Retail investors, social media and meme stocks have not broadly affected the financial stability of the country; however, the evolution of these phenomena call for continued monitoring, the Fed said in its biannual Financial Stability report.
The Fed said that longer-run changes in demographics, regulations and technology, as well as behavioral factors that could interact with these structural changes, may have influenced recent trends in the demand for and supply of retail trading opportunities in equity markets.
The report notes that because equities feature higher volatility and expected returns than many other financial assets, they tend to be more attractive to younger and less risk-averse investors.
According to survey data, in recent years, the share of direct stock owners aged 35 or younger surged nearly 6 percentage points after 2013.
The Fed also notes that along with the rise in risk appetite and the growing share of younger retail investors, access to retail equity trading opportunities has expanded over the past decade. One factor contributing to this expansion has been the elimination of trading commissions at major retail brokerages for both stocks and options.
“Many years of growing revenues from payment for order flow helped set the stage for this development,” according to the report.
So-called payment for order flow is the compensation that brokerage firms receive for directing orders to venues for trade execution and has been a thorny issue under scrutiny by regulators in the past months.
Just last month, the Securities and Exchange Commission (SEC) addressed the issue in its much-anticipated report on the GameStop frenzy, “the most famous meme stock, which raised questions about market structure and investor protections at the beginning of the year.”
When its customers buy and sell stocks and options, trading platforms such as Robinhood, for example, route those orders to high-speed traders, like Citadel Securities, which pay for the right to execute many of those trades. The practice has boosted Robinhood’s earnings, as it made $331 million from customers’ trading activity in the first quarter — more than triple the $91 million earned in the first quarter of 2020 from the so-called payment for order flow, as previously reported by GOBankingRates.
This also echoes the SEC’s comments, which said that payment for order flow and the incentives it creates “may cause broker-dealers to find novel ways to increase customer trading, including through the use of digital engagement practices.”
The Fed report also noted that in addition to eliminating commissions, retail brokerages have shifted how retail investors access and communicate about equity markets by introducing mobile trading apps.
While the services offered on some of the most popular apps are similar to those provided by a traditional stockbroker, these apps make investing more accessible, in part by offering a wider range of products, including the opportunity to easily trade fractions of equity shares or crypto-assets.
The apps also make trading more visually appealing.
“Many apps have color-coded graphical layouts that highlight stock movements, mark trading milestones and have animations celebrating a user’s first stock purchase. With their ease of access and engaging graphics, such apps can make trading seem like a game, particularly for younger or less experienced investors,” the report notes.
Again, these comments are in line with those of the SEC who brought attention to the gamification of retail investing, saying that “Consideration should be given to whether game-like features and celebratory animations that are likely intended to create positive feedback from trading lead investors to trade more than they would otherwise,” according to its October report.
Another issue the Fed raises is the way some retail equity investors communicate about markets as social media can contribute to an “echo chamber” in which retail investors find themselves communicating most frequently with others with similar interests and views, thereby reinforcing their views, even if these views are speculative or biased.
“More generally, social media platforms allow a single comment or post to reach millions of people and potentially affect market sentiment dramatically within a short period,” the Fed said.
Finally, the Fed recommends that a few areas should be monitored.
First, younger stock investors tend to have more leveraged household balance sheets, leaving them potentially more vulnerable to large swings in stock prices, as they have a larger debt service burden. Second, episodes of heightened risk appetite may continue to evolve with the interaction between social media and retail investors and may be difficult to predict.
“A potentially destabilizing outcome could emerge if elevated risk appetite among retail investors retreats rapidly to more moderate levels,” the Fed notes.
Third, the risk-management systems of the relevant financial institutions may not be calibrated for the increased volatility or financial losses that could result from the trends highlighted here.
More frequent episodes of higher volatility may require further steps to ensure the resilience of the financial system, the Fed says.
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