Disclaimer: This article is made for educational purposes. Hopefully, people find these updates helpful in keeping up with the breakneck pace of progress happening in crypto these days. This is not financial advice; always do your own due diligence on coins :)
Quick note: I meant to write this blog post only days after the Robinhood-GameStop fiasco happened in late January this year. I tried several times to write a compelling draft about this moment in history, but I failed to properly articulate what I wanted to say.
There’s so much to dissect in this incident: the issues with the U.S. clearinghouse system, TradFi, and censorship, Robinhood’s brand, the meme-fication of stocks, what a short squeeze is, the rise of r/wallstreetbets…
After a while, I realized that this article was no longer timely. Tons of articles popped up, better explaining what I tried to articulate in my initial draft. I ultimately gave up on trying to synthesize the complex feelings I had about this incident. Instead, I’m trying my best to tell a focused story on DeFi and DEXes.
I’ve been trading in the stock market for the past four years. It’s not a long time in the grand scheme of things, but I’ve already experienced some incredible, borderline nonsensical things: the meteoric rise of AMD and Tesla, losing it all playing 2u earnings, the bubbles of Hertz and Eastman Kodak, and of course the biblical March crash due to Covid.
With that said, this past week (at the time of writing) has been the absolute craziest thing I have ever seen take place in the stock market to date.
How do I even describe what I witnessed this past week?
It’s part joke, part cultural zeitgeist, part pyramid scheme, part class warfare.
This week, the collective internet — led by the popular and notoriously foul-mouthed subreddit r/wallstreetbets — fought against Melvin Capital and other short sellers in the stock market.
And so far, the Redditors are winning.
GameStop — among other meme stocks — is up 1700% from December 2020. Short sellers in the U.S. have racked up over $70 billion in losses in January alone.
Amidst it all, we have dank memes and we have wholesome stories.
We have billionaires pleading on live television for retail traders to be regulated and stopped.
We have the Avengers of Republicans, Democrats, Elon Musk, and Mia Khalifa calling for retail trader protection.
And, of course, we have a grand conspiracy of hedge funds colluding with brokerage firms to suspend trading and tank the value of certain stocks.
And we almost had a second great financial crisis due to the implosion of the infrastructure of the stock market. More on this later.
TLDR on what’s going on with GameStop and other meme stonks
“Okay Jimmy, what the hell are you talking about?”
TLDR; this week (at the time of writing) the Internet waged war over hedge funds and other short sellers over heavily shorted stocks. The Internet, comprised of retail investors, decided to invest in the stocks, causing the price to skyrocket and causing short sellers to lose money.
Before I go into more detail, it’s important to get a sense of what short selling means.
At a high level, short-sellers are individuals and firms who use specific financial instruments (like shorts and puts) to make money when a stock goes down. Examples are the famous Big Short of the housing market and Bill Ackman’s short of Herbalife.
Doubling on the mechanics behind shorting.
Firms like Citron Research and Melvin Capital saw that there were outdated companies that were likely to continue declining in value. Companies like GameStop ($GME), AMC Theatres ($AMC), Bed Bath & Beyond ($BBBY), and Nokia ($NOK) — we’ll just call them the BANG stocks or the meme stonks.
Retail investors realized that these companies were valuable, but the stock price was either depressed from shorting, or there was a potential to “squeeze” the short seller with a flood of buy pressure.
When a short seller wants to exit a position, they have to buy a share back at market price — effectively causing a feedback loop that makes the stock price go higher and higher, as the short seller accumulates more and more losses.
What happened with Robinhood on Thursday, January 27, 2021
On Thursday, January 27, 2021, Robinhood — along with other brokers — decided to freeze the ability to buy meme stonks like GME and AMC, citing “volatile market conditions”.
The Internet quickly jumped to the conclusion that Robinhood is working alongside the traditional financial services institutions to punish retail investors for challenging the short-sellers / hedge funds.
