In January 2020 an internet chat group took down a Wall Street hedge and got one back for the little guy in a classic Robinhood story – or so you’re led to believe… While there’s a tinge of truth here, a reverse Robinhood story is on-going and unsound money is at the centre. [Reading time: 10 minutes]
TLDR: The GameStop story characterises the systemic challenges faced in the 2020s. Excessive leverage has created an unwieldy financial market. Policymakers are chasing their tails for the solution which sits right in front of their faces – unsound money. Their inability to solve the problem will lead to further volatility, inequality, and distrust, which forces us towards decentralisation and lowers the barriers to bitcoin.
1. What is GameStop (GME)?
A physical gaming store that has come under pressure during the 2020 lockdown. Many large hedge funds had large short positions on this asset, totalling as much as 140% of the size of the company. A short position implies that the hedge funds were betting on a price decline.
2. Short selling is legitimate?
Some people were angry that hedge funds were betting on the decline in a company during a pandemic, but there’s nothing fundamentally wrong with short selling. Short sellers provide liquidity in financial markets. They often expose frauds and bad actors, putting wasteful companies out of business, which contributes towards economic efficiency. If you’d like to learn more about this, listen to this Grant Williams interview.
3. How could these hedge funds be 140% short?
Many hedge funds have close relationships with prime brokerages, allowing them low cost leverage. Regulators should probably tighten up these relationships. However, the primary cause for the problem is unsound money and excessively loose monetary policy, which lowers interest rates, makes liquidity cheap and encourages leverage. If monetary policy was tighter, leverage would be contained and this whole debacle wouldn’t have happened.
The graph below shows the incredible growth in margin debt as a percentage of GDP since the 1990s. We’ve now reached a RIDICULOUS plateau above 25%. Yet another sign of very unhealthy financial markets.
Not only is leverage a systemic problem, but the effect of leverage is unequal. Large hedge funds have much easier access to leverage than small retail traders. Often leverage is the primary driver of hedge fund outperformance. So, while there’s nothing wrong with short selling, nor hedge funds, the public is justifiably displeased with preferential access for large hedge funds.
4. What transpired and what’s a short squeeze?
Investors on a Reddit thread called Wall Street Bets (WSB) started talking about long positions on GME as early as 2019. Originally, the case for the long exposure was fundamental in nature. I.E. they thought the stock was undervalued. Once they discovered the large 140% short bets on GME from institutional hedge funds they engineered a short squeeze.
Traders with short positions are obligated to purchase the underlying stock at a future date. If the price increases, this squeezes short positioned traders, causing a sudden increase in price as the shorts are forced into covering their positions. WSBs started buying GME to create a short squeeze, pushing the price higher, which placed pressure on the hedge funds who were short GME. The price rose very sharply through Jan 2020 from below $40 towards $350.
5. Short squeezes are legitimate
Investors aren’t legally allowed to manipulate markets but there’s a big grey area here. Lawsuits generally arise when trading on illegitimately received information. WSBs received their information legitimately so this is a non-issue. There’s no difference between their actions and that of private hedge fund strategy dinners where they discuss trades. For a brief historical comparison, in 2008 Porsche engineered a VW short squeeze and the Porsche CEO ended up on the front cover of Fortune Magazine. https://moxreports.com/vw-infinity-squeeze/
6. Robinhood or reverse-robinhood
Robinhood (RH) is a trading platform loved by retail traders like WSB because of the cheap trading fees and access to leverage. In some senses, RH has democratised investing, “taking from the rich and giving to the poor” by allowing retail traders better access. But there’s more to this story than meets the eye… In order to allow cheap trading fees, RH takes its user data and sells it to large hedge funds. This is a similar relationship to Facebook, capitalising off naïve users.
RH’s most important clients by revenue are large hedge funds who pay for data, not the retail traders who use the platform. RH is an example of pseudo-equality. Greater access to credit or leverage never solves the unequal distribution thereof. At the end of the day, the big players always have more access to cheap credit than the little guys. Rather than provide leverage to retail traders, it would be far more beneficial if sound money removed excessive leverage from all players.
7. The real market manipulation
Robbinhood and a few other trading platforms restricted trade in GME after its dramatic rise in price. Retail traders were restricted from buying more GME. They could only sell. This dynamic eased the pressure on the short squeeze, allowing the large hedge funds an opportunity to close out their short positions.
