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The GameStop case and investor protection. Towards a new regime for the provision of executive investment services (di Matteo Arrigoni, Post-doc researcher in Corporate Law at Università Cattolica del Sacro Cuore, Milan)

Since the case of GameStop, in the first half of 2021 many listed companies registered anomalous trends of their shares. In these events, online trading platforms and internet communities have played a central role. Both facilitate access to financial markets and enable investors to reduce transaction and coordination costs. At the same time, these technological innovations favour investor overconfidence and herd effect. Therefore, it is reasonable to rethink the discipline of EU executive investment service, typically provided by the online trading platforms. From the perspective of increasing investors protection and the efficient functioning of the markets, after having presented and discussed the solutions proposed by ESMA, this paper proposes two further solutions: a cooling-off period in the execution only and appropriateness regime and an increase in the product governance discipline.

Keywords: investor protection; investment services; product regulation; MiFID II

La tutela dell’investitore alla luce del caso GameStop. Verso un nuovo regime per la prestazione dei servizi di investimento esecutivi

Nella prima metà del 2021, le azioni di numerose società quotate hanno registrato un andamento anomalo comparabile con l’oscillazione dei titoli che ha caratterizzato il caso GameStop. In queste fattispecie, un ruolo centrale è stato svolto dalle piattaforme di trading online e dalle community su internet, che: (1) acilitano l’accesso ai mercati finanziari, comportando per gli investitori una significativa riduzione nei costi di transazione e di coordinamento, ma, nel contempo, (2) sono foriere di nuovi rischi, favorendo eccessi di confidenza e comportamenti gregari. In tale contesto, è, pertanto, ragionevole ripensare la disciplina dei servizi di investimento esecutivi, tipicamente prestati dalle piattaforme di trading online. Nella prospettiva della tutela dell’investitore e dell’efficiente funzionamento dei mercati, dopo aver presentato e discusso le indicazioni dell’ESMA, il presente lavoro propone due soluzioni ulteriori: una modifica del regime di mera esecuzione e appropriatezza, mediante l’introduzione di un periodo di “riflessione”, e un rafforzamento della disciplina di product governance.


1. Introduction. - 2. The GameStop Case. - 3. The increased need for investor protection. - 4. The implications of the changed technological context in the basic setting of the discipline on the provision of investment services. - 5. The possible solutions of the European legal system. - 5.1. General tools for investor protection and the efficient functioning of the market. - 5.2. Specific tools for investor protection in the investment services provision. - 6. Some solutions proposed by ESMA. - 7. Ideas for better investor protection. - 8. Conclusions. - NOTE

1. Introduction.

In the first half of 2021 numerous listed companies registered an anomalous trend in their shares. The first company to be affected has notoriously been GameStop Corporation (hereinafter “GameStop”), which was followed by, among others, Nokia, BlackBerry, AMC Entertainment, Express and Bed Bath & Beyond. These cases are characterized by a significant accumulation of short positions due to bearish forecasts on the stock, and, at the same time, by the concerted action of some investors – often retail clients – based on information shared on social media, to provoke the so-called short squeeze, thus making a profit at the expense of short-sellers. The intervention of the supervisory authorities was timely and ESMA’s statement [1] was followed by that of the national competent authorities [2]. Indeed, the events mentioned at the beginning pose multiple problems: was there a market manipulation? Is it legal for some trading platforms – RobinHood Markets Inc., for example – to prevent the purchase of additional shares or call options on the stock [3]? Here we will consider the impact of these recent technological innovations on investment activity in the financial markets, and we will tackle the problem from the perspective of investor protection and the efficient functioning of the market, which can be compromised by them. Online trading platforms and internet communities facilitate access to financial markets and let investors reduce transaction and coordination costs. In this way: (1) they permit many people to be directed towards a single goal, but, at the same time, (2) they allow operations aimed at influencing the prices of financial instruments that were previously not granted to those who did not have high resources (= in the case under consideration: “inflate” the prices of GameStop shares) and expose the participants to significant risks (= in the case under analysis: being the “useful idiots” that allow the first investors to earn money at the expense of those who arrive later). These innovations raise numerous problems, including: the correctness of the payment system for order flows on securities; the correct execution of orders; compliance with the capital requirements for brokers; the speed of clearing; whether to limit the freedom of expression of those who, in communities or having considerable visibility on social media, can influence the formation of [...]