Quickly, conversations sprung up regarding Robinhood’s relationship with Citadel, an investor in GME short-seller Melvin Capital. Citadel is Robinhood’s largest customer, purchasing the latter’s data to front-run retail investors’ traders for profit.
People were furious, and the adage of “if the product is free, you’re not the customer, you’re the product” ringing in everyone’s minds.
Robinhood’s official statement was that because of the volatility of meme stonks like GME and AMC, the U.S. central clearinghouse DTCC required Robinhood to hold additional collateral to satisfy the T+2 settlement period for equity transactions.
But things seemed so fishy that Robinhood’s CEO Vlad Tenev had to testify to Congress on this incident.
My thoughts on the incident
Second-semester senior year, I opened a Robinhood account. Since then, I never looked back — slowly building up a portfolio.
I love Robinhood. It’s beautiful, it’s so easy to use. And it was fun — perhaps too fun. The shiny buttons telling me that this was simply a video game to be beaten. Quiet mornings where I lost whole positions, realizing that I had no idea how options worked.
But through it all, I had so much fun. And I learned about the stock market and became a more responsible, more financially literate person as a result.
What happened this week (at the time of writing) is a lot less sinister than people on Reddit and Twitter are making it out to be. I truly believe that the DTCC’s arbitrary rules forced Robinhood into a tight position.
With that said, I’m still moving my money out of Robinhood and into Fidelity (where I keep all of my boring investments and my retirement accounts). Not because that they aren’t “for the people”, but because this week, and many other times during Covid lockdown, they’ve shown me that they are very much a startup that are over their heads at times.
But I place a lot less blame on Robinhood for the freeze and much more on three factors:
- Archaic system in which equities take 2 days to officially clear/settle
- Centralized point of failure, where the DTCC made the obfuscated and unilateral assessment for Robinhood to up their collateral
- Investors relying on third-party brokers to trade assets
And I believe that DeFi can address those solutions so that this situation never arises again.
Why DeFi is the solution
All of those three factors can easily be addressed by crypto and existing (and upcoming) DeFi solutions.
On the archaic system — why do equities need a two-day period to be cleared? This stems from the days when equities were recorded on literal pieces of paper and transported from broker to broker.
Now, everything is digital and can be transacted in the span of seconds; yet, the U.S. equities system still operates under the T+2 delivery model.
DeFi is an internet-native financial system, meaning assets can be settled instantaneously because the underlying assets are purely bits of data.
On the centralized point of failure, there is no equivalent of the DTCC in crypto. There are no institutions of authority — just a purely decentralized system with autonomously actors working together within the rules of the system.
On the third-party broker aspect, individuals in crypto don’t need gatekeepers like brokerage firms to connect to exchanges and get access to liquidity. This is equivalent to people being able to directly trade on the Nasdaq as opposed to paying Fidelity — in the form of trading fees — for the right to get access to the Nasdaq order book.
The existing system exposes individual retail investors to counter-party risk where a centralized institution like Robinhood can censor and restrict access to its users for any arbitrary reason.
Crypto removes that risk by allowing individuals to directly connect to the source of the value generation — without the need for money-grubbing middlemen.
“Well that’s great for trading cryptocurrencies, Jimmy, but what about equities like GME?”
The really fascinating part is that there are already solutions out that provide investors with access to stocks and equities in a crypto-native way.
Companies like Mirror, Synthetix, and even Binance now are creating “synthetic stocks” — essentially crypto assets that exactly mimic the price and track the price movements of any asset that it's tied to — in this case, meme stonks like $GME $AMC $BB and others.
For the first time, non-Americans can get exposure to and trade U.S. equities in an open, permissionless way. There’s no need to create an overseas bank account and open up a U.S.-based brokerage account. Now, anyone with a phone and internet connection can participate in the new open financial market — with instantaneous settlement and no centralized, counter-party risk.
Once DeFi fully mirrors the stock market, there will be no more Robinhood-GameStop type events ever again :)
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