Home Compliance Can We Teach Old Watchdogs New Tricks?

Can We Teach Old Watchdogs New Tricks?

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“Dumb Money,” which opens in theaters later this month, tells the story of how retail investors turned GameStop, a struggling shopping mall staple, into the world’s hottest company; SteelEye’s Matt Smith tells the story of how federal watchdogs still haven’t learned how to deal with modern market manipulation.

When the trailer for “Dumb Money,” a movie about the remarkable story of the ragtag amateur investors responsible for the 2021 GameStop saga, was released, it may have left you, as it did me, wondering how much progress has been made in preventing a similar debacle from occurring in the future.

On the surface, it seems the answer to this is very little — that in the time it has taken for Hollywood to produce a feature-length film on the power of social media collusion in influencing financial markets, all regulators have achieved so far is a collective head-scratching.

This must change — and fast. While the curtain may have closed on the GameStop debacle, the opening credits may just be rolling with regards to the collective power of dumb money.

In terms of what the industry can do to help protect against similar disruptions in the future, institutions across the capital markets space — from hedge funds to platforms and regulators — must take meaningful preventive steps.

Revisiting risk

From a fund management perspective, the main lesson to be gleaned from the GameStop saga surrounds risk. More specifically, how to ensure the unpredictable yet highly influential nature of social media is accounted for and baked into risk models.

This goes beyond factoring for short-squeeze scenarios like the GameStop fiasco. Company chief executives are also now able to have a rapid and measurable impact on the price of a stock within seconds via mediums like Twitter. Take Elon Musk, for example. You might recall when the billionaire tech entrepreneur sent Tesla stocks plummeting when he took to Twitter to ask his then 63 million-strong followership whether he should sell 10% of his Tesla stock.

More subtly, after acquiring the majority share of Twitter, which he later renamed X, Musk replaced the company’s logo with Dogecoin’s Shiba Inu dog, helping to drive a surge in the meme coin’s market value. He was later accused of insider trading by a group of investors who claimed that the billionaire profited from driving up the coin’s value.

Watchdogs must learn new tricks

While placing increased attention on risk management will be critical in the social media age, financial regulators also have a critical role to play in protecting investors — both of the institutional and retail persuasion —  from GameStop-type market frenzies.

Just as non-compliance has high penalties, so should social media-fueled modern market manipulation in which participants in chat forums like Reddit band together to influence the price of a stock significantly, regardless of its underlying fundamentals. While this is not yet an illegal activity, it can have sudden and dramatic implications for market participants and must be regulated in a manner that reflects this.

If we do not introduce more rigorous and clear regulations around the use of social media for influencing financial markets, this type of online activity will only become more prolific.

One area in particular in which regulators have made little progress is defining clear areas of responsibility for the market institutions implicated when trades are ordered. For instance, when the GameStop saga was in full swing, retail investment platform Robinhood took the bold decision of restricting the purchase of GameStop shares through its platform when the stock price was still considerably elevated. The stock’s price reversed dramatically in the days that followed, and analysts believe Robinhood’s decision was largely responsible for this decline. Should retail trading platforms be the ones to make such highly influential decisions? Perhaps it should instead be the trading venues, or the regulators themselves. Either way, it certainly doesn’t seem like it should be in an app’s remit to decide when people can and cannot trade a particular stock.

Watchdogs need to deliver a clear and detailed framework delineating which institutions are responsible for making which calls when instances of modern market manipulation emerge. A good first step would be taking a closer look at how certain trading platforms responded to the GameStop stock frenzy.

Regulators must also explore the true potential of platforms like Reddit to meaningfully influence market prices. Largely fueled by an influx of retail investors during Covid, online communities now have enormous reach, with the likes of the sub-Reddit r/WallStreetBets boasting more than 14 million members.

This will be no easy win for regulators, which under current rules must prove intent to determine that a stock price has been set artificially. Indeed, successfully tackling modern market manipulation may necessitate a complete regulatory overhaul.

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