The creation of stock market rules often comes after a big event happens. Some examples include the stock market crash of 1929 — which led to the wide-ranging federal securities laws — and the financial crisis of 2009.
For the most part, regulators are reactive — there is usually not much effort to anticipate what may be the next crisis. And this can certainly lead to risks in the financial system. This is especially the case because of the rapid advances of technology.
As for this year, the financial markets are dealing with yet another emerging phenomenon — that is, the Reddit forum traders. They have become a major force, having propelled stocks like GameStop (NYSE:GME) and AMC (NYSE:AMC) to dizzying heights. Even silver has been caught up in the frenzy!
Congress has already held hearings on the matter and Treasury Secretary Janet Yellen has called for a meeting with federal regulators. There is even buzz of possible criminal investigations for alleged market manipulation.
So then, what are some possible actions for new stock market rules? Well, let’s take a look at seven:
Now, let’s dive in and take a closer look at each one.
Founded in 2013 in Silicon Valley, Robinhood is one of the most valuable fintech companies in the world. This online brokerage firm has over 13 million investors.
But there are concerns about how its app is structured. For example, there are gamification features that making it highly engaging. It’s kind of like bringing the addictiveness of something like Tinder or Snap (NYSE:SNAP) to investing.
The problem? It could be resulting in highly risky activities. The reality is that many investors do not have the time or expertise to be successful day traders.
Keep in mind that Massachusetts Securities Division has brought a suit against Robinhood regarding its gamification efforts. And this just may be the beginning of government intervention, especially if the extreme volatility continues.
One of Robinhood’s disruptive strategies was to have zero commissions. This allowed for strong growth in the user base.
But of course, the firm had to find ways to generate revenues! To this end, the company has relied on getting paid by market makers for “order flow.” While this is a legitimate practice, there are fears that it could be abused. For example, a brokerage firm may ultimately provide better pricing for larger clients at the expense of retail investors.
The topic of order flow is likely to not go away. It seems like this is an area where stock market rules can provide better transparency.
Source: REDPIXEL.PL / Shutterstock.com
A major complaint with brokerage firms during the Reddit surge was the lack of disclosure. It seemed somewhat arbitrary when they would place restrictions on what stocks to buy and sell. As a result, there have been a variety of lawsuits from customers.
Now the brokerage firms were certainly under much pressure. With the huge volumes, Robinhood had to quickly raise $3 billion to stabilize its balance sheet.
“No doubt, more transparency and better communication from brokerage firms will help all investors and in many ways would level the playing field for retail investors,” said Clemens Kownatzki, PhD, and a professor of finance at Pepperdine Graziadio Business School. “Institutional investors have an information advantage, often having direct channels into brokerage firms. If you are in the camp of market efficiency aficionados, you can look at market prices as information systems. Since some market makers offer pay for order flow from brokerage firms, they have the ultimate information flow and can out-navigate any retail investor, even some of the more long-term oriented institutional fund managers.”
Short selling has suddenly become a red-hot topic with the Reddit trading spectacle. Yes, this group has targeted companies with high levels of short positions. The idea is that — as the stock prices rise — this would encourage short sellers to close their positions by buying back shares.
But what was very interesting is that some companies had short positions in excess of the floats (this was the case with GameStop). In other words, this likely supercharged the short squeeze.
True, this is fine for those who are bullish. But then again, it does not seem like a good idea for the financial system to have technical deficiencies either. So one idea is to look at ways to reduce the excessive shorting of companies.
No doubt, on InvestorPlace.com, Yahoo! Finance or CNBC, there is easy access to tickers for stocks and instant quotes. But what if you want to find similar information about shares that are shorted?
There isn’t much of a system for this. The transactions are usually handled with brokerage firms and mutual funds. The market is actually quite lucrative because there are relatively high interest rates for borrowing securities.
Yet, shouldn’t there be transparency with this? Isn’t it a good idea for investors to get a sense of the flow of short selling?
This really does seem reasonable. The irony is that — after the financial crisis — the Securities and Exchange Commission was supposed to provide for a system with more disclosures. But this was never carried out.
A critical part of the stock market infrastructure is clearing. This allows for orderly payments for securities and the change of ownership.
Note that the system operates on a “T+2” settlement. This means that a transaction is not completed until two business days.
Although, when the markets are volatile, this can pose substantial risks for financial firms. They do not want to be in a position to put up large amounts of capital to back the trades.
Because of this, there are calls to have “T+1” or even real-time settlement. Granted, this will not be cheap because of the need to deal with legacy IT systems. But such a modernization will likely be essential for better performing markets.
With the markets in the bull phase, it is no surprise that there have been moves to impose new taxes. The Covid-19 pandemic has also resulted in major shortfalls with state and local budgets.
A group of Democratic congressmen have proposed a wealth tax. This will involve taxing gains even if there have not been any sales. And the goal is to raise $10.2 billion.
But the passage of such a law is not too likely, though. After all, the New York Stock Exchange has already indicated it would move its operations if this legislation comes to fruition!
On the date of publication, Tom Taulli did not have (either directly or indirectly) any positions in any of the securities mentioned in this article.
Tom Taulli (@ttaulli) is the author of various books on investing and technology, including Artificial Intelligence Basics, High-Profit IPO Strategies and All About Short Selling. He is also the author of courses on topics like the Python language and COBOL.
The post 7 Ways the Government Could Modernize Stock Market Rules appeared first on InvestorPlace.
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