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The main problem with meme stock behavior is that meme stocks are valued well above their replacement cost, setting investors up for a downturn. Still, the SEC’s list of potential flaws in the National Market System (NMS), released in the wake of the January 2021 stock meme crisis, does not mention a fix for this issue.
This is not a criticism of the SEC. This is a criticism of Wall Street’s private sector. The agency’s job is to address market inefficiencies. Clearly, the difference between an asset’s market value and its replacement cost is a function performed by Wall Street’s private sector in the frenzy of financial markets.
Stock valuation is a fundamental function of financial markets. But there’s no doubt that meme stocks are grossly overpriced. However, this price problem cannot be solved by regulation. Below is the market solution.
The SEC’s approach to meme stocks.
The SEC has begun addressing regulatory issues that overcame the meme stock fiasco. The SEC study “Staff Report on Stock and Options Market Structure Conditions in Early 2021” outlines the SEC’s concerns.
- brief interest – GameStop (GME) short holding (as a percentage of float) hit 122.97% in January 2021, far outperforming other meme stocks like Dillard’s, Inc. As the SEC study suggests,
“High short interests can trigger a short squeeze. A short push can occur when an event causes short sellers to bulk buy shares to cover their short positions. For example, if the price of a shorted stock suddenly increases, short sellers could face margin calls, requiring them to either post additional collateral or close their position. Short sellers who cover their positions by buying the underlying stock would cause further upward pressure on the share price, which could force other short sellers to exit their positions, pushing the price further higher.
The chart below shows how GameStop short interest has held up.
- Clearing agency margin and equity issuance. On January 27, 2021, the National Securities Clearing Corporation (NSCC) executed intraday margin calls from 36 clearing members totaling $6.9 billion during trading in response to market activity. Some broker-dealers have restricted their activities in a limited number of individual stocks in response to margin calls and capital charges imposed by the NSCC. This is a broker-dealer decision and is not mandated by the NSCC.
- The Role of OTC Market Makers. During the explosive trading activity in January, the ratio of on-exchange to off-exchange trading volume fell dramatically (see chart below).
SEC officials suggested corrective actions for the identified errors:
- Broker Restrictions. Increase the capital held by the liquidators and shorten the liquidation cycle.
- Payment for the progress of the order. PFOF can create a conflict of interest between retail brokers and retail investors. SEC study questions adequacy of order flow payments.
- Trade in dark pools and through wholesalers. These transactions are opaque. The quality of the prizes can be an issue.
- short sale. Improved short selling reporting would allow regulators to better monitor short selling dynamics.
A private-sector approach to valuing meme stocks. Virtual meme action.
The remedies proposed by the SEC are half a step in the right direction. A full step is a private sector solution that features a portfolio manager that manages a virtual version of meme stocks issued on an exchange.
Broker-dealers and investment managers such as BlackRock ( BLK ) and Vanguard can offer an ETF-like vehicle that mimics meme stocks when it’s in investors’ interest to do so, but is actively managed by the investment manager when meme stocks start to fluctuate.
The virtual meme stocks so created would have a different value than the meme stock itself, as the Investment Manager would have the ability to protect investors from flaws in the decision-making process of managing the meme stocks.
On the one hand, since the ownership of the meme stocks that carry the virtual meme stock portfolio rests with the virtual meme portfolio manager like other ETF managers, the manager could influence the company’s decision-making and the meme stocks diversify in the short-term. .
The positive aspects of this method include:
- Immediate settlement – a settlement solution that moves cash from buyer to seller using the same electronics as the transaction.
- A futures-style clearinghouse – the exchange-managed clearing house becomes the counterparty for both the buyer and the seller – this reduces credit risk and settlement risk to an absolute minimum. It also eliminates payment for order flow from wholesalers to retail brokers.
- An exchange-traded ETF-like security – An exchange-traded instrument would be issued by a captive fund manager who would own the meme shares to shore up the value of the listed security. A security’s specifications would differ from those of an ETF because its closing value would not match the value of the security it reflects.
- Transparency of transactions. All transaction prices and volumes would be publicly available information provided by the exchange.
- short sale it is automatically limited to the amount of virtual securities issued by the exchange.
- Broker-dealers have no option to stop trading in the virtual meme warehouse.
See my older article for a full description of virtual stock trading.
The stock meme crisis has drawn national attention to the flaws in our nation’s market system. The SEC is trying to improve the efficiency of the financial market. This article deals with the proactive handling of stock market crises in the private sector.
This solution addresses all of the issues raised in the SEC staff study. More importantly, it offers investors a more secure, professionally managed virtual version of the meme stocks themselves. It gives investors access to professional management of the circumstances that created meme stocks in the first place.