null Episode 15: Robinhood, Reddit and the SEC
Double Take podcast

Episode 15: Robinhood, Reddit and the SEC

01:05:13
Double Take podcast Audio Equity Multi-Asset
February 2021
Episode 15: Robinhood, Reddit and the SEC

In conversations with Mellon’s head of trading and analytics and the former head of the SEC's Office of Internet Enforcement, Double Take dissects the latest headline-grabbing market movement, as retail traders using forums like Reddit sparked wild stock swings, caused Robinhood to halt buys, and squeezed short sellers. We also explore the role of short selling in an efficient market, and more.

Rafe Lewis: Hello and welcome to episode 15 of Double Take, The Mellon podcast. I'm your co-host Rafe Lewis, Mellon's Director of Investigative Investment Research.

Jack Encarnacao: And I'm your other cohost and investigative researcher, Jack Encarnacao. As you likely know, Rafe and I like to bring you folks thoughtful, candid, journalistic discussions on substantial themes impacting public markets' investors, and while the biggest, beefiest theme out there right now has got to be what some are calling the meme trade or the Reddit trade, the retail rebellion, the Robinhood revolution. As some stocks soared skyward, hedge funds with short positions in those stocks began to feel some serious pain, prompting, many to cover at any cost, which compounded the skyward movements.

Meanwhile, as the hedge funds sought liquidity, they were selling long positions, which created a downdraft in stocks, nowhere near the meme trade, and all throughout this, high frequency trading shops started to get involved, grabbing capital gains along the way, and creating further price and volume distortions. It was safe to say a quintessential 2021 story filled with social media wars, political grand standing, David versus Goliath comparisons and more.

Rafe: Yeah, I think that sums it up pretty well, Jack. It's enough to make your head spin. So we wanted to put together an all-star guest list today to help you, our fair listener, better understand just what the heck is going on here and where it could all go, perhaps even more importantly. From inside of Mellon, we're bringing back the inestimable Dragan Skoko who is Mellon's head of trading and analytics, who many of you may recall was our guest during the height of the first wave of the COVID-19 pandemic. And he's going to describe what's happening today from a trading perspective and some of the distortions he's seeing, and how a guy like him can deal with this.

Then from outside of Mellon, we will bring you John Reed Stark. Now John is the founding chief of the US Securities and Exchange Commission's Office of Internet Enforcement. He has since moved on into private consulting practice, and he is also a visiting fellow at Duke University School of Law.

Dragan, it's so great to have you back on the podcast. And as usual, it only can happen when the world is going completely topsy-turvy. But at least this time it's mostly just impacting people who invest in the stock market and it's not about a pandemic per say.

But I guess, let's start on a very high level with you on this whole retail Robinhood trade phenomenon that's going on. Can you just talk, generally speaking, how unprecedented, how different is this from the perspective of you, a guy who runs a trading desk for a very large asset manager.

Dragan Skoko: Sure. So the retail participation in general, I would say the last year plus feels very much like the environment we had in say 1998, 1999, 2000. So there's just a tremendous amount of interest to participate in the equity markets among the retail investors. They are involved every day and they are certainly having an impact on a number of important market structure dynamics through their participation.

Now, there are also some important differences. The market structure itself has evolved quite a bit since that late 1990s period until today. And those differences impact how we are able to interact with or are affected by the retail participation in order flow.

Jack: Dragan, is it tough to discern what is retail order flow and what is sort of follow on tracking retail order flow? Is it hard for you as a trader to really say this is Robinhood, for instance, versus other strategies that might be picking up on momentum?

Dragan: It actually is. It's not something that's obvious just by looking at a price action on an average day. Some, just like tremendous examples, not withstanding, for a few reasons. Firstly, a good number of retail brokers do not actually directly participate in equity markets. They don't send their order flow to the exchanges or other trading venues. Some of them exclusively sell their order flow to what we refer to as wholesale market makers.

Others have a combination of that. So selling the order flow and look into internalize the order flow within their own ecosystem. So if it's a broker or a firm that has a retail brokerage arm and an institutional brokerage arm, and perhaps some other trading activities, they might bundle all of that within the ecosystem and try to internalize the order flow.

And then lastly, you do have some firms with a much more sophisticated trading infrastructure that do actually participate in a variety of ways. But that complexity does make it more difficult for us to recognize that, hey, this is heavy retail participation just by looking at a price action or even just by looking at the volume. And also the order flow that is sold to the wholesale market makers, we cannot directly interact with that order flow.

We deal with the exhaust of their order flow, so things that a wholesale market maker does not want to keep on their books and that eventually makes it out to the dark pools and exchanges and so on. But that initial order flow, we don't get to interact with directly. We don't get to participate in facing off with a retail investor. We face off against their market makers.

Rafe: Dragan, I'm wondering, without getting into any specifics about any particular trades that we may have been involved in, I'm curious if you can get into just generally speaking how our ability to trade was impacted, if at all, during these past few weeks of what's fairly unprecedented retail activity, including the stoppages of trade in certain names.

Dragan: Sure. So it's interesting. And I followed this fairly closely just because it was such a fascinating case study, frankly, in our market structure and in behavior of market participants and so on. But I think it was interesting that some buy-side folks stated on the TV channels, that they were not impacted. They're long-term investors, this does nothing for their thesis and it doesn't impact how they implement their portfolios.

