A 2021 short-squeeze transaction involving shares of video game retailer GameStop leads to new … [+]
At the start of 2021, ordinary retail investors launched an offensive against Wall Street hedge funds. By mobilizing on Reddit and relying on user-friendly trading apps like Robinhood, amateur investors triggered a brief market squeeze for video game retailer GameStop.
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Regulatory scrutiny peaked last July, when the SEC propose new rules targeting conflicts of interest in financial firms’ use of “predictive data analytics” (PDA). PDA refers to technologies that analyze financial data and make predictions about market movements and investor behavior. These include technologies such as robo-advisors, stock analysis algorithms, and other AI-based tools used by broker-dealers and investment advisors to inform their investment strategies and recommendations to investors. clients.
In the absence of new regulations, SEC Commissioner Gary Gensler says it is “almost inevitable” that AI will cause a financial crisis within the next decade. This is according to a recent interview with him in the Financial Times. But will technology inevitably cause stock price fluctuations? Don’t be so sure.
In the SEC proposal, he invokes behavioral psychology to make his point. The agency says the technology can induce excessive trading, exploiting investors’ biases and subtly “coaxing” them into herd-like behavior. However, the SEC presents no real evidence that these problems are widespread, because that would require it to know not only how “excessive” trading is, but also when investments are being made “rationally” or not.
Ironically, the rise in GameStop shares in 2021 was far from a passive reaction in response to technology. Investors deliberately coordinated using technology as a way to hold off short sellers, including hedge funds, who were betting against a beloved retailer.
What adds to the irony is that the SEC’s regulatory response is itself reactionary, seemingly driven by political pressure, rather than being a measured response to a proven systemic problem. Rather than accusing ordinary investors of irrationality, regulators might want to look in the mirror and assess the extent to which behavioral biases such as social desirability bias, which is the tendency to express support for proposals viewed as popular, or availability bias, the tendency to overestimate the importance of recent, high-profile events or experiences has helped shape this regulation.
The SEC’s proposed solution is to require companies to write policies, follow procedures, and maintain written records relating to PDA conflicts, as well as eliminate any detected conflicts. Initial compliance costs exceed $400 million by the SEC’s own estimates, with additional costs afterward. But the anecdotal nature of the GameStock saga suggests that the benefits of this regulation will be sporadic at best. Indeed, the SEC didn’t even bother to calculate benefits in its analysis of the rule, perhaps because there are none to report.
As my colleague John Berlau and I noted in a comment letter for the SEC, “the plural of anecdote is not data”. Perhaps, after gathering reliable evidence demonstrating the need for new regulation, an SEC proposal might be warranted. But all the new AI rules should come from comprehensive collection of evidence, examination of alternatives and cost-benefit analysis. In the absence of such due diligence, the SEC risks cracking down on beneficial new technologies that instead democratize trading beyond the confines of the Wall Street elite.
The public deserves policies based on rigorous, unbiased analysis, not speculative ivory tower theories about irrational investing. No one makes perfect decisions. The SEC’s proposal shows that it is not immune to imperfect decision-making either.
