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EU Regulator’s response to the Reddit rally

Short read on reddit investors

EU Regulator’s response to the Reddit rally

22.02.2021 EU law

A massive stock market rally recently suddenly developed with respect to GameStop’s shares, a moribund chain of video game stores in the United States. The instigators: users of the investment forum r/wallstreetbets on Reddit.

On 17 February 2021, the European Securities and Markets Authority delivered its strongest warning yet about the risks of using social media for investing, cautioning that any effort to coordinate trades online could violate EU market abuse regulations.

Last month, the share price of GameStop rose from USD 4 to almost USD 350, but later crashed back to around USD 50. What happened? A group of investors, organised on Reddit, noticed that institutional investors had heavily shorted GameStop’s shares . The Reddit group decided to buy shares in GameStop, forcing the institutional investors to buy back shares at higher prices, resulting in large losses for these institutional investors.

Some of investment firms (including more disruptive ones that provides their services through online apps) intervened, preventing the general public from buying shares in GameStop. The suspension of trading in GameStop shares prompted scrutiny from regulators around the globe. The actions of Reddit investors are also interesting from a financial law perspective, as they may are at risk to qualify as market abusive behavior (including but not limited to market manipulation).

On 17 February 2021, ESMA published a statement pointing out the risks of investing based on information shared on social media. ESMA warns that retail investors face significant risks when investing in stocks characterised by very high price volatility. Price trends can come to a halt and reverse, quickly exposing retail investors to heavy losses.

The statement focuses on the actions of the investors. ESMA notes that discussing the opportunity to buy or sell the shares of an issuer does not constitute market abuse. However, organising or executing coordinated strategies to trade or place orders at certain conditions and times to move a share's price may constitute market manipulation. ESMA bases this on the Market Abuse Regulation ("MAR"). Persons acting in collaboration to secure a dominant position over supply or demand for a financial instrument, which is likely to have the effect of fixing purchase or sale prices or create unfair trading conditions, are abusing the market.

In addition, ESMA states that spreading information on social media should be done with caution. Disseminating false or misleading information may also amount to market manipulation. Posting investment recommendations through any media is subject to a number of regulatory requirements. Regarding possible manipulation, ESMA is referring to MAR Article 12(1)(c). Disseminating information through the media which gives false or misleading signals, where the relevant person knew or ought to have known the information was false or misleading, constitutes market manipulation.

It will be interesting to see how ESMA and other regulators react to the GameStop situation. Until now, market manipulation involved one or a small number of investors trying to manipulate the market with a single, relatively large, transaction. It is hard to imagine any Reddit investor will be prosecuted for market manipulation. With many individuals and a large number of small transactions, this will be difficult. For now, ESMA and the local securities markets regulators will continue analysing the events and will consider adopting further initiatives aimed at preserving investor protection and market integrity where appropriate.

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