To me, it's kind of inevitable that you're going to be impacted for a host of reasons. Firstly, if you happen to be holding a security that goes through some tremendous roundtrip of going up a few thousand percent and then all the way back down, the weight of that holding in a portfolio is going to change so rapidly, intraday and from day to day, that it affects just your risk profile and your exposures.

So if you're a portfolio manager, you kind of need to think about, do you want that idiosyncratic event that is not related to the fundamental aspects or any other kind of investment thesis that you might have, do you want that to dictate your performance? And so if you don't, now you'd have to send some orders to the trading desk in order to change your risk profile.

And so if we now have a trade, now we are interacting directly with other market participants. As I said earlier, for us that will be, a good chunk of that will be against the exhaust of the wholesale market makers order flow.

And now you're trading in a security that has exceptional intraday volatility, very wide bid-ask spreads, and it's trading with a significant short-term momentum. All of those things combined, kind of cause for a very complex trading environment and some of the tools that you would use on majority of stocks, majority of time, are not going to work.

And you need to reconsider your execution strategy, your timing, your own participation throughout that event. And so, yeah, I think absolutely institutional traders and investors are affected by this in a pretty profound way.

Jack: And I guess maybe the other side of the coin here is that you had some hedge funds that were at a minimum temporarily distressed and very heavily so. And in order to deal with these short squeezes they were dealing with on their short portfolio, they had to start liquidating long holdings. And that was creating some downward momentum and a lot of stocks too. What did you see on that front?

Dragan: Of course. So there's a bunch of stuff happening, right? So firstly, if you had this massive retail participation and a handful of securities, another thing worth pointing out that a good chunk of their participation is through call options, and not in the actual stock itself. So now, I don't want to ignore the actual stock participation, that's also significant, but you also have this options activity.

Now, if you think about how the options market work, and I'm sorry that doesn't get at your question directly, but it's important and then I'll tie it back to your question as well. The way that options markets work, the retail investor will go ahead and buy the call option. And then the market maker that sells them those call options will then need to hedge out that exposure. And they'll hedge out the exposure by buying stock.

So now you have retail traders buying a stock, retail trade is buying the call option, market makers buying the stock to hedge out their exposure in the options markets. And then you have, as you mentioned, the hedge funds with extremely concentrated positions liquidating the short. So they are further exacerbating the move itself in the stocks that are being squeezed.

And as you mentioned, they are also having to liquidate their long positions to kind of manage their overall portfolio exposures or risk or cater to the margin calls. So this is where you might want to look at a 13F filings to see what their longs might be, those filings are kind of stale thing.

So, you might not have a true picture of what they're going to be involved in, but you can see how the impact spreads beyond the handful of securities in which the retail traders have interests to a broader set of stocks and potentially other securities as well.

There are so many consequences of that sort of event. One of the things that it's worth mentioning also, and I talked about the impact on volatility, the bid-ask spread the short-term momentum. Also, you see a significant change in an intraday volume profile of these securities, right? So for years we had very steady intraday volume profiles and institutional trading kind of tends to be built around that consistency, right? So you have significant liquidity and volatility on the open.

Then throughout the day, you kind of have things settled, both liquidity and volatility. And then into the end of the day, you have tapered volatility and very high liquidity. Things are different now, you might have huge volume spikes at lunchtime. You might have very inconsistent volatility profiles.

So all of these execution tools that you build for typical institutional efficient tactics, like VWAP, Volume Weighted Average Price execution strategy, you're trading on the calls, et cetera. And I think that that follows some patterns of volume and volatility is impacted drastically. And those tools have to be reconsidered. They have to be recalibrated in order for you to participate in a sensible manner.

Jack: Dragan, One of the, perhaps the flashpoint in this whole phenomenon was when Robinhood started to bar their account holders from being able to buy more of a security that was shooting to the moon as they like to say. And there was obviously a lot of discussion and speculation as to why that may have been, why suddenly they had to stop folks from being able to buy certain names.

I wonder what that signified to you as someone that knows this world, as well as you do, did we learn anything new about the limits of these trading systems or the systems that Robinhood and others use to execute retail traits?

Dragan: Yeah, that's a great question. So firstly kind of going back to the first principles of what happens when a trader buys a stock through their broker, right? So you buy a security and then while the transaction has been affected, the actual movement of stock and cash doesn't happen until two days later, that so-called T+2 settlement cycle.

So in that, 36 to 48 hour period from the time you affect the transaction until the time that shares of stock arrive in your account and cash is moved out of your account and into the seller's account. During that timeframe, the clearing house, which is for example, in the U S you have the DTCC, the clearing house requires a certain collateral from the broker. And that collateral basically protects the integrity deductions action.

In case something happens to the broker, the client, the trade can still settle and be processed. So I think that works well great majority of the time. And I think what happens in a situation like what we saw in January, is that you have a couple of brokers with such a homogenous client base with such a concentrated interest in a couple of securities. The volatility they caused, of course triggered the risk systems part of the clearing house, which in turn increased their collateral requirements of those couple of brokers.