2. The GameStop Case.

GameStop is specialized in the sale of video games. Due to the business model that could be overtaken by online video game sales and the effects of repeated lockdowns to deal with the Covid-19 pandemic that hinders retail sales, the prospects of GameStop – a company listed on the New York Stock Exchange (NYSE) – did not look good. Hence, the strong bearish position adopted by some investment funds with the choice to short sell the shares of GameStop. At the same time, often fuelled by indications found on internet communities (in particular, the r/WallStreetBets forum on Reddit), many investors adopted a bullish position [7] with a dual strategy. First, these investors directly increased the price of GameStop’s shares by purchasing large quantities of them, causing the so-called short squeeze. This mechanism consists in the choice of the short-seller to dissolve short positions when the price of the financial instrument, when sold short, exceeds a certain threshold. This sale realizes losses but, at the same time, avoids the risk of suffering greater ones. Second, these investors indirectly increased the price of GameStop shares by purchasing call options, causing the so-called gamma squeeze. This mechanism consists in the choice of market makers to buy GameStop shares to hedge the risk assumed by selling call options to investors, causing a further rise in price, useful in the first perspective to cause the short squeeze [8]. As the graphs relating to the price of the financial instruments involved show, these dynamics caused a bubble: in fact, the share price had reached a completely different level from the real value of the issuer. The bubble then burst, with evident initial positive impacts for the first long investors and subsequent losses for investors who had last adopted bullish positions on the stock.

3. The increased need for investor protection.

This story shows how more and more people – often retail clients [9] – access the capital market favoured by new technologies [10]. One contributing factor is the spread of online trading platforms, which reduces transaction costs – it is possible to operate on the markets directly from your smartphone, at costs that are often much lower than traditional channels [11]; even better: sometimes some brokers do not apply trading commissions to the end customer, due to the incentives received from directing the flow of orders collected from other broker intermediaries (so-called “payment for order flow”), and allow investors to invest even with minimal input amounts (sometimes even with the possibility of leveraged investments). Even more importantly, the birth of communities on the internet in which investment opinions are exchanged [12] makes it possible to overcome the problem of information asymmetries: trusting the “rating” read on the blog, an investor decides to allocate her/his savings to the listed company that borrows the reputation of the community. A similar dynamic occurs with certain statements of “financial gurus” expressed through social networks, like Twitter. Hence, the rise of the so-called “meme-stocks”. At the same time, the urgency of effective investor protection has increased. In fact, due to reading the ratings or tweets, overconfident investors do not consider it justified to seek the assistance of a financial advisor who is more expensive but also more protective. In this way, they expose themselves to new risks, risks recognized by the European legislators [13]. In the same sense, ESMA has, in fact, recalled that «an increased participation of retail investors in stock markets is welcome for the development of the Capital Markets Union. Nonetheless, ESMA urges retail investors to be careful when taking investment decisions based exclusively on information from social media and other unregulated online platforms, if they cannot verify the reliability and quality of that information» [14]. Furthermore, by helping overcome collective action problems, communities generate the illusion of being able to “join forces” to move and beat the market. Thus, they favour the emergence of the herd effect [15] and facilitate the creation of bubbles, which are profitable for leaders and harmful for followers [16]. From a [...]

4. The implications of the changed technological context in the basic setting of the discipline on the provision of investment services.

The online trading platforms offer mostly low value-added investment services (typically, the service of execution of orders on behalf of clients) [21]. The distance relationship – without human interaction – and the ease of operating make it reasonable to offer less complicated services than investment advice [22] and portfolio management [23]. At the same time, the business model focused more on the number of transactions than on their amount favours the promotion of large-scale services [24], according to a pattern typical of executive services. The client will therefore execute the transaction under the appropriateness test (if the product is complex) or at his own risk in execution-only (if the product is not complex and the transaction is regarded as being at the client’s initiative) [respectively, art. 25(3) and art. 25(4) MiFID II]. In this way, online trading platforms avoid the risk of “blocking” the order in the event of a negative judgment of suitability [art. 25(2) MiFID II and art. 55 Commission Delegated Regulation (EU) 2017/565, “MiFID II Delegated Regulation” [25]]. Instead, they take advantage of the absence of constraints, in the case of execution only, or of the possibility of proceeding with the release from liability, in the event of a negative judgment of appropriateness or lack of information from the client [26]. Since this is only a reinforced information obligation, this latter constraint is easily respected without relevant costs, neither for the intermediary (who must only adapt its IT systems) [27] nor for the customer (who, often without reading the warning, must only click one more box than the order to buy or sell a specific financial instrument). Due to these technological innovations, the choice of applying the suitability regime as a default rule becomes less effective. That choice was a solution adopted by the supervisory authorities during the Directive 2004/39/EC (MiFID I) regime and confirmed in the MiFID II regime. Indeed, EU supervisors decided to interpret the definition of investment advice [art. 4(1)(4) MiFID I and art. 52 Directive 73/2006/EC] in a broader way, «considering “investment advice” also ‘spot’ recommendations on a particular financial instrument provided by the intermediary during the performance of any other investment service». Hence, any single transaction was virtually subjected to [...]

