The Only Free Cheese Is in a Mousetrap…
In other words, do your due diligence.
This is a story where everything in the investment world flipped upside down: with Robinhood coming out as ‘not so much of a good guy,’ your everyday retail investor being accused of market manipulation, huge hedge fund crying for mercy as its losses multiplied, and the brick-and-mortar entity, which many thought was doomed for bankruptcy, seeing its share prices skyrocket to unbelievable highs. At first glance, none of this seems to make sense, as if out of the blue someone came into your world and said: “it’s not flat, it’s round.” But that’s exactly it — the world IS round (until someone proves otherwise) and it’s about time we straightened out the facts.
Setting the Story
2021 started off with an unprecedented short squeeze of the GameStop stock which rose to over US $480 per share on its peak day of January 28. For my ‘kindred spirits’ who might not be as savvy in the investment lingo and affairs au courant, I’ll do some decomposing to make a little more sense of everything (watch out for the 👉 sign). Many of you may have heard of GameStop, maybe you’ve bought video games from them or just peaked in the store while strolling through your local mall. If you’ve been to EB Games in Canada, Micromania-Zing in France, or ThinkGeek in the US — you’ve been to GameStop (the parent company). However, unless you are an active investor or a curious know-it-all, you’re likely not aware of the company’s financials and might be scratching your head at why everyone awed in surprise when its stock hiked up in January. This American brick and mortar games company was originally founded as Baggage’s in 1984 and took on its current name in 1999. However, since the mid-2010s it has been seeing a decline as a result of games sales transitioning to online platforms and a number of unsuccessful investments. Considering that no major changes to the company’s operations seem to have recently taken place, there weren’t any reasons, at least according to the logic of traditional ‘investing canons,’ for the stock to start rising. On the contrary, many hedge funds bet on its further decline, in other words shorting the company.
👉A short position is a trading technique where an investor sells a security with plans to buy it later at a lesser cost, anticipating that the security price will fall in the short term. It is common practice for short sellers to borrow stock shares from an investment bank or another FI. While the share is in the short position, a fee is paid to the lender.
Shorting is rewarding when the stock performs as anticipated by dropping down, however, it can also be very risky when the stock behaves against odds and could lead to the dangers of a short-squeeze — a scenario we witnessed with GameStop’s stock.
👉 While the potential for profit in a short position is limited to the stock’s distance to zero, therefore making it finite, the potential for losses is infinite, as the stock could continue rising for years. When a heavily shorted stock, which was the case with GameStop, suddenly begins to increase in price, the traders that are in the short positions begin to cover the stock in order to avoid further losses. This, in turn, pushes the price even higher resulting in what is known as a short-squeeze.
So why did GameStop’s stock price increase in the first place?
This is, probably, the most amusing part of the story as it is a new phenomenon which required quite the coordination and collective action of rather unrelated strangers. You could even say this has some aspects of a unique mini social movement protesting against ‘big investment players and their privileged rights in the investment market.’
A group of investors who are participants of an online platform r/wallstreetbets (also known as WallStreetBets, abbrev. WSB) organized an online campaign to intentionally drive GameStop’s stock prices up.
👉 WSB is a Subreddit site where participants can discuss stock and option trading. It is alleged to promote a “get-rich-quick” gains mentality through highly speculative leveraged options trading. WSP members are said to often be “young retail traders and investors who ignore fundamental investment practices and risk management techniques, so their activity is considered gambling.” On its site, the WSB group simply describes itself as “community for making money and being amused while doing it.” Some , however, go beyond that and view the group as activists against Wall Street and as an opposition to mainstream investing.
The goal of this bushwhacker campaign was to make money while trolling massive hedge funds. Knowing how heavily shorted the stock was, this was an opportunity to ‘turn the tables’ and make the hedge funds cash all out while highlighting the absurdity of the stock market having no connection with reality. It was the ‘everyday Joe against Wall Street’ standoff, where the Reddit crowd saw the cynicism of Wall Street and simply exposed it.
