The biggest problem with the behavior of meme stocks is that meme stocks are priced well above their replacement cost, setting investors up for a fall. Yet the SEC’s long list of possible shortcomings of the National Market System (NMS) has been published following the same January 2021 stock market crash makes no mention of a solution to this problem.
This is not a criticism of the SEC. It is a critique of the private sector of Wall Street. The agency is responsible for finding solutions to market inefficiencies. The disparity between the market value and the replacement cost of an asset is clearly the function that the private sector of Wall Street fulfills in the competitive hubbub of the financial market.
The valuation of stocks is the essential function of the financial markets. But there’s no doubt that meme stock prices are wildly out of line. However, this pricing problem cannot be solved by regulation. Below is a market-based solution.
The SEC’s approach to meme actions.
The SEC has begun to address the regulatory issues that the meme stocks fiasco laid bare. The second study “Staff Report on Equity and Options Market Structure Conditions in Early 2021” lists SEC concerns.
- Short interest – GameStop (GME) short interest (as a percentage of float) in January 2021 reached 122.97%, far outpacing other meme stocks like Dillard’s, Inc. As indicated by the SEC study ,
“High levels of short-term interest can trigger a short-term squeeze. A short squeeze can occur when an event causes short sellers to en masse buy stocks to cover their short positions. there is a sudden increase in the price of the stock being sold short, short sellers could face margin calls forcing them to either post additional collateral or exit their position. their positions buying the underlying stock would put additional upward pressure on the stock’s price, which could force other short sellers out of their positions, adding upward price pressure.
The chart below shows how GameStop’s short interest fared.
- Clearing Agency Margin and Capital Matters. On January 27, 2021, in response to market activity during the trading session, the National Securities Clearing Corporation (NSCC) made intraday margin calls to 36 clearing members for a total of $6.9 billion. dollars. Some brokers have restricted their activities on a limited number of individual stocks in reaction to margin calls and capital charges imposed by the NSCC. This, the staff document notes, is a decision made by the brokers and not directed by the NSCC.
- Role of off-exchange market makers. During the burst of trading activity in January, the ratio of on-exchange to off-exchange trading volume dropped dramatically (see chart below).
Solutions suggested by SEC staff for identified failures:
- Broker Trading Restrictions. Increase the amount of capital held by clearers and shorten the settlement cycle.
- Order flow payment. The PFOF may create a conflict of interest between retail brokers and retail investors. The SEC study questions the relevance of payments for order flow.
- Trading in dark pools and through wholesalers. These transactions are opaque. Price quality can be an issue.
- Short sale. Improved reporting of short sales would allow regulators to better track the dynamics of short sellers.
A private sector approach to evaluating meme stocks. Virtual meme stocks.
The remedies offered by the SEC are a half step in the right direction. A Full Stage is a private sector solution that includes a portfolio manager managing a virtual exchange-issued version of the same stock.
Brokers and investment managers like BlackRock (BLK) and Vanguard could offer an ETF-like instrument that emulates the same stock when it is in investors’ best interests, but is actively managed by the investment manager when the same stock begins to decline.
The virtual meme stocks thus created would have a different value than the meme stock itself since the investment manager would have the discretion to protect investors from gaps in the decision-making process of meme stock management. .
Since, as with other ETF managers, ownership of the meme stocks supporting the virtual meme stock portfolio resides with the virtual meme portfolio manager, the manager could on the one hand influence the decision-making of the company and, in the shorter term, to diversify from meme action. .
Positive aspects of this method include:
- Instant release – a compensation solution that transfers money from the buyer to the seller with the same electronics as the transaction.
- A futures-type clearing house – the clearing house run by the exchange becomes the counterparty of the buyer and the seller – this reduces credit risk and performance risk to an absolute minimum. It also eliminates payment for order flow from wholesalers to retail brokers.
- An ETF-type security issued on the stock exchange – the exchange-traded instrument would be issued by a captive fund manager who would become the owner of the very shares it holds to back up the value of the exchange-traded security. The specifications of the security would be different from those of an ETF because its closing value would not be the same as that of the security it mirrors.
- Transparency of transactions. All prices and trading volumes would be public domain information provided by the exchange.
- Short sale is automatically limited to the amount of the virtual security issued by the exchange.
- Brokers do not have the ability to stop trades in the virtual meme store.
See my previous article for a fuller description of virtual securities trading.
The memestock crisis has drawn national attention to the shortcomings of our national market system. The SEC seeks to improve the efficiency of financial markets. This article envisions a proactive private sector solution to the problems laid bare by the meme stock crisis.
This solution addresses each of the issues raised by the SEC staff study. More importantly, it provides investors with a safer, professionally managed virtual version of the very stocks themselves. It gives investors access to professional management of the circumstances that created the meme stock in the first place.