Events on Wall Street over the last few weeks have been interesting. For perhaps the first time, the small guys seem to have turned the tables on the big boys. To recap, retail investors on Reddit used the discussion website to gang up against hedge funds that were shorting GameStop, a small video games retailer.
The small investors had used the commission-free online broker Robinhood to take long positions on both GameStop stock and its call options. In true David vs Goliath form, the retail players were collectively taking a position opposite that of the hedge funds.
GameStop stock, which was around US$6 in September 2020 and US$20 in early January this year, ended the month at US$347 — a rise of about 1,600%. The traded volume of the puny company’s stock exceeded that of the likes of Tesla and Apple, Tesla being more than 200 times its size.
As if targeting GameStop stock was not enough, the retail players on the same Reddit forum also singled out silver, jumping on a silver exchange-traded fund (ETF), causing a huge spike in spot prices. The foray into silver, however, seems to have been shorter-lived and much less successful than their move on stocks.
Like vigilantes, who in the absence of authorised enforcement, take it upon themselves to clean up a neighbourhood, these retail investors had chosen to go up against the hedge funds. Hedge funds, as some critics have alleged, have for long been able to rig markets, given their size and financial clout.
This was probably the first time that retail investors had orchestrated a broad-based pushback against hedge funds. As a result, at least one large hedge fund was forced to close out its short position in GameStop at losses estimated in tens of billions.
While not many would shed tears for the hedge funds, the incident raises disturbing questions about fairness and equity in financial markets. The incident also lent credence to the view of many critics of markets and capitalism in general, such as Bernie Sanders, who said that “the business model of Wall Street is fraud”.
Yet, well-functioning markets are the very essence of capitalism. Markets evolve over time and are necessary for the key purpose of price discovery. Proper price discovery, however, requires equal access, transparency of information and, above all, fair play. But when hedge funds and the big boys are able to establish short positions far larger than outstanding stocks, both by borrowing and through option positions, price formation is necessarily skewed.
The short ratio for GameStop stock in mid-January was reportedly higher than 2.0, implying that the percentage of short stock positions to available float exceeded 200%. Clearly, prices were being rigged. The regulators and regulatory action sorely needed here seem to be missing. For too long, there might have been a policy of benign neglect and even a serious case of regulatory capture.
Loose regulation on short-selling; extensive use of derivatives, particularly equity options that make it easy to synthesise short positions without actually shorting the stock; low trading fees and taxes on gains, all give undue advantage to the big players, which have access to borrowed capital.
Establishing synthetic short positions using options avoids the need to borrow the underlying stock, thus placing little restriction on how large the short position could be. Ironically, what is tolerated on Wall Street would not be in other asset markets.
For example, in commodity futures markets, uptick rules, risk-based margining and, perhaps most importantly, position limits act as constraints. Furthermore, on many occasions, derivative exchanges have stepped in to change delivery requirements when there is clear evidence of a market squeeze or cornering. Such initiatives effectively cause the ill-gotten profits to evaporate. Thus, the derivative markets may have tighter and more effective regulatory control on players than does Wall Street.
Despite the issues, short-selling should not be stopped, for it does have an important role, especially in arbitrage activity. Well-functioning markets need arbitrageurs to keep prices in line.
When prices go out of line to be either artificially depressed or pumped up through speculation, arbitrage activity can move in to take advantage of relative mispricing, effectively killing off the speculation and restoring “equilibrium” prices. Many hedging strategies too may require the taking of short positions as part of the overall hedge. Thus, a blanket prohibition on short-selling would be misplaced.
What the Reddit investors did with GameStop was by no means an arbitrage. Quite the opposite, they were actually taking naked speculative positions themselves by going long in such a big way, in a stock that had little by way of fundamentals. Their collective action amounted to little more than syndicated ramping to pump up prices.
Indeed GameStop’s stock price movement over the two-week period (Jan 20 to Feb 4) showed a classic pump-and-dump pattern. The stock, which was at US$39 on Jan 20, hit its peak of US$347 a week later on Jan 27 before sliding to US$53 on Feb 4. It remained at that price range to end at US$52 on Feb 12.
On most exchanges, such action would constitute a serious violation. So, while the hedge funds on the short side were wrong, so too were the retail players. Two wrongs do not make a right.
While there is no doubt that markets should be sufficiently free in order to operate efficiently, this must be balanced against the need for regulatory oversight to ensure that they are free from manipulation.
Like everything else, there is a trade-off. A huge social cost arises when markets are not credible and are unfair and lack integrity. Disintermediation and reduced investor interest can cause a substantial increase in the cost of funds to all listed firms and this in turn leads to reduced national competitiveness and systemic problems.
Dr Obiyathulla Ismath Bacha is professor of finance at the International Centre for Education in Islamic Finance (INCEIF)