5. The possible solutions of the European legal system.

In the perspective that interests us here, investor protection and the orderly and efficient performance of the financial markets are pursued through a plurality of safeguards: some of a general nature (Section 5.1.); others specifically aimed at regulating the activity of the investment services provisions (Section 5.2.).

5.1. General tools for investor protection and the efficient functioning of the market.

The legal system combines a variety of tools for investor protection and the efficient functioning of the market [31]. First, ESMA and National Competent Authorities (NCAs) have the power to temporarily restrict or prohibit the marketing, distribution, or sale of financial products when the issue raises either: a significant investor protection concern; a threat to the orderly functioning and integrity of financial markets or commodity markets; or a threat to the stability of the whole or part of the financial system [so-called “product intervention”: art. 40 and art. 42 MiFIR; see also art. 69(2)(m-n) MiFID II]. However, the supervisory authorities can intervene in advance only in strictly limited cases: in fact, the freedom to conduct a business (see art. 16 Charter of Fundamental Rights of the European Union) of investors in the financial market can be limited only if it is «justified by the overall objectives pursued by the Community, on condition that the substance of these rights is left untouched» [32]. From this point of view, the possibility for the supervisory authorities to suspend trading on a specific financial product could be justified in the presence of those conditions that exist in cases like GameStop: when financial instruments relating to listed companies with low capitalization are involved and there is high short interest (see above, par. 3). The precise identification of these criteria (how low should the capitalization be? What should be the short interest threshold?) could also grant greater legal certainty, which could be beneficial both for the supervisory authorities and for the market players. Likewise, market management companies can reject unusual and irregular orders and/or temporarily halt or constrain trading if there is a significant price movement in a financial instrument [33]. However, both solutions do not seem completely decisive for the case in question. The first, preventive, does not consider the fact that in the case under analysis there is no “irregular” order, but the operation consists of a multitude of orders which, when considered individually, do not appear anomalous. The second, on the other hand, can be applied but is an ex-post tool which, by definition, does not prevent the occurrence of damage (and is also the object of strong criticism by those who do not want obstacles in the dynamics of the market). Third, there is the prohibition of market [...]

5.2. Specific tools for investor protection in the investment services provision.

Regarding the investment services provisions, the investor receives a first form of protection from the limitation of the scope of the execution only regime. Indeed, «when providing investment services that only consist of execution or reception and transmission of client orders», investment firms can «provide those investment services to their clients without the need to obtain the information or make the [assessment of appropriateness]» where «the services relate to» a non-complex «financial instruments» [art. 25(4)(a) MiFID II]. From this point of view, options are not considered non-complex financial instruments and therefore could not be bought in the execution only regime [apart from if they meet the conditions set out in art. 57 MiFID II Delegated Regulation]. Moreover, the possibility to provide investment services that consist only of execution and/or of the reception and transmission of client orders is excluded if it is «in conjunction with the ancillary service consisting of granting credits or loans to investors to allow them to carry out a transaction in which the investment firm is involved» and «the criteria for the selection of the financial instruments to which those services should relate» should «exclude certain financial instruments, including those which embed a derivative or incorporate a structure which makes it difficult for the client to understand the risk involved» (Recital no. 80 MiFID II) [37]. While excluding options and transactions made with financial leverage, however, this solution clearly cannot prevent the shares from being subject to the execution only regime. Secondly, in the event of a negative judgment of appropriateness or lack of information communicated by the client, the latter receives a form of protection from the obligation of “enhanced information” that is imposed on the intermediary and requires them to warn the client. Such a solution seems, not very effective, however, because it does not consider the typical behaviour of the client who does not read the warning, to save time, or does not understand the meaning of it, due to cognitive bias [38]. Third, there is the distributor’s product governance obligation [art. 9(3), art. 16(3), art. 24(1-2), MiFID II] to which the online trading platforms are also subjected when they offer or recommend financial instruments manufactured by entities that [...]