And, those that were not as well capitalized, ran out of their cash position to be able to cover those collateral requirements pretty quickly. Typically even on a very bullish market day, a broker will see something like 52% of order flow to say skewed to the buy-side 48 to the sell-side. Here not only did you see a significant skew in one direction, you saw it in a handful of stocks.

And so the combination of the one way flow and the extreme volatility caused the clearing house to do what they had to do, and the broker to manage its own risk and to maintain its own sustainability had to kind of protect its capital position, its cash position and limit kind of the ability for clients to open positions.

None of it is new is just the magnitude of the event and the attention the event had, that just made it such a profound kind of situation for everybody. And I think the unfortunate bit is that, it fed into this populous conversation and dialogue right away. And among people that have the ear and eyes of a lot of followers, but don't necessarily have the know-how and the true understanding of how capital markets function.

Jack: Right, right. Yeah. There was an education here for a lot of folks, no question. And what forced the curiosity was not being able to buy when you wanted to buy, that gets people asking the right questions rather quickly after they realize perhaps that the conclusions they at first jumped to might not be the reason that they couldn't trade.

So I wonder Dragan, the next time a name picks up steam like this, we must assume going forward I suppose, that on any given day, a Reddit thread could explode another name. Do you expect market participants to respond any differently? If and when that happens again than what we saw in this instance?

Dragan: So sort of another great question. I think that you might see brokers react a little faster to the incredible demand and strain that this puts on their cash position. So you might see the risk management tools be calibrated to react to this better, right? So that you don't have to go to increase your lines of credit and go to the venture capital community to raise billions of dollars in order to remain solvent.

So I would expect, if anything, a faster reaction. I do want to point out one thing, this is not a retail trading phenomenon. In other words, us institutional traders, we get turned away by brokers when they're facing some extreme circumstances in the trades that we may make. Which is why we spread out brokerage exposure risks across many counterparties.

But on any given day, any of the brokers might not want to transact in certain names, they might not want to commit capital. They might not want to accommodate certain settlement instructions. And we deal with that just the same. I think the fundamental difference is that we understand the constraints that lead to those circumstances.

And we hedge out our risk and manage our risk by having many broker relationships and understanding where to trade for what type of a trade and given the constraints that we're dealing with.

Rafe: Dragan, last question for you from me. Is there any long lasting lesson we can learn from all of this as institutional asset managers?

Dragan: I think that's also a great question. Well, firstly, I think we need to improve our execution tools by enriching the data sets with more and better sentiment data, and another alternative data that really picks up on some of the activity. Because, as I mentioned earlier, the nature of that activity is more nuanced than one would think.

Secondly, I think in portfolio construction and management of risk, we have to rethink the reliance on historical volatility models. Because what we saw in January is really unprecedented in terms of the volatility move in some of the securities that were well studied since then.

Lastly, what I would say is that we cannot expect the behavior that we saw in January to be regulated away anytime soon. And even those things that do get regulated away, the new regulation might lead to new dislocations and new opportunities for changes in market structure. And we have to be ready to react to that as well.

Jack: Well Dragan, I want to thank you for laying a wonderful foundation for us and trying to unpack kind of what it all comes down to when a phenomenon like this occurs is trading and the limits and the guardrails. I think there's going to be a lot more interest in the coming months and years into sort of how folks like yourself have the finger on the trigger in terms of being able to consummate these things when the markets get crazy. So we really appreciate you joining us again on Double Take and look forward to talking to you again at some point.

Dragan: Not a problem at all. Thank you for reaching out and looking forward to chatting again.

Rafe: Well, it was great hearing from Dragan just now about the veritable trench warfare going on worldwide as traders and portfolio managers have tried to make sense of the Robin Hood revolution and not get disemboweled by it financially. So now let's turn to John Reed Stark, formerly the head of the SEC's Office of Internet Enforcement. He was actually the founding head of that office. And let's get his take on the regulatory and legal perspective on all of this. John, welcome to the podcast.

John Stark: Thanks, Rafe. Great to talk to you guys.

Rafe: Well, we're thrilled. John, a lot of pundits are saying that the recent retail day trader stock frenzies smack of market manipulation, which is a very specific legal term of art. That said, neither Jack nor I are lawyers. We don't even pretend to be. So can you, a rather well-known and a reputable lawyer, can you please explain what market manipulation is? And much more importantly maybe, in your opinion, is that what we're seeing here?

John: Oh, absolutely. Yeah. I've worked in the SEC Division of Enforcement for almost 20 years, and I don't think anybody there really fully understands what market manipulation is. It's something you know it when you see it. It's evolved extraordinarily over time.

Historically, market manipulation meant wash trades, match trades, layering, spoofing, which are all terms used where traders would orchestrate trading in a way to make the trading look like there's more volume than there is. There's more interest than there is. And that's historically what was meant by market manipulation. And it was very specific. Required specific types of intent and a very complex trading throughout, and really a fairly significant conspiracy.

Well, fast-forward to the eighties and the nineties and things changed dramatically for market manipulations. And really instead of the SEC using some of their specific statutory provisions that deal with washed and matched trades and so on, they used their much broader provision, which is just their anti-fraud provision, Section 10B and Rule 10B-5, which essentially say you can't lie, cheat, or steal in connection with the purchase of a security.

