A Sober Look at the GameStop Saga

Last Thursday, my Mum, a primary school teacher with absolutely no financial markets interest whatsoever, asked me what is going on with the stock market - and how shorting stocks actually works.

Sounded pretty bizarre, but to be fair this was a crazy week too. A meme-fueled stock frenzy driven by an army of Redditors has completely taken over the global markets. If you’re a tech writer, you’re kind of forced to cover the tale of GameStop, Reddit and Robinhood, and number of great pieces have been written already (like this one from Matt Levine).

I’m not going to beat a dead horse here, but focus on outcomes instead — and analyze how bunch of Reddit degens might have activated the very first sequence of events that will begin a fundamental change in investing.

Love it or hate it, Robinhood is here to stay.

Being a primary tool for retail investors to ride a GameStop wave, Robinhood came under fire for halting trading on several stocks cherry-picked by the WallStreetBets community. Halted trading killed growth momentum, share prices took a dive, hedge funds covered their short positions, and an army of Robinhood users lost their money. In other words, David stopped beating Goliath - that is retail bros knocking out cold big Wall Street guys. It didn’t take long for public opinion to form a conclusion that this is becoming sketchy. Robinhood went from a finance democratization icon to the most hated brokerage platform on the planet (and becoming a 1-star rated app on Google Play).

The real story is, frankly, quite boring. Due to crazy volatility on GME, AMC and couple other “meme stocks”, Robinhood’s clearinghouse deposit requirements increased massively and the app was hit with a margin call of its own. While not all elements of this tale are clear (why was the deposit explanation communicated days later?), and we have every right to be pissed, it seems like Robinhood didn’t really have any other choice.

Let’s put emotions and business models (hey, Citadel) aside, and focus on the big picture here. Dirty or not, Robinhood did democratize access to financial markets and enabled millions of individuals to trade.

Source: Robinhood, Forbes, Fortune.

Truth to be told, an average Joe doesn’t care too much how his broker makes money. So what that Robinhood sells my order flow to Citadel? As long as I’m getting safe, commission-free trading packaged into a beautiful and intuitive app - I’m all good 🤝

Now this is hell of a simplification and not a very accurate way to approach things, yet there is a reason why Robinhood is so popular. Retail investors were finally given a zero-fee trading platform that made buying stocks as easy as posting an Instagram story.

Robinhood paved the way for other retail-centric trading platforms (M1 Finance, BUX, Freetrade) and one thing is certain - commission-free investing is here to stay.

Retails investors aren’t exactly “dumb money”, but…

Imagine you’re a fancy hedge fund manager who spent the entire life honing the craft of investing, only to get absolutely wrecked by a bunch of Redditors driving stocks to the moon by sending memes.

Who is the the dumb money now?

Jokes aside, the GameStop saga ultimately proved what should have been clearly recognized before - retail investors are crucial market participants and should be treated as such. Individuals are powerful and with the rise of Robinhood-like trading platforms, become more and more bullish.

When in February the pandemic hit, large allocators quickly “rushed to exit”, selling their portfolios and tanking the markets. Guess who was buying those assets? You got that. Retail bros.
European Corporate Governance Institute researchers observed that retail investors scooping up cheap stocks amidst the pandemic, acted as a market-stabilizing force providing liquidity for institutional players.

The GameStop saga might seem bizarre, but the underlying takeaway is clear - retail investors are a force “smart money” cannot longer ignore. The combination of seamless, inexpensive access to trading and ubiquitous social media created a fundamental change in the global investing landscape.

… leverage limits might not be such a bad idea.

Let’s face it, margin option trading is scary, yet unbelievably appealing. When everything goes right you feel smarter than a Warren Buffet. When things turn south, it’s bad. Like really, really bad. Margin calls can be brutal and force traders to close positions at the worst times, resulting in massive losses.

Options trading is very complicated. I’m an experienced investment banking professional and still got crushed badly a few times, even though on paper I was a fairly sophisticated investor. Options are hard and should not be traded without understanding all of underlying mechanics - otherwise it’s just pure gambling.

Robinhood knew that, yet built its whole business model on encouraging unsophisticated investors to trade options on a margin. While this isn’t illegal per se, there is a razor thin line between democratized access to financial markets and putting people into jeopardy - which already ended tragically.

Spot the difference: option trading on Robinhood (left) vs. Interactive Brokers (right)

Leverage is a very efficient way of trading capital, but proves immense risk for an uneducated investor. A research paper from Alp Simsek (MIT) and Rawley Heimer (Boston College) finds that certain margin limits don’t harm overall market liquidity and result in more controlled, smaller losses for the most aggressive traders. The GameStop saga might be a catalyst for the SEC to increase protection of “small guys” - but balancing investor security, market liquidity and politics is going to be hell of a task.

So what now?

What happened last week is not abnormal. We‘re seeing a rapidly progressing, Internet-fueled shift in retail investor behaviour. Individuals no longer trade on broker research, but dive into social media hype. The modern retail investor is determined, aggressive and not afraid to take risks. The power of communities like WallStreetBets is enormous and fully capable of giving Wall Street a run for their money.

We are most likely to see some kind of regulation on both sides too. Robinhood’s drama is not over yet and the SEC has said to “closely review actions taken by regulated entities that may disadvantage investors or otherwise unduly inhibit their ability to trade certain securities”. We might get some retail protections mechanisms as well, in order to limit potential losses of risky individuals playing with fire (i.e. trading options on the margin).

Ultimately though, the stories of democratized investing and meme-driven stocks will flourish only if the stock market itself continues to go up. After all, who wants to be playing with Robinhood if you can’t make those “sweet gainz” anymore?

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