Part One: GameStop, Robinhood, and Sticking It To The Man
Over the course of a nearly 30-year career in securities law, I became accustomed to my chosen profession being a total snooze-fest for friends and family, intermittently broken up by brief intervals where it was all they wanted to talk about. Like topics ranging from politics to technology to religion, the world of securities and investing lurks quietly in the background, the scourge of cocktail party banter generally ignored by saner minds until some scandal elevates it back into the headlines, and suddenly everybody is an expert with an opinion to share.
In recent days, the stock market is once again a topic of discussion, particularly for the very online crowd. Whether it’s the sudden rocketing of relatively-sleepy GameStop stock into the stratosphere courtesy of Reddit provocateurs, or supposed insider trading by Congress and tech billionaires, it seems mandatory for everyone with a Twitter account to start shouting into the digital void. I’ll circle back to insider trading next time around, but first, what the hell is happening with GameStop? Here are some basics to help you argue with strangers on the internet.
GameStop And Other Stocks Blast Off
Over the past week or so, a number of companies — primarily those which have fallen on tough times, like video game retailer GameStop, movie theater chain AMC, and 20%-off-coupon-perennial Bed, Bath & Beyond — have suddenly seen their stock price skyrocket. GameStop, in particular, has risen from around $17 per share at the beginning of 2021 to a high of nearly $350. This dramatic (or downright insane) reversal of fortune isn’t tied to any change in these companies’ financial performance — it’s not like they’ve announced massive revenue growth, the development of some hot new product line, or that they’re being acquired by a corporate behemoth.
Rather, it appears that the ballooning stock prices have been triggered by a number of online denizens, primarily participants in a Reddit investment forum, deciding to plow money into selected stocks. From there, it’s just a matter of supply and demand — if thousands of retail investors decide to corner the market on a particular stock, its price is going to rise, whether the stock is actually worth it or not.
So if these stock prices are through the roof, does that mean everybody’s getting rich? Not exactly. Investors who bought the stock before things went crazy, and successfully unload it while the price is still inflated, can obviously make a lot of money; those are the success stories you’ll hear about. Ultimately, though, these stock prices will plummet back down to earth — again, the stock price reflects irrational (and temporary) gamesmanship, not any apparent change in the market’s assessment of the company’s financial prospects — and any investors who bought in after the price had started to rise are going to find themselves left holding the bag. The Redditors may be pleading with everyone to hold onto their shares, but it’s a game of chicken, and once investors start selling, the price will collapse the same way it skyrocketed when everyone was buying.
But the real losers so far appear to be the short sellers — the hedge funds which had shorted GameStop and the other companies currently in play, and who may have been the real targets of all this activity in the first place.
Squeezing The Shorts
While suddenly driving a lot of online conversation, short-selling isn’t necessarily a concept familiar to everyone. So let’s take a step back. What the hell is short-selling?
As a general matter, if you think a company is a good investment, and that its stock price is going to rise over time, you can buy some shares. Simple enough. But what if you think a company is going to do poorly, and its stock price is going to fall? You can short the stock — essentially, selling stock you don’t own by “borrowing” it from your stockbroker at today’s price, then replacing it at a lower price down the road.
Let’s say ABC Co. is currently trading at $10 a share, but you think it’s due for a fall. You short the stock by borrowing it and selling it for $10. If the stock price falls to $5, when the broker asks you to return the stock — known as “covering your short” — you can buy a new share to replace the one you borrowed for only $5, pocketing the $5 difference.
Short-selling is particularly risky, as in theory you can lose an unlimited amount of money if you guess wrong. If you buy $10 of ABC Co. stock and the company goes bankrupt, the most you can lose is your $10 investment. But what if you shorted ABC stock at $10 thinking it would fall in value, yet instead the stock price rises to $20? When your broker demands that you cover your short, you have to pay $20 to replace it — you’ve just lost $10. What if the stock rises to $30? To $100? You still have to make up the difference, however much that ends up costing you.
Given the risk of significant losses, short-selling is often the domain of wealthy investors, primarily those who invest in high-risk hedge funds who can afford to take a big hit if they bet wrong. Short sales can also be used to “hedge” other bets — a hedge fund may buy certain stocks anticipating market growth, while shorting other stocks just in case the market falls. (Hence the “hedge” in hedge fund. In contrast, the traditional mutual funds where most retail investors put their money are not allowed to engage in such hedging activity.)
Short-selling is not without controversy. Just as buying a company’s stock can hike its price, short-selling can put downward pressure on the price — arguably to an unfair degree. It’s one thing for current investors with doubts about the company’s future to sell their shares and cause a price decline; that happens any time a company announces bad news. It’s another for large money managers who do not even own the stock to make a big bet against the company by shorting. Look at it this way: If you don’t like the coffee shop across the street, do you pass it by and spend your money at the one you prefer down the block? Or do you slam them on Yelp in the hope they go out of business?
Conversely, short-sellers see themselves as whistleblowers of sorts, identifying overvalued companies and, in their view, forcing the price to fall back where it belongs. Indeed, some shorts will issue public reports detailing supposed problems with the company (though, given their profit motive in driving down the price, such reports must be taken with a grain of salt).
