4 Questions Lawmakers Should Ask About GameStop Drama

A hearing on Thursday by the House Financial Services Committee promises to provide insights into what happened last month — as well as what could have happened — during what many labeled the retail investor uprising. While it is likely to produce many headlines, it is unlikely to arm regulators with clear guidance given the complex competing issues in play.

I can think of at least four reasons for lawmakers (and regulators) to be interested in an episode that captured attention well beyond financial markets:

Are small investors inadequately protected?

The drastic round-trip in the price of GameStop Corp. and a handful of other stocks involved in the uprising is likely to have imposed significant losses on small investors, especially those who entered the trade late. Easy and engaging access to trading, including on margin — the Robinhood effect — were important in enabling considerable involvement by small investors, as was the availability of higher cash savings and, for some, the stimulus checks. The subsequent decision by Robinhood to restrict these investors from buying more of their favored stocks acted as a catalyst for the sharp turnaround of the stocks’ price trajectory, making even more vivid a whole host of questions about investment suitability and the associated vulnerability of small investors to sudden changes in operating rules.

How close did the Reddit interactions get to the risk of inappropriate market manipulation?

Interactions on Reddit popularized trades that attracted significant participation by small investors. Some appear to have also encouraged, if not implored, them to act in a certain way. Indeed, a few of those involved felt that Reddit itself was hijacked in the late stages of the uprising by outsiders to divert purchase flows to silver, a decoy “target.” All this points to the risk of inappropriate market manipulation in an area that, until now, does not appear to have been on regulators’ radar screen, let alone be supervised closely.

Does the host of interactions between broker-dealers and hedge funds increase the risk of collusion?

While Robinhood positioned itself as the friend of small investors, the uprising exposed their close interactions with hedge funds. These raise a number of questions, particularly when it comes to payments for order flow that some argue could provide an unfair edge to participants as well as the alignment of financial incentives that can increase the risk of collusion.

How close did we get to a market accident?

Robinhood’s urgent mobilization of more than $3 billion in funding was essential to keep the company operational. Had such funding failed to materialize, Robinhood’s account base would have faced considerable instability with likely spillovers to the exchanges, which would have likely come under pressure. Also at risk were the credit lines extended by banks and others to Robinhood.

There is also the fact that the uprising, as small as it was, contributed initially to wiping out quickly more than 5% of the value of the S&P 500 Index. That, in itself, highlights the risk of broad market contagion associated with the sudden de-grossing of balance sheets that have ballooned thanks to minimal borrowing costs and ample liquidity.

The Financial Services Committee hearing will take place in the context of continued ultra-loose liquidity conditions that are likely to become even looser as considerable additional fiscal stimulus accompanies the “pedal to the metal” policy stance of the Federal Reserve. It will point to the possibility of changing market structure after the considerable migration of risk from the banking sector to nonbanks. And while it is likely to produce many dramatic soundbites as it highlights the extent to which regulators have lagged developments on the ground, it is unlikely to provide them with clear guidance given the complex crosscurrents.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Mohamed A. El-Erian is a Bloomberg Opinion columnist. He is president of Queens’ College, Cambridge; chief economic adviser at Allianz SE, the parent company of Pimco where he served as CEO and co-CIO; and chair of Gramercy Fund Management. His books include "The Only Game in Town" and "When Markets Collide."

©2021 Bloomberg L.P.

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