliberation. They have to listen to a wide range of public input. and they often leave much regulatory ambiguity in place.

The trading frenzy that sent shares of GameStop Corp. soaring 400% a couple of weeks ago and then plummeting back to a reality level exploded in a flash. But the regulatory response is likely to be a long slog.

Those who oversee the markets are not built to react quickly to disruptions within them. Theirs is a world of study and deliberation. They have to listen to a wide range of public input and they often leave much regulatory ambiguity in place.

Treasury Secretary Janet Yellen met with securities regulators on Feb. 4 to talk about the whirlwind of buying instigated on the online forum Reddit that propelled GameStop and other stocks that had been shorted by hedge funds and other Wall Street players.

The current four-member Securities and Exchange Commission earlier issued a statement vowing to protect investors from market manipulation and to review actions taken by brokerages, such as halting trading in volatile stocks.

Despite that vow, Peter Chepucavage, an independent regulatory consultant, doubts there will be a robust SEC response.

“I expect them to do an investigation, write a report, hold a roundtable, propose a rule and by that time, four years will have gone by and everybody will forget what the problem was,” he said.

Tyler Gellasch, executive director of Healthy Markets, an investor trade group, also foresees a sluggish SEC pace of “a few enforcement cases, a lot of public hand-wringing and few significant rule changes.”

The wildcard is the nominee for SEC chair, Gary Gensler, who has a reputation as being a tough regulator. “He is uniquely proven to have the rarest of things in D.C., which is political courage,” Gellasch said.

Still, a slow policy response is the best bet, and it has to do with politics. The House Financial Services Committee will hold a Feb. 18 hearing on GameStop, and the Senate Banking Committee is planning one, too.

Those panels are led by Democrats, who hold narrow House and Senate majorities. But Republicans are pushing back. Sen. Patrick Toomey, R-Pa. and the highest-ranking Republican on the Senate panel, cautioned policymakers to “avoid needlessly inserting themselves into equity markets.”

A go-slow message also is coming from the Financial Services Institute, which represents independent broker-dealers and financial advisers.

“We’re going to urge regulators … to avoid overreacting,” said FSI chief executive Dale Brown.

Dilatory regulating following past crises has left problems unaddressed. For instance, Gellasch said broker capital requirements were a weakness that contributed to the collapse of Lehman Brothers during the financial crisis. They continue to linger.

“What we don’t know is how close we came to having a large broker failure” during the GameStop vortex, Gellasch said. “We’re lucky we’re not wrestling today with thousands of frozen accounts.”

The holdup on broker capital reform can be attributed in part to “regulatory capture,” said Gellasch, a former SEC counsel and Senate Democratic aide.

Such capture occurs when the financial industry lobbies the SEC to go soft. But regulators do have to listen to both sides — and that can slow things down.

For instance, payment for order flow, which occurs when a platform like Robinhood directs trades to certain high-frequency traders and brokerages for execution, has come under criticism. In a recent SEC settlement, Robinhood agreed to pay $65 million for not giving customers the best prices for trades from 2015-18.

But the SEC will hear from defenders of such payments.

“It’s easy to politically malign payment for order flow as an idea,” said Tim Foley, counsel at Alston & Bird. “But in reality, payment for order flow is standing in the place of commissions that retail traders used to pay.”

FINRA TO WEIGH IN

There’s also the question of whether the GameStop situation can be addressed by current regulations. For instance, the Financial Industry Regulatory Authority Inc. has made an examination priority of probing brokerage communications with customers, especially as they pertain to new forms of “game-like” trading.

Steve Marsh, founder and chairman of Smarsh, a digital communications compliance firm, said brokerages could use technology better to monitor what their representatives are doing on Reddit and in other outside business activities.

“The biggest challenge for the regulators is getting the industry to understand the rules that are already in place,” Marsh said. “The technology is not adequately deployed by most of these firms at a level that is going to address the riskiest forms of communication.”

But a regulatory breakthrough related to GameStop is possible. Valerie Dahiya, a former SEC and Finra official, anticipates the SEC will utilize Regulation Best Interest, the broker investment advice standard.

“This is the first real test for Reg BI and how the staff will apply and interpret it,” said Dahiya, a partner at Perkins Coie. “That will send a very clear message.”

Another market conflagration has given the SEC another chance to find political courage. Perhaps it will be provided by Gensler.