The revenge of retail investors

Written By Vineet Samuel John

Game Stop. It’s a name that’s unlikely to ring a bell in the mind of most Indians, barring a handful of urban millennial gamers who follow trends in the United States. However, it should be a name that most in the financial world would (or perhaps should) be familiar with. There’s good reason for this. Somehow, a dying American video game retail chain, which served as a testament to the larger death of brick-and-mortar firms, was brought back to life by a discussion forum on Reddit.

The story itself is remarkable. One year ago, a single share in the loss-making video game retailer, was traded as low as $3.25. On January 27, it was trading at $347.51. How does one explain such a rapid change of fortune? We find our answer in a financial tussle that turned Game Stop into a battleground, with established funds like Citron Research and Melvin Capital on the one side, and members of the r/wallstreetbets subreddit on the other.

The entire fiasco began when Game Stop announced the appointment of three new directors to their board, including Ryan Cohen, (co-founder of Chewy, a pet food-e-tailer) who took up a 13 per cent stake in the firm last September. Positive investor sentiment surrounding Cohen’s competence in e-tail, saw a moderate rise in share price, which was further pushed up as retail investors bought up shares en masse through the Robin Hood trading platform. Noted short-selling specialists like Andrew-Left-led Citron Research and Gabriel-Plotkin-led Melvin Capital, however, disagreed with this sentiment. Both funds took up massive, short positions on Game Stop that amounted to 140 per cent of the float.

For reference, shorting a stock involves borrowing shares from a broker at market price, and immediately dumping them, with the hope that the price sinks. Following this, the borrower then buys back the shares at the new (lower) price and returns them to the broker, while pocketing the difference. As one can imagine, this technique is extremely risky. In an ideal scenario the price of the stock falls, but just in case the price rises, buying back the shares becomes increasingly expensive.

For years now, retail investors have viewed short sellers with contempt, for embodying the worst tendencies of elite Wall Street avarice. This is not helped by the fact that such large-scale shorts can potentially be devastating to a company’s fortunes. So, when news of the short positions reached users of r/wallstreetbets, around January 22, hundreds of thousands of its members committed to initiating a “short squeeze”, which involved aggressively buying the stock and pushing its price up, forcing both Melvin Capital and Citron to buy their shares back at a higher price. By January 27, the stock had spiked 700 per cent and both short sellers were in deep trouble. Melvin was down 30 per cent on its total holdings of $13 billion and Citron’s Andrew Left claimed he had covered the majority of his Game Stop bets at “a loss of 100 per cent”. Users of the subreddit, however, didn’t buy the claim, and continued to push the price up further to $347.51, imploring other users to hold on till Friday, January 29.

The consequent damage done to short sellers, however, led to a major establishment push back. First the CEO of Nasdaq called on financial regulators to intervene, with commentators on popular financial channels alleging market manipulation. This was followed by popular chat forum Discord banning the wallstreetsbets server for “hateful and discriminatory content”, and the r/wallstreetbets being forced to go private, albeit temporarily. Finally, with hedge funds claiming that the price of the share no longer correlated with any market fundamentals, trading platform Robin Hood effectively banned the purchase of the stock, bringing an end to the bull run and leaving a bitter taste in the mouths of retail investors.

Though established players may have cut their losses this time, the question for hedge funds and regulators remains — how will they negotiate the democratisation of finance brought about by platforms like Robin Hood?

It took nothing short of a trading ban to halt this short squeeze, and there is nothing to stop the phenomenon from repeating. The fact remains that the emergence of platforms like Robin Hood could very well have the same impact on the world of finance, as Facebook and Twitter have had on the media.

This battle between everyday retail investors and giant hedge funds has also had the unforeseen effect of bringing together characters from both ends of the political spectrum. Support for users of r/wallstreetbets from noted left-leaning Democrats like Elizabeth Warren, Alexandria Ocasio Cortez and Rashida Tlaib, has also resonated with Donald Trump Jr, who tweeted that “big tech, big government and corporate media” were “colluding to protect their hedge fund buddies on Wall Street”.

While a class action lawsuit has now been filed against the trading platform Robin Hood, the debacle has convinced several retail investors that the world of finance, long considered a bastion of the free market, has, in fact, been rigged against them. The success of the case, and the response by the Securities and Exchange Commission, will, in many ways, define how the United States responds to this evolution in the world of finance, and this lesson may prove to be instructive to financial regulators, around the world.

The author is a German Chancellors Fellow based out of the Hertie School of Governance, Berlin.

 

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