Democratising finance

March 8, 2021

The GameStop share frenzy sent shockwaves throughout the financial world as a group of retail investors following the Reddit sub- page r/wallstreetbets ended up making millions virtually overnight while some of the most prestigious hedge funds in the world suffered huge losses. It was the first time retail investors had really demonstrated their market moving capabilities, with some saying the financial industry had been democratised and therefore no longer just the playground of institutional investors. But does the GameStop saga really represent a change? Or is it simply the latest iteration of a speculation-fuelled story that is as old as the markets themselves? Richard Dawson asks currency strategist Grant Murray and investment director James Kyle what’s really happening with these ‘meme’ stocks and whether the digital trading platforms that have widened access to the markets have a responsibility to protect users from their dangers.

On the first trading day of 2021 (January 4), shares in the American video games retailer GameStop were exchanging at $17.25 each.

Three weeks later, the same shares closed out the day at $347.51 – a little more than a 2000 per cent increase.

What had changed?

Very little looking at it from the point of view of the company. A bricks and mortar retailer, GameStop had been struggling like many others due to the coronavirus pandemic and the long- term competitive advantage of online distribution services.

But the people buying GameStop (NYSE:GME) weren’t interested in what finance professionals call the fundamentals, they were interested in the multi-billion-dollar hedge funds, which had taken out very large short positions against the company, betting that its share price would continue to go down.

Short selling is a controversial and high-risk trading strategy whereby an investor borrows shares at a certain price and then immediately sells them, hoping to buy them back later at a lower price, return them to the lender and pocket the difference.

It’s risky because if the share price goes up, the investor is then under pressure to buy them back at the higher price to cover their position before the losses get too big.

So confident were a number of major hedge funds that GameStop would continue to fall, that 140 per cent of the company’s total publicly available shares had been sold short, meaning that some shares had actually been shorted twice (i.e., borrowed, sold, re- borrowed, re-sold).

What we know now is that a lot of people didn’t agree with the hedge funds and saw an opportunity for a short squeeze – pushing the share price higher so short sellers have to buy back the stock to cover their positions, which in turn pushes the price higher still.

Wall Street hedge fund Melvin Capital Management had been shorting GameStop since 2014 and was estimated to have lost around $4.5 billion by the end of January.

But what was interesting about the GameStop short squeeze was that it didn’t come from other institutional investors and hedge funds, it came from a new generation of retail investors who demonstrated their market moving powers for the first time.

A retail investor is someone who trades stocks and shares from their own personal account, rather than on behalf of a company or client.

The number of retail investors entering the market has grown steadily over the years but since the pandemic began, their numbers have exploded.

There are numerous reasons for this, but the most compelling is the emergence of digital trading platforms offering a cheap and easy route into the markets.

The one making all the headlines is the US platform Robinhood, which recently had to testify to the US Congress in a hearing about the GameStop situation and possible market manipulation.

In the UK, we have Trading212, eToro and Plus500, which are essentially the same thing.

These platforms have dramatically widened access to financial markets because they allow users to trade stocks and shares with zero fees and zero commission.

They are also incredibly intuitive and user-friendly, available on a mobile phone app as well as online.

Whereas previously a retail investor would have had to pay a fixed commission through a brokerage for every trade executed, now it can be done for free with just the click of a button.

When you couple this technology with the fact that, during the ongoing pandemic, many people are spending more time at home and thinking about how to make some extra money, it’s no surprise that so many more ordinary folks are finding their way into the markets.

The only thing stopping them is how complicated the markets themselves are to navigate and understand – a heady mix of securities, derivatives, commodities, equities, cryptocurrencies, forex, bonds, treasuries and gilts. It’s small wonder that many bright people spend years studying for a career in the financial industry.

But even here, technology is helping people find the answers they need.

During the GameStop short squeeze, for example, it was information sharing on the social news website Reddit that allowed retail investors to learn from one another and beat both the market and the hedge funds.

A number of users on the Reddit sub-page r/wallstreetbets had been discussing how GameStop was undervalued and how hedge funds like Melvin had taken out short positions that they could not hold if the share price suddenly started rocketing.

Once the wider internet and social media got hold of this information, it didn’t take long for GME to become the most traded stock on the New York Stock Exchange, with many retail investors spotting an opportunity to make some serious cash by driving the price up and squeezing billions of dollars out of the short sellers.

