The Market Plumbing Behind the Meme Stock Frenzies

Despite their name, penny stocks sometimes cost more than a dollar. The core idea is: They are the smallest companies, the backlog of stocks. While some stocks listed on the New York Stock Exchange or the Nasdaq meet the definition, the vast majority trades over the counter – basically in the Wild West, where there are no listing requirements and almost anything is possible. Prior to the pandemic, daily over the counter (OTC) volume was typically less than 10 billion shares. But when people were quarantined at home, retail sales exploded. The total OTC volume exceeded 20 billion shares in November and exceeded 140 billion shares by February 8. Companies like Zomedica Corp., a no-sales veterinary drug maker, suddenly became the most heavily traded stocks in America.

Orders from individuals to Robinhood Markets Inc., Charles Schwab Corp. or any of the other major retail brokers rarely get into public markets like the NYSE or Nasdaq. Instead, they are usually routed to a middleman like Citadel Securities LLC or Virtu Financial Inc. who pays the brokers for the privilege. These so-called high frequency trading companies use advanced technology to execute orders efficiently enough that they can generate profit by collecting a tiny spread over large volumes of trading. They want orders from retail customers whose buying and selling tend to offset each other rather than from institutions who are more likely to make big, smart bets that will cause high frequency companies to lose money.

By paying for the flow of orders, retail brokers could no longer charge their customers for trading. Without the barrier of fees, apps like Robinhood that make trading easy and fun have spawned increasing retail volumes and social media-driven commerce. However, when the retail brokers are making money from payments for order flow payments rather than trading fees, which customers are they really trying to serve?

GameStop is the best-known example, but a meme stock is any investment that is hyped on a social media site like Reddit. In January 2021, a collective online campaign raised prices for GameStop, theater operator AMC Entertainment Holdings Inc., and even silver. During the height of the January frenzy, the rally cry on the WallStreetBets subreddit was “Diamond Hands,” a call to hold on to whatever the case – and give the traditional investment industry a figurative middle finger. As the losses escalated, many participants had to sell. Some critics have compared the social media campaigns to the pump-and-dump scams, where unscrupulous brokers advertise stocks they already own in order to increase their value before throwing them off for a huge profit.

All US equity dealings are handled by the Depository Trust & Clearing Corp. stopped, part of the market lot that rarely attracts attention. When GameStop shares, which traded at an average price of about $ 7 in 2020, hit a staggering high of $ 483 on Jan. 28, the DTCC urged Robinhood to raise more money to cover potential losses. This resulted in Robinhood temporarily banning GameStop and other hot stocks trading and the bubble burst.

Although stock transactions appear instantaneous, it actually takes two days to process – known as T + 2. In other words, the buyer doesn’t get the stock and the seller doesn’t get the money for two days. In the meantime, DTCC has funds on hand to protect both sides of the transaction from loss in case something goes wrong. Robinhood executives say two days is too long and trades should be completed in real time. The DTCC has proposed dividing the difference over a day or T + 1 by 2023. Some have argued that a blockchain – the type of shared computer database that digital currencies like Bitcoin are based on – is well suited for this task. Meanwhile, others say that reducing turnaround times will impose significant implementation costs on the financial industry.

• US Securities and Exchange Commission guidelines on OTC fraud.

• A QuickTake when paying for the order flow.

• A QuickTake to the GameStop trading frenzy.

• The DTCC proposal to reduce processing times.

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