YOLO or No-No? Fed Paper Looks at Retail Trader Behaviour

Although the debate over the “Reddit trade” phenomena has moved on (some would say descended) to arguments around the US equity market structure, there are still questions that could be asked over what happened in a regulatory sense. Was this really a case of relatively uninformed retail investors ganging up and “handing it to the man”, or a deliberate strategy driven by inducements to these traders to not only to jump on a position, but also to sustain it?

There are those who would argue that if a group of hedge funds got together on a forum and decided to buy (or sell) an asset, that could be seen as price manipulation – after all, that what was happening on the chat rooms populated by several FX traders a decade ago, which led to billions in dollars in fines for institutions and court time for individuals.

The converse argument is that these investors were trading upon publicly available information regarding the short positions in certain stocks and they were taking significant risks in buying them, therefore they simply traded the market as anyone could have done.

Into this debate has stepped Maggie Sklar, senior policy advisor and director of international engagement and the Federal Reserve Bank of Chicago and former senior counsel to CFTC chair Chris Giancarlo, with a paper published by the Chicago Fed. She asks the question, do the retail trader actions amount to fraudulent or manipulative behaviour?

The paper observes that the so-called YOLO (you only live once) trading behaviour, does not fit neatly into existing ideas around financial fraud and market manipulation and therefore pose new questions for policymakers, specifically, “[Is] the ability for users to gather together on social media and move the price of a financial product – for reasons unrelated to market news or market fundamentals – a larger vulnerability, whether this activity fits into tools to prevent or stop market manipulation or not, and if there is a gap in regulatory ways to address such activity”?

Noting that “at this point there is no clear evidence” that the recent retail activity threatens financial stability, the paper nonetheless argues it is a “new risk to be aware of, particularly as it is one that current regulatory tools directed at the firm-level, or enforcement actions based on the usual forms of market manipulation and fraud, may not be equipped to address.”

Quite rightly, the paper observes that there is little new in investors sharing ideas online and then trading off them, as has been observed in these pages before, mirror trading has long been an aspect of the retail-orientated market. As has been the case in other challenges faced by the financial markets, not least high frequency latency arbitrage, the difference this time is the speed involved, thanks to electronic trading and the availability of apps providing access to the market.

The paper observes that “YOLOing the market” could, conceptually, be seen as market manipulation as some of the online promoting activity echoes “pump and dump” schemes by brokers, or “boiler room” activities where salespeople use information they know is wrong to push people to invest in certain assets. It further notes, however, that to prosecute such schemes there has to be proof that the information provided by those promoting the asset was intentionally deceitful or misleading.

On price manipulation the paper makes some surprising observations, not least where it states, “the purchaser buys securities legally, but does so with the purpose to affect the price of the security”. Given the intention of every buyer is for the market to go up and vice versa for sellers, it could be argued that every trader deals with that intention. Going into the issue in more depth, the paper explains that manipulation in some cases can be seen as, “engaging in securities transactions that raise or lower the price of the security, for the purpose of inducing the purchase or sale of such security by others.”

“Existing tools for detecting and preventing market manipulation in the derivatives markets…are aimed to some degree at large market participants”

Here there seems to be firmer ground, for it is hard to argue that the promoters of some stocks on the forums were without doubt seeking to get others to drive the price up, but again, it could be argued that all these people were doing was promoting an idea they had (albeit one that flew in the face of economic logic).

The key difference in this episode, compared to others, is highlighted by Sklar when she discusses existing regulatory tools aimed at managing these events, “Existing tools for detecting and preventing market manipulation in the derivatives markets…are aimed to some degree at large market participants, such as exchange enforcement of position limits and regular large position reporting that is used to monitor large positions.”

She also observes that a staple of the authorities, investor advisories and warnings, are “practically unlikely” to be effective because few of the same retail traders posting their “YOLOing” messages online and trading based on others’ posts are going to read a notice about investor education on a government website and change their behaviour.

Ultimately, Sklar observes that there is not a clear or one-size fits all answer when it comes to addressing the thousands of online posts for one stock alone. “However, it is possible that when put on a sliding scale, one could see differences between a purely optimistic post (such as the use of a rocket ship emoji) – and a lengthy post encouraging others to join in on the trading for a purpose such as personal revenge, or a post offering food or other forms of in-kind compensation to others for continued trading,” she writes. “Nonetheless, a traditional fraud-based manipulation claim would likely be a difficult fit, even for many of the optimistic “pump”-like statements.”

The sense is that Sklar feels there is more to the price manipulation angle, writing as she does, “just because a statement or an alleged agreement is not secretive and is out in the open in online forum comments should not discount its value as showing conduct, collusion, or purpose.”

The conclusion in the paper is that new guidelines or laws may be required to meet this latest challenge to the market structure, although it notes that changes have costs, which must be weighed against the benefits.

Another conclusion, that could be arrived at is highlighted earlier in the paper where Sklar observes that market manipulation can undermine confidence in markets, even if the behaviour is not technically illegal, but the public perception is that it is. This highlights another aspect of the saga – the emotion still driving the debate.

It is hard to escape the feeling that some established institutional players are bothered that the market equilibrium has been upset and that they can no longer act and trade the way they used to. This is a challenge faced by traders the world over on a regular basis so one would think they would be used to it, but the GameStop episode in particular delivered such a slap to the face that for now at least, the professional investors have to start paying attention to their smaller brethren.

As to whether these activities are lawful or not, one suspects that in the US court system, at some stage, an answer will be delivered – there’s simply too much at stake for too many people for someone not to try the litigation route. Only then, will we have a real answer to the question.

The full paper can be accessed at https://www.chicagofed.org/publications/policy-discussion-papers/2021/2021-01