How a frenetic run on buying GameStop and AMC’s stocks shed new light on the democratization of finance, social media and regulations
What caused the market mayhem?
GameStop and others such as BlackBerry and AMC Entertainment have lately become synonymous with a new wave of day traders that, during last week’s rally, have swept into US financial markets inflicting billions of dollars of losses to hedge funds who had bet on the decline of the company’s shares.
The markets turmoil originated from social warfare against Wall Street and the causes are both sociological and cultural.
The financial crisis that brought the US and the entire world to its knees 12 years ago has left deep scars on a huge part of the population. This, apparently, is still echoing to those who (still young back then) have seen their parents lose their job and witnessed a massive taxpayer bailout of the major financial institutions. It is there that was born, again, a widespread skepticism against Wall Street and what it represents.
Then, the Covid-19 crisis hit and the combo of helicopter money from the US government and a never seen before accessibility to financial markets have helped, especially the millennials, to become young ad often naif trader gambling with money against a not-well-defined enemy.
How do brokers such as Robinhood fit into this?
All of this is possible thanks to platforms such as Robinhood which have democratized finance through the gamification of trading, opening the doors of Wall Street to small retail investors. It did so with the disruptive innovation of a platform whose success is based on three key points: the elimination of commissions, the elimination of any minimum deposit to open an account and the ability to operate on fractional shares with reduced amounts. This simple and intuitive app counts now more than 13 million users (+500k just in the last week).
If in the mass opinion Robinhood used to steal from the rich (hedge funds) to give to the poor (retail investors), the truth is that in Wall Street it does not work like that or, at least, not completely. GameStop and AMC’s stocks soaring last week, following inflows from small investors who gathered in online communities such as Reddit Wallstreetbets, is proof.
Conflict of interests
Despite not charging any fee on trading, Robinhood relies on what is known as payment for order flow as their profit comes mostly from commissions. Payment for order flow is a common practice that has been lately criticized for its lack of transparency. Market makers, such as Citadel Securities or Virtu, pay e-brokers like Robinhood for the right to execute customer trades. The fee goes up especially in the case of option that, due to a larger spread between the bid and ask price, allows Robinhood to make a higher percentage of their revenues from options trades rather than from equity trades.
The catch is that trading option is difficult and this implies a greater risk of bearing losses for inexpert traders.
Moreover, when the company sells its order flow to third parties, those are the ones who execute the trades, but they also get access to the data. This means that Robinhood is the “Facebook of investing” and that you are the user and not the customer. In fact, these kinds of information can be very valuable to high-frequency traders who make money off the tiny spread in pricing during the time between buy and sell orders.
Shading even darker light on the events of last week there is the fact that, on Thursday, Robinhood no longer accepted requests to buy shares of a handful of companies calling for “market volatility.”
This makes perfect sense when it surfaces that the company’s largest customer for order flow, the before mentioned Citadel Securities, is the sister company of one of the firms that had invested in the hedge fund that took the biggest hit ($6.6 bn) from the short squeeze, Melvin Capital.
Volatility and Liquidity
Volatility in the markets has been crazy and this means huge potential loss not only for the big sharks but also for the small fishes. If we add to this that, while been considered as one of the worst examples of financial speculation, short selling helps the market being more liquid, it is harder to understand the real ratio behind what happened.
Big financial operators have lost an awful amount of money, but this is also true for small investors that got caught up in the market’s mayhem.
Plus, when Financial intermediaries or big hedge funds start losing money this means only one thing: a higher need for liquidity. Liquidity, that often comes from the indiscriminate selling of other assets; which is normally called the feedback effect. This means that if they start selling, the prices of those stocks are set to go down, making other retail investors (maybe even those who participated in Reddit’s run to GameStop or AMC’s stocks) lose money.
This liquidity needs, in the case of Robinhood, arose from margin deposits with clearing houses, which made the Silicon Valley unicorn receive an injection of about $3.4bn in the time span of a few days.
Greed and Fear
On Tuesday, GameStop, AMC and BlackBerry’s stocks value declines have wiped roughly $27bn from the last week pumped-up valuations of the three companies.
This benefited those hedge funds who have stuck with their negative bets and were making money again. The situation has thus reversed and people who jumped on this trade, especially buying those stocks (often on leverage), are now left with portfolios bearing massive losses.
What do we need?
Platforms like Robinhood, E*Trade or Schwab have helped shape the future of financial services by making trading more accessible, but this does not necessarily mean more market discipline and happier retail investors. The democratization of finance has positively disrupted the industry and has enhanced innovation, but too often small market participants are missing one key input: education.
Young, without financial preparation but ready to “play” with stocks, cryptos as well as more sophisticated instruments like option and leverage. Pari passu, this also means that they do not fully understand the concept of risk.
These events showed us how technology and socio-political impulses interfere with the government and the fate of companies, markets, and stock market prices. An interference that due to a lack of knowledge and education is sometimes motivated by economic-financial purposes but it is often confusing and irrational.
A fundamental role is played by social networks, apps and regulations which now cover each aspect of our lives, allowing us to do things that were unthinkable until yesterday. This, in the financial sphere, means going towards uncharted areas.
Traders that ran on buying GameStop’s stocks were the same traders that hours later were limited to transact when Robinhood blocked the possibility of buying and left the one of selling. Stock market manipulation and disturbance are crimes that we punish in the real world so why do not we try to extend these rules to social networks and apps?
Securities regulators and lawmakers have plenty to ponder about what to do with the hot-headed investors and the platforms enabling them during the incredible stock frenzy. But even more important is going to be the education that allows people to clearly understand the impact and risk of their behaviors. It requires courage and long-term commitment.
Bocconi Students Fintech Society
https://24plus.ilsole24ore.com/art/come-funziona-robinhood-app-millennial-che-democratizza-wall-street-AD2GKEHB https://24plus.ilsole24ore.com/art/gamestop-piattaforma-robin-hood-raccoglie-1-miliardo-reintegrare-garanzie-ADhzkNGB https://www.ft.com/content/fa74a7c6-bcb0-469e-8b76-c5dfc04b9564 https://www.ft.com/content/29b4cc1f-a970-4cd7-b452-90d982aacfb9 https://observer.com/2021/01/gamestop-robin-hood-hedge-fund-hearing-responsibility/