The democratization of finance and social media have been constant topics on this blog since I started it 4 years ago and especially since I started blogging twice weekly over 2 years ago. If you are heavily vested in market developments and social media as I am, this past week has been a rollercoaster.

To recap, the struggling video game retailer GameStop’s stock caught fire on the Wallstreetbets Reddit forum and retail investors piled into the stock. This produced a jump in the share price from around $40 per share the week of January 18th to as much as $470 a share as of Thursday January 28th, a return in 5 days of around 1,100%. If you just held onto the shares, this produced a massive short term gain but as has been building steam for a while now, retail traders have discovered that call options are a powerful tool for those with small amounts of capital to produce huge gains that would be similar to those seen by investors with much larger sums of money to put to work. The most extreme case of this was showcased by Reddit user u/DeepFuckingValue who as of Thursday was still holding his shares and calls valued at $33 million that had reached as high as almost $50 million in value.

This mad dash into the stock as well as others that were down on their luck and heavily shorted such as AMC, Blackberry, Bed Bath & Beyond and Nokia, produced a rare short squeeze that probably hasn’t been seen since the days of the financial crisis when volatility was much higher. Hedge funds like Citron Capital and Melvin Capital are reported to have lost billions in the short squeeze. Melvin is run by a former portfolio manager for SAC Capital named Gabe Plotkin. SAC Capital is owned by Steve Cohen who also runs Point72, one of the funds that bailed out Melvin. Another hedge fund, Citadel, owned by Ken Griffin provided part of the $2.75 billion bailout of Melvin after it saw the huge losses that the short squeeze produced, but it appears this was just the beginning of the story.

On Thursday January 28th, popular stock trading app Robinhood, halted all buying of shares in the viral stocks like GME and AMC. However, it allowed these shares to be sold, and likely to be shorted. In fact, it was even shared on social media that some retail investors had been forcibly liquidated at a price chosen by Robinhood, over which they had no control. Other online brokers followed suit in restricting trading in these shares but none other that I know of forcibly liquidated investors shares. Social media and retail traders went wild. It was quickly shared that Citadel is actually the largest customer of Robinhood, buying its trades in exchange for being able to glean what retail traders are doing before they actually execute the trades. Citadel is then able to make their own trades based off of this and profit from momentum, either up or down, in a particular stock or set of stocks. This is because apart from being a hedge fund, another subsidiary of Citadel, Citadel Securities, is actually a market maker in equities and options. The conflict of interest here is obvious: Robinhood’s largest customer could essentially have the power to dictate what it wants Robinhood to trade or could pull their business away from them. Rumors swirled that Griffey and Cohen were behind stopping retail traders from buying the stock as well as the alleged forced liquidations. At that point, politicians such as Alexandria Ocasio-Cortez and Ted Cruz started to get involved saying they wanted hearings on the matter in Washington. There was even a rumor from an Reddit poster who claimed to be an anonymous Robinhood worker claiming that co-founder Vladimir Tenev had received calls directly from the White House demanding that Robinhood halt trading in the stock. Faced with the onslaught from both the regulators and their largest customer, it seems that Robinhood’s management caved under the pressure. Not only did they start restricting the purchase of many beaten down shares that were going viral, they preemptively drew down their credit lines from banks to be prepared for any further onslaught from either side. Robinhood and others claimed this need to stop trading and draw on their credit lines was due to the capital and deposit requirements of the clearinghouses. The spike in volatility likely meant that these firms had to make huge deposits to cover their own credit risk given that they were holding so much of a wildly volatile stock at any instant. Whether this pressure to deposit more came because of rules or government pressure is open to speculation.

The Freedom to be Dumb

The allure of GME and the stocks pushed on r/wallstreetbets is as old as time: fast money. The founder, Jaime Rogozinski admits that he stated the forum when he first got into investing because he was bored of the slow and steady philosophy of other investing communities like Bogleheads. Stocks are going viral in the same way video clips and memes have been going viral for the past decade, the only difference now is that there is much more money involved. The debacle with Robinhood adds a familiar element to this though: populism.

