Finance

SEC could set short interest caps, hike trading taxes to combat wild moves, analysts say

The Securities and Exchange Commission could consider a wide range of new regulations to help prevent future volatility and eye-popping short squeezes like those in GameStop and AMC Entertainment that enthralled Wall Street last week.

The agency that oversees U.S. markets could pursue a litany of rules, ranging from a cap on the level of short interest on a specific security to aggressive taxes on short-term trading, according to Bank of America Merrill Lynch.

“Brokerage platforms have already been creating restrictions on margins, options, and trading in certain securities with unusual activity,” BofA analyst Michael Carrier write in a note to clients.

Carrier ticked off a list of rules the SEC may be likely to pursue if it is serious about preventing the dramatic swings that marked the last week of January.

In addition to the short interest cap and taxing short-term bets, Carrier said the commission may move to review payment for order flows as well as bulk up on its social-media oversight to ward off market manipulation.

It remains unclear when Gary Gensler, President Joe Biden’s pick to chair the SEC, will be confirmed to his post given the Senate’s focus on confirming cabinet-level nominees and former President Donald Trump’s looming impeachment trial.

A representative for the SEC declined to comment on this story, but referred CNBC to a statement it issued on Friday. Though the regulator did not mention any parties by name, it vowed to protect individual traders and look into accusations of unfair trading restrictions that brokerages may have imposed.

Still, Bank of America wasn’t the only Wall Street research firm curious if the SEC may ultimately take decisive action after a chaotic few days in a handful of heavily shorted stocks.

The poster child of last week’s wild trading, GameStop rallied 399.9% from its closing price on Jan. 22 to its close on Jan. 29. Its stock spike, unexpected given a dismal fundamental outlook for the brick-and-mortar video game business, took most of Wall Street by surprise.

As the week progressed, it became clear that the rally was in large part the result of a coordinated group of retail traders taking advantage of an outsized level of short selling in GameStop shares. The group, which appears to have originated on Reddit, also targeted AMC and headphone maker Koss.

Short selling is a strategy in which investors borrow shares of a stock at a certain price in expectations that the market value will fall below that level when it’s time to pay for the borrowed shares.

When the price of those shares rises instead of falls, short sellers are often forced to buy back the shares they borrowed to prevent further losses. When this happen en masse, it can lead to a so-called short squeeze and even further gain in the stock’s price.

But the explosive moves, and subsequent actions by brokerages to curb trading, drew ire from both sides of the political aisle. Sen. Elizabeth Warren, an outspoken champion of financial oversight, lambasted the SEC on Thursday for the regulator’s failure to take action.

“We need an SEC that has clear rules about market manipulation and then has the backbone to get in and enforce those rules,” Warren said at the time. “To have a healthy stock market, you’ve got to have a cop on the beat.”

Echoing Bank of America’s analysis, Jefferies shared its own thoughts on how the SEC may try to stop future short squeezes of the same magnitude.

“With Gary Gensler set to be confirmed as the new SEC Chairman, the issue of market structure and retail investor participation has moved to the forefront,” analyst Daniel Fannon wrote in a note published on Friday.

The analyst said he thinks the regulator could weigh greater investor education around derivatives and risk management and hike costs for certain products or services like leverage and derivatives. He echoed Carrier’s thoughts that the SEC could end up keeping a closer tab on hedge funds’ short positions and stricter oversight of payment for order flow.

“Limiting access, increasing margin requirements, and restricting stocks create a temporary stop-gap giving the incoming SEC Chairman a longer-term problem to solve,” Fannon wrote. “Historically, changes to market structure, even in small sizes, take time and typically involve hearings, pilot programs along with comments/feedback from market participants.”

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