Well, what does that have to do with market manipulation? The way the SEC looked at it and it's been accepted by the courts, is that if you're spreading false information to drive a stock up or down in the form of pump and dump scheme, and that could be using social media to publish a bogus press release about positive earnings, a phony rumor of a new treatment that cures some terrible disease, a fake news story about an acquisition, or any other sort of scam or masquerade that would somehow jumpstart a stock price to go up or hit it hard to go down. Most of the SEC's cases are pump and dump schemes as opposed to any sort of a short scheme where you're trying to drive down a price because it's historically been much easier to prove.

And the way the SEC brought these cases, and if you look historically at all the cases brought that were under the rubric of market manipulation, there was usually a concrete, false statement. Like I said, a fake press release or fake rumor or a fake contract that you had. And you as an investigator at the SEC, which I was, could call and confirm that fact. You could find out is this earnings announcement true? Did it really come from the company? Does the company really have this big contract? And then you would follow the three trails: the trading trail, the money trail, and the internet protocol trail, to figure out who the people were that were spreading this false information and look to see if they profited.

But interestingly, you don't even really, necessarily have to profit. The SEC has brought cases of market manipulation where the perpetrator of the scam didn't even profit. So that's a long answer to-

Rafe: So that's like the attempted murder as opposed to the murder, right? They certainly tried to move money. It just didn't work.

John: Yes, exactly.

Jack: Wow. So I just have to ask, John, how, if at all, do you expect the SEC might crack down on the type of trading we've been seeing? Not to prejudice the jury, not to suggest that they should, but would you expect them to based on what played out in the past couple of weeks?

John: Well, I think no matter what, look, when there's a case, when there's a situation that's in the headlines, the SEC is always going to investigate. Period. End of story. And when they investigate, there's no conclusion as to wrongdoing. They spend a lot of time trying to seek the truth. And in this situation, they will pour over all the trading data. They will pour over all those message board postings, probably dump them into some sort of e-discovery database and use artificial intelligence to parse any particular postings that seem particularly suspicious. They will look for SEC registered persons involved in the mix, because they typically have higher fiduciary obligations, record keeping obligations, supervisory obligations. And they'll probably give those people closer scrutiny.

And then the SEC has an additional tool that's really developed significantly over the last five or 10 years, which is their tipster line. They have very, very significant whistleblower provisions that can award significant financial benefits to anyone who turns in anyone else involved in securities fraud. And there's an electronic way to do it. There's a way to submit your complaint anonymously.

So the fourth track of investigating that the SEC will be doing is looking at all those complaints. And 98% of them are probably not worthy of further review. They're just people ticked off at what they've seen. But maybe 1 or 2% will be from company insiders or other people who have special information to share with the SEC that wouldn't otherwise be publicly available or at their fingertips in the context of the investigation.

Rafe: My heart goes out to the SEC a little bit here, because I think about what the FBI has to try to do with the attack on the Capitol building. You've got thousands and thousands of people coursing in and out of that building, and you're supposed to now try to put Humpty Dumpty back together again and figure out who all these people were and who may have had more malicious intent than others.

In this case, you have thousands and thousands, maybe tens of thousands of retail traders and day traders who were getting amped up about this through the Reddit posts, these kind of notorious rooms that were going on over there and elsewhere. And I wonder, is this actually of a scale that the SEC has ever dealt with before?

John: Probably not. In my office when I was chief for 11 years, we dealt with a lot of very heavily touted stocks on various message boards, but never to the extent that the subreddit that I've seen. So probably not, but the technology is better for getting through all of that. And remember, there's a couple things to note here. The people who are having these conversations and talking about stocks on Reddit and gathering together, I haven't seen any allegation of anybody saying anything that wasn't true. In fact, there's a remarkable amount of transparency in saying what they're doing.

So that's the biggest hurdle here, I think, for the SEC is finding, like you said, malicious intent, finding a false statement, finding something to grab hold of in the context of any type of action. Because the SEC can't be the speech police. They can't, and neither can Reddit. No one can really take that job. So I think the SEC is going to have to look very hard.

Another thing they can look for, which again, I haven't heard or seen any evidence of, but that doesn't mean it's not possible, is there's a little known statute called Section 17B of the Securities Act. And there haven't been many cases brought in the early days of it. It was enacted, I think as I said, in '33, and I don't think there were ever any rules written on it. There's not much case law on it. And what it essentially says that if you're touting a stock, meaning you're promoting it whether it be by megaphone or a newspaper or Reddit or subreddit, if you're touting that stock and you're being paid by the company, the nature source and amount of that compensation was that. So you have to disclose the nature source and amounts of any compensation that you're receiving from a company to tout that company's securities.

And it's a strict liability violation. And back in 1998 when we saw all this action on message boards and on the internet where there was initially just a huge amount of touting, and companies were waking up in the morning and just paying legions of people to promote their stock all over the internet, we brought a series of sweeps that made incredible news. And the truth is that bringing those cases as we did in '98, '99, it was like shooting fish in a barrel because the 33 Act of Section 17B is actually what's known as a strict liability statute. So that means that it doesn't matter if you knew what you were doing was right or wrong. As to the act, if you knew you were actually doing something, meaning you posted that message and you knew you were posting it, you weren't drunk when you did it or not of sound mind, then you violated Section 17B.