I would like to take a moment and explain the perceived inequalities between the large and small investors that the WSB participants aimed to draw attention to. As Chris Arnade, a former two-decade Wall Street bond trader, who grew disillusioned with his profession’s culture, put it (paraphrased): the Reddit crowd did to hedge funds what the hedge funds do to normal investors all the time. He further explained in an interview for Vox, that hedge funds can operate in several ways with a classic one being that of taking a position with their portfolio holdings and then discussing these holdings in a way that would create interest and consecutively buyers of these securities. This “book talking” is achieved through going to news outlets, sending out morning newsletters, direct messages via Bloomberg, etc. And this type of behavior, according to Chris Arnade, is welcomed on Wall Street.
While hedge funds have a number of tools and technicalities at their disposal, as well as significant leverage (borrowing funds to amplify returns) and insight into positions that other investors hold, small individual investors are limited to news, publicly available information and, if applicable, the skills of their financial advisor. This time around, however, having a platform for joining efforts allowed an estimate of 2.3 million individual investors to collectively ‘take a position and talk their books’. Yet, for some reason, Wall Street did not seem to like this. Accusations of market manipulation poured in against the Reddit crowd and talks of the Securities Exchange Commission coming down on WallStreetBets spurred. However, while some would consider this a “classic pump-and-dump” scheme, there is no evidence of fraud or insider trading as all of the information around hyping up the GameStop stock was exchanged in the open through a public forum.
Though WSB has been around since 2012, it has seen a steep surge of subscribers from under 2 million to over 5 over the beginning of 2021. Aside from the number of factors created by the pandemic that are attributed to the exponential growth of the WSP community, the no-fee options trading offered by Robinhood has also been considered to have had a major impact. So, let’s talk a little more about Robinhood, which had an interesting role of its own in this GameStop saga.
The Twist
Founded in 2013 by its current co-CEOs Vlad Tenev and Baiju Bhatt, Robinhood is an American financial services company known for offering commission-free trades of stocks and exchange-traded funds through a mobile app that was introduced in 2015. The company positions itself as an “investing for everyone” solution with a “mission to democratize finance for all,” thus appealing to everyday individual investors looking to access financial markets and benefit from them. Since Robinhood doesn’t charge commission one might ask how it makes money. Well, the company sells customer orders to firms such as Citadel Securities to make revenue.
👉 Citadel Securities is one of the 2 primary businesses of Citadel LLC, which is an American multinational hedge fund and financial services company — an important piece of information to keep in mind as the story unravels further.
January 28, 2021 wasn’t only marked by GME (stock symbol for GameStopbeing) at its peak, it was also the day that Robinhood’s actions appeared in numerous headlines making jaws drop and eyes bulge. The company “restricted transactions for certain securities to position closing only.” In other words, Robinhood permitted only the sale and not the purchase of certain stocks, including GameStop. Those buying outside of the platform, in particular the hedge funds, were still able to purchase GameStop stock, while those holding it through Robinhood, in particular the WallStreetBets crowd, were only able to sell. This, of course, resulted in a turning point for the stock’s trajectory driving the price down to a closing of US $193.6 per share (compare to the same day high of US $483).
Robinhood’s maneuver raised a number of serious questions: Why take such action? Who are they trying to protect? Is the company really committed to democratizing finance and making markets accessible to everyday investors, or is it just luring people in to make profit? Are its actions legal or is this an example of market intervention? As with many situations, there are often no easy answers, but here is what I have gathered:
Conflict of Interest
As mentioned above, one of Robinhood’s largest clients is Citadel Securities, which is affiliated with Citadel (one of the world’s largest alternative asset managers) through their parent company Citadel LLC. During the GME short squeeze Citadel the asset manager provided USD $2 billion investment in Melvin Capital, who happened to be one of the main short seller hedge funds. Major concerns around conflict of interest were raised by Robinhood’s users as well as some prominent politicians such as Senator Elizabeth Warren, Senator Ted Cruz and Representative Alexandria Ocasio-Cortez. There are also speculations that the firm simply wanted to protect itself as it was in an onslaught of high cash demand to cover money owed to customers from trades and to post additional cash to its clearing facility to insulate its trading partners from potential losses.
