Don’t try to fix what’s not broken in securities

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The meteoric rise of a few stocks apparently propelled by social media-driven retail investors is a hot topic these days. Individual investors, hedge funds and securities firms have been vilified. Regulators have been excoriated for not taking swift action. But securities markets are working, though some don’t like what they see. 

Consumer advocates and regulators have long sought to bring individual investors back into the markets, as direct, stock-owning, investors. Competitive forces have pressured securities firms to reduce fees (commissions, historically) that individual investors pay for securities transactions.   

Technology now allows individuals to communicate directly with each other, for better or for worse, about all manner of ideas. Sophisticated institutions and their supercomputers now make it possible for both individual investors and institutions to access markets through regulated intermediaries electronically in real time. 

Securities regulation is supposed to provide a framework for markets in which any investor, institutional or retail, can place an order, long or short — and know that the system is sound and the order will be executed, cleared and settled. Irrespective of whether the investors’ decisions are sound, in the required timeframe investors will receive the securities they bought or receive the funds for the securities they sold.   

The federal securities laws are not designed to stop investors from making bad decisions, or from making decisions based on thin air — though the law does address those who give bad advice in order to advance their own interests. Federal securities regulation does mandate that market participants vigorously monitor risk and also maintain sufficient capital to avoid coming anywhere close to financial collapse.

The infrastructure built to satisfy these requirements and the underlying principles seems to be working.  Broker-dealers that extended credit to investors (as permitted by law and regulation) are requiring up to 100 percent collateral on the most volatile securities; they are closing out over-leveraged positions in clients’ accounts that do not have sufficient credit to address the increased risk created by such securities, as required by law and to mitigate the heightened risk to the overall system. The clearance and settlement system is processing, clearing and settling trades in increasing volumes, with none of the problems experienced in earlier decades.

So, what should happen now? 

The immediate question is whether one or a group of individuals, or computers designed to act as individuals, is using fraudulent information to create market frenzy and effect on-line pump and dump schemes (think Jordan Belfort in “The Wolf of Wall Street”) or otherwise unlawfully manipulating markets for their gain. If that is so, we urge securities regulators and prosecutors to find the perpetrators, shut them down as quickly as possible and prosecute them.

The SEC and other regulators must look carefully at all entities in the chain from order to settlement, to assure that they are attentive to regulatory capital and risk mitigation obligations. Based on what we have seen over the past 30 plus years, there already are teams of investigators and lawyers working 24-7 at regulators around the world monitoring, examining and investigating in order to ensure that the securities markets continue to function effectively and bad actors are identified and stopped in their tracks.

Regulators and their critics should stop viewing retail investors and how they invest as a monolith. Recent regulation focused on protecting retail investors assumes a model of advice and reliance.   

The market for providing investment advice to retail customers has seen its own explosive growth, often fueled by innovative use of technology to deliver investment advice. However, a substantial new generation of retail investors apparently is not interested (or only partially interested) in receiving advice from sage (or not) advisors and making decisions based on that advice. This new generation of investors, for better or worse, relies on its own methods and makes its own decisions, often in ways that seem disconnected from traditional investing and more similar to other non-financial decisions that are driven by social media.   

They use technology to act on those decisions, rather than placing orders one by one with a broker. In response, regulators should:

  • Continue to focus on the basic safety and soundness of the markets and ensure that, no matter who makes the investment decision, or on what basis the decision is made, the trade will be safely and timely executed. Focus on technological infrastructure, which must constantly evolve and expand to meet the demands of a safe and sound market.
  • Step up investor education. Regulators have outstanding websites with information for investors and hold outstanding town hall meetings, attended mainly by traditional buy and hold investors. Investor education now needs to be taken to the new generation of investors, including on-line investor forums. Investors need to understand the life of their trades and the critical importance of effective clearance and settlement systems so they understand what is behind their trades. And most importantly, every investor should regularly be reminded about the limits of information — the concept of ‘buyer beware’ is universal and all investor education should include the basic lesson that ‘if it seems too good to be true, it probably is.’ Perhaps consider a program of annual investor continuing education, which would work well in the click-through environment of online trading.
  • Engage with retail uses of technology. Technology is here to stay. Retail electronic order entry and routing, in effect retail direct market access (which already is the norm for institutional investors), will continue to grow and will increasingly be integrated with other widely used technologies. Regulators should plan now and adjust oversight accordingly.

Regulators must understand what drives investing behaviors of this new generation of investors, rather than accepting the facile idea that they are all driven by the herd mentality, in order to shape whatever changes in law or regulation may prove necessary in the future.

What we do not need right now is new regulation. The current regulatory system and the markets are holding up remarkably well under the current pressure.

Timothy W. Levin, is a partner with Morgan, Lewis & Bockius and the leader of the firm’s investment management practice. Amy Natterson Kroll is a partner with Morgan, Lewis & Bockius in the firm’s investment management practice. They can be reached at

Tags economy Finance Financial markets GameStop short squeeze Hedge fund Institutional investor investors Money Security Short Stock Stock market United States Securities Regulation

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