And I think in those two years after '98, '99, there haven't been many 17B violations forever until, oddly, when the initial coin offering craze happened. And all of these people started touting different types of digital coins on various message boards and other places. And some of them were celebrities like DJ Khaled, like Steven Seagal, TI, Floyd Money Man Mayweather. They were all being paid by these cryptocurrency firms to tout these cryptocurrencies. And they weren't disclosing the nature and source and amount of their compensation. So the SEC once again woke up Section 17B of the Securities Act and charged all of those people with violations of Section 17B.

So if there are people, because somebody with some ingenuity running some company, might say, "Hey, I want to get this board touting my company because look what it does for stock. So there might have been someone going on the message boards doing that. And as I said before, also a registered person who really is not supposed to be doing what they're doing. Meaning SEC registered, maybe state registered or otherwise.

Jack: John, let me sort of frame it like this. I'm interested in how you respond to this. So you've got this sort of hive of people who are doing everything in the open in terms of trading their enthusiasm and reasons for enthusiasm on a stock on a message board or on an internet forum, that's available to anybody. It's not a closed forum. It's not a members only forum. Anybody can look at what the basis is for this bullishness in this case. And the reason they're driving a stock through the sky is because it would be funny and it would be awesome and it would be a meme. How does the SEC approach that? Do they even have to? It seems like there's no value judgment at all in why a stock is going up. It's strictly are any of those players who are exchanging enthusiasm on a stock being paid to exchange that enthusiasm by people behind the scenes who stand to benefit?

John: Well, when it comes to dictating how to invest, the SEC job of preaching to investors is probably limited to just that, preaching. And they do a pretty good job of that. Arthur Levitt, I worked for, I think, six or seven different chairman and Arthur Levitt was one of the more famous ones who was all about telling people how to invest. And he would hold these town meetings all over the country. And there's never been anything like it since, and I used to go with him on these on occasion. And he would stand up and answer any question that anybody had about anything having to do with investing. And he wasn't afraid to look someone in the eye and say, "Don't subscribe to the greater fool theory. Don't subscribe to momentum trading. Do your research, look at a stock as a value investor would. Look at its cash generation, its price to earnings ratio. Study the markets, read the filings, look at their debt load, look at earnings expectations."

That's what he would say to people. "And don't make an investment decision based on a recommendation, unless you can look that person in the eye." And this was incredibly effective back then, because people were using the internet just like they did with this Reddit, a lot of people were basing their investment decisions on the internet. And at the same time, there was this extraordinary revolution, this disintermediation revolution that Robinhood kind of picked up on, but they weren't the first ones to do it. Because if you remember back then, the E-Trade commercial of someone sitting outside in a coffee shop on their computer and they see a jogger run by, enjoying some particular technology and they turn to their computer and quickly make their trades.

So there was a real surge in people making these kinds of decisions, instantaneous decisions and investing for the short term. So I think the SEC's role in this, because you bring up a good point about all these people using an investment strategy that personally, I would never recommend. That no professional investor or investment advisor would ever recommend, but they're all excited to go about doing anyway. And you can see it in Bitcoin as well. Most people don't understand what Bitcoin is, but they feel like, "Hey, somebody else is going to be out there who will pay more. So why don't I get in on this and get rich quick?" And it's the wrong way to invest, but it's a legitimate strategy for some people. And who am I to tell somebody or who is the SEC to tell somebody they shouldn't use a strategy if that's what they want so long as they understand the risks.

Jack: That's totally fair. But John, one of the real targets here of these Robinhood retail traders were the hedge funds that had built up substantial short positions on some of these companies. And I think it was a stated intent quite often, that the goal was to squeeze the short sellers, force them to cover their positions at huge losses. And in some cases there were monumental losses to the point where at least one fund, was pushed to the brink of insolvency and had to get a liquidity infusion from peers. And so, it raises a lot of questions. And one of them that I'd like to ask you is just kind of, from our point of view, I guess, as investors, Jack, we look at short selling is something that could potentially be an efficiency creator in the market.

Now, on the other hand, some people often refer to it as kind of pernicious evil activity that's trying to destroy wealth and, and move it into the hands of a very few. I'm curious, what is the house view at the SEC of short selling and are they really crying when hedge funds get their butts handed to them in a situation like this?

John: What a great question, because it brings back a memory I had. When I started working at the SEC, I used to work with the head of office market surveillance and his name was Joe Salah. He's retired, but he was really the best market guy the SEC had, or has ever had, I think in terms of, he really understood the markets. And he noticed in me, every time we talked, a certain cynicism or even like vitriol towards short sellers. And he pulled me aside one day and he said, "Look, you sit there and you're so negative about short sellers because they're betting against companies, but they actually perform a very important function in the marketplace, pushing back bubbles and corporate malfeasance. And they shed light, just like class action lawyers. They can shed light on misconduct or misperceptions." And so they do have this function that really does serve the market very well, but right or wrong, hedge fund fees just create obscene levels of wealth for their owners.

And that's always going to draw ire from people, from Congress, from the SEC, from pretty much everyone except other hedge fund owners. And the other idea, especially during the pandemic of short companies badly damaged by the pandemic, then being hit harder by these funds. It seems like hitting someone who's already down for the count. And it also seems like an attack against the company's workers. And the analogy I look at if you ever played craps, there's the pass betters, and then there's that don't pass better at the table who's betting with the house. And nobody likes that person and nobody wants that person at the table, but they do perform a function and they have their own way of betting. So, I think, as far as hedge funds let's go, they will always be under scrutiny for these reasons.