The reason provided by RH was the margin requirements being charged by their clearing house. It’s at this stage where the answers start to get a little fishy. Where RHs capital controls so poor that they were unable to post capital requirements? Was RH honest about their liquidity position? Was RH pressurised by the large hedge funds? We know that the large hedge funds and RHs major clients, so there’s justifiable reason for scepticism…
Whatever the answer, we know that the retail traders were severely restricted in their ability to act for several hours. Many traders are very angry about this development, justifiably so. It may have cost them a lot of money and it saved a few large hedge funds a lot of money, which leaves a very sour taste in the mouth.
Moreover, RH received a $3.4bn capital injection in the days following the height of the GME saga, which is more than they raised in all the previous investment rounds combined. Who came to the rescue with all this capital?
We’re left with more answers than questions…
What are the implications for us?
- It’s possible that regulators could restrict the short interest on a specific company by limiting it to 100%, for example, but this isn’t the primary problem.
- Unsound money is a primary cause of the problem. It creates excessive leverage, undue volatility and it has an unequal impact on the distribution of returns.
- Regulators should investigate the relationship between retail trading platforms and large hedge funds. It’s unethical for trading platforms to sell client data – it’s a conflict of interest.
- If there was any communication between the trading platforms and the hedge funds regarding restricting trade in GME, criminal charges should be levied. Unfortunately, experience of previous market events like this tells us that a nominal fine is a best we can hope for.
- Markets are increasingly rigged. It’s not because markets are inherently bad. Its because of unsound money and centralised control over-regulation, counterparties and exchanges, which are open to manipulation.
- Gating retail traders from access is not a sustainable solution. In free and fair markets there should be equal opportunity for gains and losses.
- The actions of RH and other retail trading platforms leads to increasing distrust amongst market participants. Distrust is a major macro theme
- Distrust with large hedge funds, retail trading platforms and regulators lowers the barriers to entry into bitcoin.
- A major factor restraining many from investing into bitcoin is regulation. As people lose trust in the authority of regulators to manage a free and fair financial system, interest in bitcoin grows. Important to note that this isn’t the only reason for bitcoin interest. It merely stokes the flames.
- One of bitcoin’s primary characteristics is censorship resistance. If you custody your own bitcoin, no one can prevent you from transacting in it. Bitcoin holders will never wake up one day and be blocked out of their account or stopped from transacting. Yes, regulators could make transactions more difficult. But if you have access to the internet, you can find a way to transact in bitcoin.
- Lastly, decentralised exchanges are growing in the cryptocurrency world. These exchanges are governed by pre-determined rules, which removes the central point of interference and reduces the risk that exchanges clearing houses, regulators or large hedge funds can manipulate market outcomes. There’s still work to be done on these exchanges before they can handle to volumes required by traditional financial markets but eventually, they will eat the lunch of traditional financial markets.
The GME debacle highlights several deep problems in financial markets but don’t mistake the woods for the trees. There’s nothing wrong with financial markets themselves. There’s nothing wrong with short-selling and there’s nothing wrong with hedge funds. These are tools and techniques that serve different purposes. There’s also nothing wrong with retail traders taking advantage of market anomalies and profiteering handsomely. But there is a problem with excessive leverage in centrally controlled markets that benefits and protects industry powerbrokers. This game will only stop when the debt bubble is deflated. Until then I expect further volatility, inequality and market anomalies. Regulators are very unlikely to solve this problem because they’re unable and unwilling to identify the primary sources of the problem, unsound money. Patchwork solutions like restricting trading for certain participants and the closed-door conversations between powerful senior executives of these companies sows disinformation and distrust, which further lowers the barrier to entry to bitcoin.
Until next time.
- What is bitcoin and who needs it?
- How much should I allocate to bitcoin?
- Sound Money Monthly: (ed.6) Invest capital into a sound future
- FOMO is bitcoin’s number 1 marketing strategy
- Embracing speculation: high-probability potential in a speculative world
- Learning bitcoin’s golden language: adoption cycles will persist post 2021
- Don’t “believe” in bitcoin; understand store of value and stock-to-flow and network effects
- Sound Money Monthly: (ed. 5) Central banking is an environmental disaster
- Tech disruption framework: bitcoin undervalued at $20K
- Bitcoin Bulletin: (Nov 2020) Shifting from accumulation to aggressive price appreciation phase