6. Some solutions proposed by ESMA.

To increase investor protection in the case of “non-advised services” (i.e., investment services with a low-added value that require appropriateness or mere execution), ESMA has published a consultation paper [45]. In the perspective under analysis, ESMA’s approach consists of favouring the flow of information between client and intermediary and in improving the obligation of reinforced information. In this way, it is assumed, the investor should make more well-founded decisions. More specifically, ESMA intervenes in the phase preceding the provision of executive investment services, first asking intermediaries to fulfil a disclosure obligation: «firms should, in good time before the provision of non-advised services, inform their clients clearly and simply about the appropriateness assessment and its purpose which is to enable the firm to act in the client’s best interest» (Guideline 1 ESMA CP) [46]. In the case of intermediaries providing «online services», ESMA also believes that for transparency to be effective, these companies must «emphasi[ze] the relevant information (e.g. through the use of design features such as pop-up boxes)» and «considering whether some information should be accompanied by interactive text (e.g. through the use of design features such as tooltips) or other means to provide additional details to clients who are seeking further information (e.g. through a F.A.Q. section)» [47]. Second, ESMA intends to facilitate the flow of information from the client to the intermediary: «ESMA emphasises that firms […] do not discourage clients in any way from providing this information. A warning that the firm is not in a position to determine the appropriateness of the investment service or product should thus only be given after all questions have been asked to the client and it turns out that the firm does not have the necessary information. Moreover, firms should encourage a client that has not provided the necessary information for the appropriateness assessment to provide this information anyway, for example by reminding the client of providing this information before each transaction» [48]. In the event of a negative judgment of appropriateness or impossibility of judgment due to lack of information, ESMA instead requires that the warning to the client be effective. «To ensure its effectiveness, the warning issued by [...]

7. Ideas for better investor protection.

The problem of market malfunction could be solved by affecting the dynamics of short selling. However, banning short selling altogether seems extreme, since it would eliminate some benefits: a more correct price formation (short-sellers signal to the market the possible overvaluation of security), if not a faster discovery of fraud (e.g., the Wirecard scandal) [53], and an increase in market liquidity [54]. On the other hand, it could be more appropriate to intervene to avoid situations that favour short squeeze [55], which is less frequent in the European Union because, unlike in the United States, short selling is not allowed without the availability of the underlying security [art. 12 Regulation (EU) No. 236/2012, SSR] [56]. More generally, there may be sources of damage other than those relating to securities with high short interest and in the perspective promoted by the supervisory authorities of «analyzing market events and consider adopting further initiatives aimed at preserving investor protection and market integrity as appropriate» [57]. The protection of the investor could pass from a strengthening of the discipline in the case of investment services with low-added value. In addition to the ESMA approach, there may be solutions that, based on behavioural finance studies and nudging techniques, favour the adoption of more “reasoned” decisions [58]. In this perspective, first, instead of operating in any case, the indemnity could allow the execution of an inappropriate order only if one of the following conditions is met: (1) the order has a sufficiently high minimum denomination (e.g., € 10,000), so as to induce greater caution in the investor who may be the victim of overconfidence; (2) between the warning received and the possibility of proceeding with the order there is a period of time (e.g., 2 hours or 1 day) – the so-called cooling-off period [59] – that encourages the adoption of a less impulsive choice) which ESMA proposes regarding the different hypotheses of responding more than once to a questionnaire [60]. Due to the size of the amount of the “forced” passage of time, in fact, the investor is encouraged to move from a spontaneous search of an intuitive solution that sometimes fails (fast thinking) to a more deliberate and effortful form of thinking (slow thinking), or – according to the well-known expressions of Daniel Kahneman [...]

8. Conclusions.

The cases related to GameStop, Nokia, BlackBerry, AMC Entertainment, Express and Bed Bath & Beyond have made it clear how technological innovations can compromise investor protection and the efficient functioning of the markets. In fact, the online trading platforms and the internet communities let many people work towards a single goal, but, at the same time, they permit operations aimed at influencing the prices of financial instruments previously closed to those who did not have high resources and expose those participants to significant risks. Those who buy last bear the risk of having to face a large loss, indeed – the price of the financial instrument could drop drastically, once the speculative thrust is exhausted. Even if the European legal system has tools aimed at preventing such problems, it is quite clear that without adequate rules, the financial markets favour anomalous behaviours – especially due to overconfidence and herd effect – that, in the end, cause a mere redistribution of wealth among investors and (possibly) systemic risks. Within a more general framework that aims to fully address the new problems, the improvement of the discipline of executive services and of the product governance regime offered by this work aims to promote investors’ protection and the correct transfer of resources from investors to companies, according to the real purpose of the financial markets. As we have tried to demonstrate, in fact, the benefits introduced by these policy suggestions would in fact exceed their costs. The European Commission is preparing a retail investment strategy for the first half of 2022 [66]. In this regard, the elements that emerged in the GameStop affair will be taken into consideration for the protection of retail investors. The present work intends to provide its contribution to the debate.