They will always be under scrutiny by Congress, especially. And the regulations involving hedge funds, involving short-selling are very complicated. They involve mostly regulation SHO, which among other things is designed to stop what's called naked short selling, which is when the seller does not borrow or arrange to borrow the securities in time to make the delivery to the buyer within the standard three-day settlement period. So the seller fails to deliver the securities to the buyer when the delivery is due. Let's call it a delivery fail or fail to deliver. And SHO has these very important standards. They're called locate standards, to make sure that when these transactions happen, the brokers have a reasonable belief that that equity that's being shorted can be borrowed and delivered on a specific date before the short selling can occur. And there've been a lot criticisms of regulation SHO that it doesn't go far enough.

So I think there'll certainly be some scrutiny to see if there were violations of SHO. And and that will involve looking at the hedge funds. And again, that takes us all back to this idea of the SEC tip line. So all it takes is one disgruntled employee from a hedge fund or one really upset competitor who's got some special information to share with the SEC and the SEC will fan out, take everyone's testimony, maybe refer the facts in the matter to criminal authorities. There are FBI agents typically embedded at the SEC at headquarters. And if they're not embedded, my group used to have a weekly briefing with the FBI and assistant US attorneys as well, telling them all about our case inventory and letting them cherry pick their favorite cases from that bunch.

Jack: Wow. So, John, there are a few notable websites that have specialized in publishing the kind of short reports we're talking about. They make no secret to the fact that they publish after they've already built up short positions, so they can profit if you sort of buy into the conclusions they've reached. And in the wake of what's happened with GameStop and some other names that were popularized on Reddit. One notable short report publisher called Citron. The owner of that firm said he's not going to put out notes on short positions anymore, because what happened here left him open to being sort of, I guess, ganged up on by the Reddit crowd. Is this a bad thing or a good thing? Why isn't publishing a short report and then covering the short position when the stock plummets on publication form of market manipulation, can we see it that way?

John: Wow. Well, that's a tough question. Because either side has its negatives, right? By publishing the report, you can have a dramatic impact on that stock. And remember it works in reverse also. When Warren buffet decided to buy Apple, the whole world bought Apple the next day, and that's not a bad trading strategy. And when Warren buffet decides to sell something, the whole world starts selling the next day. That's not a terrible trading method. Now, I think Warren buffet has all sorts of controls in there, so that this information is not announced until he's already done that trading.

My guess is because his lawyers are, he is concerned about somehow conditioning the market by just announcing, "Hey, this is what we're going to do." But I don't know that there's anything wrong with that, so the reverse shouldn't necessarily be illegal either. I think transparency into trading, it happened with Warren Buffett because his company is a publicly traded company, so eventually, he's going to be disclosing what his holdings are, but if you're a private investor, I don't know that you have those disclosure responsibilities to the public. The short sellers are giving up something there too because, again, my guess is that adding something to a short list could certainly have an extraordinarily negative impact on that stock.

At the SEC, I always used to preach, and I've been teaching first at Georgetown Law School and now at Duke Law School a technology course. Now it's more about cyber and data breaches. Initially, my course was about technology and the SEC, and there was always a lot of, well, what does a company say when somebody comes out and says that company is doing terrible things or the company is doing great things and those things... and what people are saying is wrong? How does the company react to that?

I think the best answer to that for a public company is to say, "Look at our filings. That's what we have to say on this subject. Thank you very much." When you go out and you start picking out certain ideas to communicate, but you're not... so you're communicating positive things, but you're forgetting to say the negative, you can get into trouble. I see this in all sorts of stock promotions. You just have to disclose the risks at the same time.

Getting back to your question, for a short seller, do they have to tell the world that they might be short something if that's their strategy? That isn't necessarily true. Again, you have to look at specific regulations of what they are required to say by the SEC and what they're required to say to their shareholders in their various shareholders or limited partnership agreements.

Rafe: Do you know, this whole saga seems to me like we've seen technology as a great democratizer. I mean, maybe these subreddits are the key to that, but the fact is that ordinary investors now can see what the short percentages of any given float of a public company now with the touch of a button. They don't need a special dashboard or a subscription to some kind of fancy service to be able to do that, or a broker even. They can just find it, so they don't necessarily need, I guess, the short report seller to tell them where the skeptics are.

John: Yeah. Oh, absolutely. I mean, I think that's one of the most incredible things about the internet is that information is everywhere. I think the SEC did a decent job when the internet first started becoming popular, as Arthur Levitt did, to try to explain to people how to find the right information. I mean, for you guys, for Jack here, you're every day digging into the right information. An analyst might look at all the public filings, might even show up on a Sunday and see how many parked cars are outside of a company headquarters on a particular afternoon, or you might stand outside of a Nordstrom and count the people who walk out with bags. You can really-

Rafe: Sounds like investigative research, John. I like it.