Not surprisingly, supporters of a public company — its executives and shareholders, not to mention random people on the internet who just happen to like the business — are not big fans of the short sellers. Which brings us back to GameStop.
Some of the online investors hyping GameStop and other under-performing stocks, aware that hedge funds had taken large short positions, urged others to buy up the shares to stick it to the shorts — to drive up the stock price and force the short-sellers to suffer losses when they covered their positions (something known as a “short squeeze”). The strategy proved surprisingly effective; by some reports, hedge funds which had shorted GameStop lost around $20 billion as a result of last week’s unexpected price hike.
And Then There’s Robinhood
Amidst the flurry of totally out-of-whack trading activity around GameStop and other targeted stocks, Robinhood (a popular app that lets individuals buy and sell stocks on their phones ostensibly without fees) and other brokers limited their customers’ ability to continue making such purchases. A loud hue and cry arose immediately, not just among frustrated traders, but from legislators across the political spectrum. Some decried the closing of the market to ordinary investors who had shown the gall to take on the big Wall Street players; others whispered conspiracy theories about Robinhood being in bed with the large hedge funds.
The truth is likely far more mundane. The brokerage industry is highly regulated, imposing limitations on brokers in order to mitigate the risk of dramatic market swings, and ensuring a run on the bank doesn’t leave the system without enough cash to work smoothly. Moreover, some brokers had enabled their customers to buy the stock “on margin,” a fancy way of saying that the broker spotted them the funds: the customer deposited $500 cash into their brokerage account but could purchase $1,000 of stock. Which is a handy convenience, with the customer later able to sell some of the stock to repay the loan. But what happens if the value of that stock suddenly craters (as seems inevitable with GameStop), and the investor who spent $20,000 on stock and has to repay $10,000 to the broker (a “margin call”) is holding a bunch of shares no longer worth enough to cover the repayment? The contracts Robinhood and other brokers enter into with their customers almost certainly give the broker the latitude to take steps to protect itself from such situations.
That said, just a few weeks ago Robinhood entered into a $65 million settlement with the SEC, which had alleged that the firm’s claims of free stock trading were belied by undisclosed back-end costs. So they haven’t exactly won a lot of customer goodwill lately.
But Is Any Of This Illegal?
Probably not. The federal securities laws prohibit market manipulation, which is an attempt to artificially distort the market for a security. But market manipulation is generally defined narrowly to include obviously fraudulent schemes — for example, a large shareholder paying associates to trade shares back and forth to create the illusion of huge demand for a stock they hope to dump into the market at an inflated price. A bunch of bored investors with the Robinhood app and a few hundred bucks deciding to shiv the hedge funds by buying a bunch of stock? Probably not.
Similarly, fraud is obviously against the law. If someone bought up a lot of GameStop stock on the cheap, then started posting messages falsely touting the company’s prospects, only to unload the stock as soon as the price rose, sure, the SEC would be all over that. But, again, online traders urging each other to corner the GameStop market probably don’t make the cut.
Certainly, given all the attention, the SEC will need to dig around. They have access to records identifying everyone who traded shares, and with a little digging can identify those who have posted messages online. And there may be good reason to be suspicious; it does stretch credulity to think that a few (or even a few thousand) small investors could drive $20 billion in short-seller losses through a few Reddit posts, and it could very well be that some unknown actors behind the scenes have been improperly manipulating the market. But some day-trader stuck at home during a pandemic who dropped a couple thousand dollars to troll the big guys probably doesn’t need to call a lawyer just yet.
Should I Care About Any Of This?
Some are heralding this as a sort of populist revolution, of ordinary investors sticking it to the man, raking in profits while causing crushing losses to the filthy rich. What could be more noble than a few kids in a chatroom taking down Wall Street? But it’s never that simple.
First, while hedge funds are primarily an investment vehicle for high-net-worth investors, some pension fund managers allocate a portion of their holdings to hedge funds as a means of diversification. So, yeah, “the man” you’re sticking to could include teachers, firefighters, and union workers.
More broadly, recent activity raises concerns about the legitimacy of the market. Stock prices are supposed to reflect a good faith valuation of a company by the market at large; when you decide to buy or sell a security, you’re assuming that the price you pay (or receive) reflects the market’s reasonable assessment of the company based on good old-fashioned financial analysis. How can it be healthy when the price of that stock suddenly explodes or plunges at the whim of a fistful of online activists?
At heart, both the unbridled shorting of underperforming stocks by large hedge funds, and the mischievous gaming of stock prices by chat-room cowboys, lay bare the illusion that the stock market is simply an investment alternative to your bank account. All of this is flat-out gambling, naked betting on whether a stock will go up or down, while trying to use market power to goose it one way or the other. And gambling tends to make regulators nervous.
Ultimately it will fall on the SEC or Congress to determine whether additional rules are needed to ensure that the markets are not unduly susceptible to raw gamesmanship. Whether there is some politically viable regulatory change that can limit such activity, or it’s just one more hazard we need to accept as a given in the internet age, remains to be seen.