Robinhood’s co-CEO Vlad Tenev defended the company’s position on placing restrictions by suggesting that the actions taken were not on the account of Citadel or any other market participant and were proactively taken to protect the company and its customers. However, regardless of its motives, the question of legality remains. Up to date, over 30 class-action lawsuits have been filed against Robinhood with complaints claiming that restricting transactions resulted in financial losses for its users and benefitted the short-selling hedge-funds. While these lawsuits are not likely to result in the plaintiffs’ victory as Robinhood’s customers signed agreement notes stipulating that the company can stop stock buys without any prior notice, its public image has certainly been tainted and its name has to an extent become the subject of irony.
Where is GME at now?
Looking at the 6 months GME behavior shows that after the famous short squeeze, while dropping in late February, it regained a significant amount of its value hovering at least over a US $120 mark. Comparing this to the stock’s consistent below US $20 value leading to the spike, makes one wonder why the stock is still valued over 6 times more today?
Among a number of reasons that I won’t get into, one of the factors is the future potential the company is speculated to have due to one recent event. Ryan Cohen, the Chewy co-founder and former CEO who sold the company to PetSmart in 2017 for US $3.35 billion, has been announced to lead GameStop’s new strategic initiative to transform the company into the Amazon of gaming. If this holds true, we might see another spike of GME, but more likely stretched over a longer period of time and related to tangible economic reasons rather than social movement initiatives. (Please don’t consider this a queue to invest in GME, unless you have done your own research).
The Takeaways
While it was close to impossible predicting this GameStop rush, there were, of course, some underlying factors that led to it and we are not going to miss out on the chance to learn from them!
1. The investment game field is changing. With investing becoming more ‘democratized’ or rather more accessible to the everyday retail investor with platforms like Robinhood, the number of players has increased exponentially. Just think of the populations of India, or China, or any other highly populated country and anyone with a smartphone and a couple spare dollars being able to enter the investment world. Think of the thousands and millions of people buying a dollar of a certain stock — what would this do to its price? In this situation, the growing stock price would not be a result of its increased value related to the company’s potential, it would simply be the result of increased demand of the respective stock. And what would this mean for these companies? Well, more money in their pockets, so better think twice before making a trade.
2. Never underestimate the power of luck and the power of risk. As Morgan Housel writes in his recent book The Psychology of Money: “Luck and risk are siblings. They are both the reality that every outcome in life is guided by forces other than individual effort” (p 25). Perhaps, one of the most important things to keep in mind when investing is the fact that even if you are 99% sure of the outcome of a certain investment, there is that 1% chance it won’t go as planned. We saw this happen twice in the above story: first, when GME’s price soared due to unprecedented collective action of the WSB crowd; and the second time, when Robinhood blocked GameStop stock purchases on its platform. While one might argue that the WSB investors are a group of amateurs and therefore were not properly assessing their risks, it is hard to say the same about the large hedge companies that shorted the stock. Both, regardless of their investment knowledge and experience, ended up in a scenario where “things didn’t go as planned” due to unforeseen circumstances beyond their control. One of the best pieces of advice I learned about investing from Housel’s book is: to always be ready to lose as much as you have the potential of gaining.
3. Finally, the investing industry has outgrown its regulatory framework and is in need of a new harness. Changes both on Wall Street and in the accessibility to investing call for more regulatory scrutiny. If anything, this GME short-squeeze story attracted more public attention to the grey zones of investing and the inequalities that appear at the surface between corporate and individual retail investors. While these inequalities are part of the general structural shortcomings of the current capitalist system, the need for change is evident.
We look forward to further developments with GameStop and the investment industry as it evolves. In the meantime: stay prudent and do your due diligence!
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