John: Yeah. I mean, that's what makes you guys special in terms of providing information for people. It's getting them the kind of information that they just can't find anywhere else and really taking that information, putting it together, and drawing conclusions. But what's so interesting, there are so many ironies in all of this is that in some ways the system has worked, and I'm a big critic of the system so it's pretty rare for me to say something like that, but if you look at, for instance, Robinhood, I think it was awful that they suddenly stopped trading in these stocks, although they did allow their customers to liquidate their positions.

What I think that is so interesting about all this is some of the ironies that we've been able to see firsthand, and they come to light in different ways. I'm not a person who hasn't criticized the SEC. In fact, many times I've criticized the SEC, but in this situation, I think it's okay to say that the system worked. You might say, "What, are you crazy? What do you mean the system worked?"

Well, okay, let's consider Robinhood, for example. Now, Robinhood and a whole bunch of other brokerage firms had to actually stop their trading in particular issues, particular stocks. The reason they did that was because of net capital requirements, because of requirements from their clearing broker, all of these circuit breakers that were there that would force Robinhood... Again, I'm not an expert on RobinHood's operations or anything else, but they would force Robinhood to protect all of their customers.

I think when Robinhood said, "Hey, you can liquidate your positions if you want, but we don't want you buying any more of these stocks. It's creating too much for us. We're just not big enough to handle this," and so they stopped trading, and so it's triggered 30 or 40 different class actions and this incredible outrage on Capitol Hill. But the reality is that's what the system is supposed to do. It's supposed to protect all investors above all else. That's why you look at Robinhood's terms of service that says they may at any time in their discretion without notice to anyone prohibit or restrict the ability to trade securities.

It's kind of a "no shirts, no service" type of business retail brokerage. If they don't want your business, they don't have to take it. That's their prerogative. I don't mean to defend them a decision as to whether or not you should have an account there. You should certainly consider what happens. This wasn't the first failure of them. They failed also on March 2nd, 2020 for about 17 hours with an outage of their trading services.

That's a different outage. That's one maybe they might have had some responsibility to make sure their people could at least liquidate or get out of a stock instead of having to watch their investments go down and unable to trade. Investors expect the ability to instantaneous trade. I don't think that's unreasonable given the way technology is. Investors also expect that you are getting the best possible price when they ask you to buy a particular security.

I think those are not just reasonable expectations, I think those are expectations that every single brokerage should meet. In this situation, Robinhood did meet them. That might not necessarily mean that Robinhood has broken law. I really make no conclusion on that. But it does mean when I look at the way the shutdown occurred, a lot of people were asking for the SEC to suspend trading in those securities, which would have been a much more dramatic step that would have been wholly unprecedented.

In this situation, whoever was in charge of Robinhood's compliance and their general counsel and all the people working to make this decision I think, arguably, and this might upset Robinhood investors or it might upset people on Capitol Hill, but they're supposed to meet these net capital requirements, meet their clearinghouse requirements, and if they can't meet them, there is a danger, there's a threat to their very existence, which would be a real threat to all of their investors, so they took the time out to borrow money and get their net capital in line.

Again, all of this will come out in these lawsuits, and I'm sure the SEC is investigating. I'm sure there's a for cause examinations team at Robinhood and the other brokerages right now looking at all this very, very carefully, but that's a big irony that I see in front of it that in all of this mess, it might actually be that the system worked.

Jack: Quite the take-home message, especially when you're in the fray. It didn't seem like anything was working, but that could be the ultimate takeaway looking back. One of the things I think this situation highlighted, John, are instances where you actually have more than 100% of a company's publicly floated shares being shorted, that the short interest exceeds the amount of available shares. I think a lot of people were surprised to know that that was even possible. Would you think that after all of this, that might be a matter of further scrutiny for the SEC?

John: Absolutely. Absolutely. I think that's something the SEC certainly wanted to prohibit with regulation SHO, and I think it's very bothersome. There have there been allegiance of people complaining about naked short selling and those sort of shenanigans. It gets, again, so complex that you can't really find the intent, but I do see that as a very important avenue of SEC investigation and FINRA investigation, the financial regulatory authority, the self-regulatory organization. They have tremendous expertise in shorting. I guarantee you that teams at FINRA and teams at the SEC are studying this carefully, not just to see if there was any fraud, but also just to confirm that their rules don't need updating or repair given this situation.

Rafe: Yeah. It feels like the technology can always run faster than the regulators. This is one of those moments, I think, where there'll be some catch-up maybe. One of the things that's also come up here, and it's kind of a different angle on this entire affair that's gone on, is that some in Congress have said that the real bad guy in all of this was trading firms, particularly high-frequency traders that were kind of... The allegation was they're using this situation as a casino, getting out in front of retail traders and maybe even institutional traders and driving up the prices and distorting the markets even further. Curious to get your take on that because it seemed like an area when Congresspeople start to complain about something, there's the possibility of legislation and regulation.

John: Yeah. That always bothers me. I mean, so many people treat stock picking like a casino. And I don't think it's right, but it's not against the law so long as you're not committing fraud. So I think it's easy to point fingers, as I said about these hedge funds, because they have created obscene levels of wealth for their owners. And it's hard to justify. Personally, do I want to invest in a hedge fund? That's a very, very tough question because remember Warren Buffett's famous bet with the Vanguard S&P index fund with a hedge fund as whether or not over 10 years that investment would bet the hedge fund investment? And it did. And that was, I think, a million dollar bet that Warren Buffett won. An index fund is totally liquid. It ebbs and flows with the way the market goes. It beats most funds all of the time. I should say, it beats most funds most of the time. It's probably not accurate all the time. I'm sure there are hedge funds that have done incredibly well.