In this example, technology essentially filled the knowledge gap, allowing people with nothing but an internet connection and an appetite for risk to take on the market and win.

The GameStop short squeeze was pitted as a ‘David v Goliath’ story, a band of rookie retail investors challenging the billion-dollar hedge funds and coming to the rescue of a beleaguered company that had been aggressively shorted by Wall Street. But was there really anything virtuous going on? Were we witnessing the beginning of a new form of financial activism?

Or was it simply the latest iteration of the greed-driven, get-rich-quick fable we’ve seen play out so many times throughout history?

Grant Murray, currency strategist for the UK North and Europe at GPS Capital Markets, says: “Greed and fear tend to be the most basic human emotions in financial markets where people react.

“In this particular case, these two things have played out.

“Are these retail investors thinking, ‘let’s take on the hedge funds, let’s completely reset the financial markets, let’s have a rebellion – it’s us against Wall Street?’

“I don’t think it’s as deep as that. It’s just about making money.”

Speculation is as old as the markets themselves, with many traders having always regarded themselves as players in a game, rather than investors in a company.

Digital trading platforms, which essentially mirror gambling apps in terms of user experience, play on this fact and have exacerbated what James Kyle, investment director at Rathbones, calls “the game-ification of the investment world”.

He explains: “We’ve got a dangerous environment at the moment where there will be some retail investors who substantially benefit from this surge of interest in particular companies, but I expect the vast majority who do get tempted to ride the wave will ultimately lose money.

“Many are buying in not really understanding the dynamics of these shares and what’s driving the prices other than pure momentum – it’s not based on the fundamentals of the company.

“Inexperienced investors are getting sucked into this and I’m afraid greed is in the ascendancy.”

This is the trouble with speculation, or “pump and dump” as in the case of GameStop.

A small minority of retail investors will have gotten in at the bottom of the market, but the majority probably bought shares when the price had already surged.

Some unlucky traders will have also gotten in at the top of the market when GME was trading at nearly $350, only to see their investment nosedive in subsequent days when the price fell back towards $50.

“It’s a pyramid or Ponzi scheme ultimately because it’s purely based on momentum,” says James.

The original swindler, Charles Ponzi conned scores of investors out of millions of dollars in the 1920s, promising clients a 50 per cent profit within 45 days or 100 per cent within 90 days.

He could keep up the promise so long as he continued to bring in new investors to pay back the earlier supporters, but eventually, the scheme ended up costing investors around $250 million in today’s money.

There are many other examples from history around the foibles of speculative investing, but the punch line is always the same – most people lose money.

Grant adds: “This isn’t some alchemy that no one has ever thought of before. All it really is, is a rehashed story of history repeating itself.”

GameStop was one of a number of “meme stocks” that was short squeezed by retail investors back in January. Others included AMC Entertainment, BlackBerry, Nokia and Koss Corporation.

In each case, some retail investors made money and some hedge funds lost but the reverse is also true.

“Wall Street will not be a loser from this,” James posits.

“There might be companies that suffer but there will be an equal number that do very well out of what is happening.

“It’s like betting against the casino.”

Indeed, while Melvin Capital was getting squeezed for every penny, another hedge fund called Senvest Management was riding the wave, amassing a $700 million fortune during the frenzy.

“The hedge funds use algorithms where if the trend reverses and they’ve shorted the stock, they’ll double down and go the other way,” says Grant. “I’m afraid the house always wins.”

All things considered, while it does not appear that retail investors have taken over the financial world and displaced institutional investors and hedge funds as the primary movers of markets, their emergence still shows how the industry is being democratised.

James says: “This saga could herald a new era of retail influence over stock markets.”

The democratisation of finance, where virtually anyone can put their capital to work no matter what their skill level or experience, should ultimately be viewed as a good thing because it shows that more and more people are taking control of their financial future.

In an era of ultra-low interest rates and defined contribution pension schemes, savings left alone no longer guarantee the kind of returns they once did, so it’s easy to see how the search for better yields is driving more retail money into the markets.

The challenge is ensuring people are investing carefully and responsibly, rather than piling into risky assets and potentially losing all of their money.

This is what the Securities and Exchange Commission (SEC) is currently looking at – whether or not digital trading platforms like Robinhood are doing enough to educate their users about the risks of investing or whether they are in fact encouraging game- ification because it’s good for business.

After all, in the Gold Rush, the people who made the real money were the ones selling the shovels.

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