Despite their name, penny stocks sometimes cost more than a dollar. The core idea is this: They’re the tiniest companies, the backwater of equities. Although some stocks listed on the New York Stock Exchange or Nasdaq meet the definition, the vast majority trade over the counter — basically the Wild West, where there are no listing requirements and almost anything goes. Before the pandemic, daily over-the-counter (OTC) volume was usually below 10 billion shares. But when people were quarantined at home, retail trading exploded. Total OTC volume topped 20 billion shares in November, then exceeded 140 billion by Feb. 8. Companies such as Zomedica Corp., a maker of pet medicine with no revenue, were suddenly the most traded stocks in America.
Orders placed by individuals with Robinhood Markets Inc., Charles Schwab Corp. or any of the other big retail brokers rarely make it to public markets such as the NYSE or Nasdaq. Instead, they’re typically routed to a middleman such as Citadel Securities LLC or Virtu Financial Inc., which pay the brokers for the privilege. Those so-called high-frequency trading firms use advanced technology to execute orders so efficiently that they can reap profits by collecting a tiny spread on vast trading volumes. They want orders from retail customers, whose buying and selling tends to even out, instead of from institutions, which are more likely to make big, savvy bets that leave the high-frequency firms with losses.
Payment for order flow has allowed retail brokers to stop charging their customers for trading. Without the barrier of fees, apps such as Robinhood that make trading seem easy and fun have generated soaring retail volumes and social-media-driven trading. But when the retail brokers earn money from payment-for-order-flow deals, not from trading fees, it raises the question of which customers they’re really trying to serve.
GameStop is the most famous example, but a meme stock is any investment being hyped on a social media site such as Reddit. In January 2021, a collective online campaign boosted prices for GameStop, theater operator AMC Entertainment Holdings Inc., and even silver. During the height of the January frenzy, the rallying cry on the WallStreetBets subreddit was “diamond hands,” a call to hold on no matter what — and to give the traditional investing industry a figurative middle finger. But when losses escalated, many participants were forced to sell. Some critics have compared the social media campaigns to the pump-and-dump scams in which unscrupulous brokers tout stocks they already own to boost their value before dumping the shares at a huge profit.
All U.S. stock trades are backstopped by the Depository Trust & Clearing Corp., a piece of the market bedrock that rarely attracts attention. When GameStop’s shares — which traded at an average price of about $7 throughout 2020 — reached a dizzying peak of $483 on Jan. 28, the DTCC told Robinhood to pony up more money to cover potential losses. That led Robinhood to temporarily ban trading of GameStop and other hot stocks, popping the bubble.
Stock transactions, though they seem instantaneous, actually take two days — known as T+2 — to settle. In other words, the buyer doesn’t get the stock and the seller doesn’t get the money for two days. In the meantime, the DTCC keeps money on hand to protect both sides of the transaction from losses if something goes wrong. Robinhood’s executives say two days is too long and trades should settle in real time. The DTCC has proposed splitting the difference, moving to one day, or T+1, by 2023. Some have argued that a blockchain — the type of shared computer database that underpins digital currencies such as Bitcoin — is well suited to the task. Meanwhile, others say reducing settlement times will impose onerous implementation costs for the financial industry.
• U.S. Securities and Exchange Commission guidance on OTC fraud.
• A QuickTake on payment for order flow.
• A QuickTake on the GameStop trading frenzy.
• The DTCC’s proposal for speeding settlement times.