Robinhood has touted itself as none other than the democratization of finance and this episode laid bare that if it isn’t being manipulated by powerful forces, there is surely the opportunity for that to happen which leads to a lot of cynicism and skepticism. Make no mistake that they severely damaged a brand that took years to build up with this episode. The overriding theme in much of the criticism is that it’s the people versus the establishment. This is the same type of populism at the heart of the election of Trump, and the general discontent which has spread through much of the rich world. Wall Street seems to be learning that the madness of the crowd can not only upend politics, popular culture and the way we interact with each other, but markets as well.

Yet it isn’t that simple, there are fundamental questions at the heart of how this new phenomenon should be handled and they go back to our overriding philosophies on freedom, markets and the public good. Retail traders should be free to make or lose as much money as they like no matter whether fundamentals underly their decisions or not. Make no mistake that retail traders are the other side of the coin that has been playing out for a long time: large players get to bet on where a stock will go next. Due to fundamentals, GME was the most shorted stock on the exchange just a few weeks ago. Many argued that it was over shorted. Even institutional investors tend to move in beards and everyone had piled into the trade short. Retail investors then piled on the trade the opposite way and were able to flex their power showing they could break the backs of hedge funds with billions of dollars at stake. So what if they sent the stock into the stratosphere to do so?

In the medium and long term, the knowledgeable and patient investors will be rewarded in this scenario, as well as the speculators that take massive risks. Knowing there were no fundamentals to the underlying stock when it was trading near $500 a share, it was an easy call to buy some deep out of the money puts on the stock. Once buying was halted, these positions shot up as shown by the IG account @wall_street_trapper the other day who was able to capitalize.

There are a number of reasons that the vault in trading was just short term thinking and that Wall Street should be embracing this new paradigm when it comes to investing and not allowing the government and institutions to try and keep people from hurting themselves:

• Volume Increase – One immediate consequence is that increased volumes mean increased revenue for institutions. This comes from executing trades, increased hedging and options writing. None of these are a bad thing from an institutional perspective and represent a bump in revenue.
• Investors Learn – Many willingly admit they don’t have a clue about what they are doing but this isn’t necessarily a bad thing. All investors have to learn hard lessons at one time or another, we should let traders make mistake and profit from outsized risks. The hard part is making money again once you have done so once, this isn’t easy to continue doing. Getting burned will eventually bring people more into the fold of financial advisors, index funds and the establishment many are shunning at the moment.
• New Opportunities for Seasoned Investors – As displayed above, the madness open whole new opportunities for experienced investors. They can dedicate a small portion of their portfolio to momentum risk plays for upside, take advantage of volatility, both up and down or increase income writing options for positions they already have. It also allows some long term investors to exit some bad investments as we saw with the Ontario Teachers Pension Fund. This will also likely create a new opportunity for actively managed funds, an area that has been under pressure for years due to index funds. In the long term, it even boasts well for hedge funds. Not only does it create new momentum strategies but retail traders have provided a huge check on lazy, heard following short positions. Funds will have to more diligently manage their short positions to not get burned like this again.

Hedge Funds Will be OK

This movement to go long via the most shorted stocks has been dubbed the “dash to trash” people should have the freedom to so. The popular narrative that this is the people against the institutions does have some weight, not because hedge funds or institutions are bad but because it will offer a new check on their influence and power. If they did push brokers to restrict trading, they may have won the short term battle but they may end up losing the war if they fail to pivot towards this new wave of investors.

Even some in the establishment press have pointed towards the fact that hedge fund’s clients are accounts linked to regular folks as well. Hurting those funds may end up hurting pension funds, endowments and foundations. This is nonsense. Although these are big clients of hedge funds, hedge funds usually represent a small portion of their assets.

You could use the argument that some pensions and foundations have a lot of assets in hedge funds and those beneficiaries could be hurt, but I would counter that if they have such a significant portion of assets in hedge funds in the first place then they are likely being poorly managed anyway and should do themselves a favor by firing the administrators.

Conclusion

So in conclusion, the retail traders may be ignorant, crass and upending the status quo but this is a good thing. Memes are even circulating arguing that they have done more to reform Wall St than Occupy Wall Street and they have a point. Government and well connected industry needs to get out of the way and let the heard roam.

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