How “Reddit Traders” Changed the Course, Destiny and Impact of Retail Trading

The thing about money is, how ever much you think you have got it, someone could always get more.

Last week on Wall Street, money changed a lot of hands within a very short span of time. People who never had any claim to running businesses or possessing financial acumen, turned the tables on the hedge fund honchos. Reason: They were united in cause, target and purpose.

What happened with Gamestop and Melvin Capital is a story that will be recounted a lot of times amongst Redditors with aplomb, and a great many times by the short-sellers who will never wish to remain “short-sighted” of the market advances made by an army of retail investors in the future.

But what remains to be seen is the effect of this upset on the market and its potential implication on the way business is done in stock markets. Let’s see about the box of possibilities that the acts of Reddit’s retail investors have opened up.

Immediate Fallout

After members of r/WallStreetBets noticed Melvin’s $55m-large short position against GameStop and called on their army to rally up the share price, the company which was once on the precipice of bankruptcy was revived with an eye-popping 779% gain in a month and ushered into the coveted Fortune 500 list (№464!).

But make no mistake, Gamestop is still not above water. Besides a dismal 30% drop in the latest quarterly earnings, the loss of business during the lockdown period has been striking. At $325 a share, although the company figures close to $23bn in valuation, its assets are worth no more than $2bn. So, the inflated gains from the Reddit rally have actually taken the company “to the moon” and back.

Without steady cash flow projections, growth in business and debt management, it is only a matter of time before the company’s stock returns to earlier levels once the hysteria subsides. But the Reddit optimists are hopeful about Ryan Cohen turning things around.

Cohen is an activist investor whose recent entry into GameStop’s Board had him anointed as a saviour by the puritans of the gaming community who believe in his ideas and vision to reform the company’s product lines and stage a comeback through the digital renaissance of operations.

Emergence of Social Media Conscription

Oh, we are a long way from getting there. But one has to wonder, with the global nature of the economy in the present times and the ease with which ideas are conceived, translated and publicised into action across the borders, are we in an age of true financial autonomy?

It is unfair to brand the internet as the villain and the Reddit traders as angry online mobs in this context. It is, however, okay to presume that as the internet can democratise access to financial channels, it is an instrument in upsetting the power dynamics between the people and the traditional institutions like hedge funds.

The dynamics soon go haywire as the upsets turn into dominos and start pervading into the general equilibrium of the economy. GameStop was joined by a roster of similarly shorted stocks such as AMC Entertainment, BlackBerry, Koss Corp, Express Inc, etc. Which soared on account of the same social media call to action.

More recently, the Reddit frenzy has crossed into the precious metals markets as retail investors are driving up the prices and demands of silver and gold. This uptick in consumer demand has overwhelmed the physical supply of silver coins. The popular drive is to debunk the widely-held belief that big banks were deliberately and artificially trying to suppress prices.

Some have even gone on to paint the GameStop uprising to be as populist and powerful as Donald Trump’s call to Make America Great Again! Similar sentiments have been witnessed in both — a sense of disrespect towards the elites, a belief that systemic rules have been written to benefit insiders at the expense of regular people AND operating with new internet and social media tech which disseminates power that was earlier concentrated in a few exclusive hands.

Honing in Like a “Hedge” Hound

Market makers like brokerage firms, trading platforms and stock option providers are expected to benefit from this surge in trading volumes. Even private equity firms are reported to have made huge gains by adopting cashing-out strategies against their shares in these shorted stocks (e.g. Silver Lake and BlackRock led with $284m and c. $2bn profits on paper through ownership of AMC and GameStop stocks respectively).

However, when it comes to balancing the scales, hedge funds do play a critical role in deleveraging risks and reducing stock market volatility. Sometimes, they invest large amounts in companies to earn a seat at the board and steer the management towards optimum and economised business solutions.

So, hedge funds liquidating their portfolios en masse, as they did last week to stave off the market uncertainties from rippling, is not a promising outlook. It leads to sharp drops in market indices, brokerages bleeding dry on cash and millions of investors maintaining enormously speculative positions. Too much volatility stymying positive market growth.

Regulatory Compliance

With market manipulation of this nature, one wonders where is the culpability? Or does law enforcement also fancy itself a show where the wealthy take a beating out of the common man’s hand?

The issue is again under interpretation of the law, which is conveniently vague on this point. The Securities and Exchange Act of 1934 prohibits usage of “manipulative devices” in stock regulation without precisely defining those devices. Instances of manipulating acts in usual parlance include things like insider trading, misrepresentation of company financials, ratings fixation etc.

So, if you wish to draw a parallel out of the above examples in a scenario where a random social media campaign (covered under First Amendment free speech regulation) takes off to rally up one particular stock, with full knowledge of the company’s fate and fuelled by sheer resolve to send shockwaves in the market with the tools of mutual contempt against the “rich cronies of Wall Street”, you are more likely to attribute it as a “movement” instead of “manipulation”. In the absence of deception, there is no trading done in bad faith, especially from people who have little or no market power.

On the other hand, when Robinhood placed trading restrictions for GameStop, it drew a bi-partisan flak from the annals of the US Congress indicating that compromised capital margins for brokerage firms silently dictates their allegiances to hedge funds (Robinhood drew millions in credit lines and raised $1bn in new emergency cash as its clearinghouse reserves rose tenfold during the frenzied hours of GameStop trading).

A New Era in Trading Imminent?

Analysts don’t think the Reddit traders can hold on to their wild gains made recently. At the end of the day, we are talking about a very small fraction of retail investors pushing around an even smaller fraction of stocks.

On the other hand, if the gains and trends persist, that would call for severe regulatory examination and perhaps, even revision of some already-executed trades. Once the trading fortunes reach an extent where one party can prove unjust enrichment by the other without justification, that’s when the regulatory ceiling collapses.

However, the short and gamma squeezes that were witnessed in the interim have sufficiently upset market economics up to a point where investors will likely need to “recalibrate” their trading activities. The “gamification” of stock trading and the resulting instability could unleash broader market losses and upend the traditional trading model as wild investor enthusiasm continues to play out in the markets.

(Originally published February 2nd 2021 in transfin.in)