But on the other hand, I think that those are very complex investments. And I think that if you're really looking carefully as an investor, and you're trying to figure out whether you should be part of the casino or not, I think Congress is right that the big players probably know a lot more than the small players. And that's never fair. But that's the rules of road for any sort of activity. And I think that it's important that everything be transparent, nobody be allowed to commit fraud. But whether or not people just want to gamble with respect to investing, I just don't know how you could regulate that even if you wanted to. Other than disclosure. That's why 17B is a great actpp that just says, "Hey, you're being paid to promote a stock. You can do that, but you have to disclose the nature, source and amount of that compensation." Just wants to make sure that the information that people know that you're not objective. That's a simple regulation, but I think it's also very effective.

Jack: So this has been wonderful, John. So I'd close with this. Looking back, let's say a year from now, you've made great points around the system working, which might also be read as there might not be a great need for significant tinkering with how this new kind of trading momentum is being established and exploding into the marketplace. Maybe this was just a blip, maybe it won't happen again. Who knows? But where's your gut right now? When we're a year out from what happened here, what do you think we'll look back on as the lessons learned? If any?

John: Oh, absolutely. Well, I think Congress will hold hearings and point fingers and do lots of grand standing, demanding new regulations. But so far I don't see anything that would get much traction. Thought you never know. We have a new administration. Right now it's bizarre because at the SEC you have an Acting Head of the Office of Market Regulation, an Acting Head of Enforcement, and an acting chairperson. So for this whole mess to happen at this time is really, really challenging for the SEC with the lack of leadership that they have right now. I can't say whether they're doing a good job or a bad job. I think it's too early to tell. But I think normally if there were a chairman like Arthur Levitt or like Harvey Pitt, some of the more...

If you remember, after 9/11 Harvey Pitt got on a train somehow the next day, got his way to Wall Street, and after five days, just by sheer will, he got the markets open again. So he was really front and center during that. And you don't see that at the SEC right now, you see some quiet statements that, "Hey, we're going to investigate." Not necessarily anything wrong with that. But you're not seeing tremendous leadership. You're not seeing them on television. You're not seeing them speaking out. And they really can't because these are all acting people who know that just in a matter of probably a month or two they're going to no longer be in their job as acting, will be back to their ordinary civil service job.

Remember, there's very few political appointees at the SEC. So I think SEC will investigate thoroughly. Perhaps they'll discover a few really inculpatory emails or texts, or maybe identify a disgruntled employee from a hedge fund, maybe an informant, maybe somebody on the sub Reddit will be a registered person with the SEC and shouldn't be saying what they say, and that person will be investigated and maybe their licensure will be questioned. And they'll be probably held to a higher standard. Not to say that there are necessarily any violations, but the SEC will pour through and look for fraud, look for registered persons, look for, again, schemes and conspiracies that are nefarious and not just a bunch of people trying to spread the word about a company that they, for whatever reason, believed the stock should be higher.

There were some legitimate long holders who believed that the GameStop stock, for instance, was undervalued. So I don't want to analyze every one of those stocks. I certainly believe that, again, those aren't the kind of investments that I would recommend. But at the same time, they're going to be pouring over all of that data, all of the trading data. The states' investigations might be more aggressive. Some of them have criminal authority, some of them have lighter standards and some of them are very, very, very aggressive like Texas and New York. So I think you'll see those states take the lead in looking for things as well. I think the FBI will get involved sooner or later because remember, as I said, they're embedded in the SEC Enforcement Division anyway. They're constantly meeting with the SEC.

So if there is really powerful evidence of fraud or deceit or nefarious intent, that'll be moved over to the Department of Justice to investigate, and that will probably make headlines, but those will be hard cases to bring. I think what I'm hoping for is that the democratization of the financial marketplace will continue because pioneering firms like Reddit and Robinhood, they've really done a lot for individual investors. And I believe that any short sellers or if other market participants have violated regulation SHO, I think the SEC will get to the bottom of that and those bad actors will be charged. I think it would be nice if investors after all of this embraced more traditional value based investing. And I also think it would be nice if hedge funds eased up on their profiteering and almost scavenger like attacks on these pandemic damaged companies.

And then I guess the last thing I would say is there's going to be a whole legion of market participants, and I'm sure you've already noticed this in some of your research, who are going to try to take advantage of this phenomenon and use it to profit. And I would just warn those people to be careful because these Reddit users are a force to be reckoned with. Their membership is growing and their influence can pop up at any time. And I don't think you want to be on the wrong end of their wrath by any stretch of the imagination.

Rafe: Well, 2021 United States of America, it is a nation of conspiracies, both real and imagined. And I guess we'll have to find out if what has gone on here is a real conspiracy or an imagined one. Well, John Reed Stark, unbelievable conversation. I learned a ton. I hope we can count on you to come back when the next bizarro chapter of stock trading happens in America. And we await a regulatory response. Thank you so much for joining Double Take.

John: Oh, absolutely. Thanks, Rafe. Thanks, Jack. Thanks for having me. This was a lot of fun. Can't wait to listen to it.

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