The recent events of the beginning of 2021 such as the « bump-dumping » of a small group of stock such as Game Stop, Nokia, AMC, XRP, … etc raise some fundamental questions about how the financial market should operate and how the current behavior of investor is hurting the economy.
What happened?
During the pandemic and lockdown, we have seen the rise of a new type of investor on the financial markets: The day trader, without any background in economics or finance, manipulated with the obsession to invest in some given stock by Wall Street bets and other platforms. In these people's minds, Game Stop, Nokia, and other particular stocks became companies worth invest in without looking at the financial background. Indeed Wall Street bet having hundred of thousand of “followers investor”, uneducated, determined to follow the investment notice given on such platform without second thoughts. This could only result in a rise in the price and it did: these stock went to the roof in a few days ( Game Stop: + 2000% in 8 days, AMC: + 1100 % in 6 days ) but shortly after plummet ( Game Stop: - 800 % in 4 days, AMC: - 500% in 6 days ).
Hedge funds and institutional investors seeing the absurdity of the rising of such stocks decided to short it. It basically means that they create a derivate that rises when the stock goes down. However, when the stock goes up, it costs them money. The stock going to the roof because of these hundreds of thousand so call day traders, it became really hard for an institutional investor to stay short on the stock, costing them more money as the stock kept rising. So what’s happening is that the investor which was betting against a stock has now to buy it back. This only adds more buying pressure on the stock and create a situation called “short-squeeze battle” between day traders and hedge fund.
The danger of asymmetrical information
One of the most important changes in brokerages business models is to target the day trader ( household ) with the rise of zero-commission trading like Schwab, eToro, E*Trade which followed Robinhood policy in eliminating commission. Brokerages realized that they didn’t need to charge commissions to make money: They could use the power of a free product demonstrated by Google and Facebook before.
Appearances are deceptive, what appears to be free in reality isn’t. Barry Ritholtz explains for Bloomberg, there is a fundamental difference between a cheap and a free service: Cheap is great, it means you’re paying less and getting a service, but free raise all sort of question : If it’s free then you’re the product and not the customer.
As social media platforms relies on user information to sell advertising, Robinhood uses the cover of a zero-cost commission to monetize information. But there is a twist, they don’t sell their users’ information, they sell their lack of it. In the financial market information is everything: No one wants to do a transaction with someone holding more information because they are assured to lose.
Robinhood’s business model is to sell their hold of active non-professional traders, uniformed to market makers who pay for the ability to realize a deal without taking the risk of trading with informed traders. Retail investors get to trade for free, the new generation of Wall Street monetizes their ignorance.
As a result, Robinhood users aren’t the customers which explains why most of them suffered from important losses. The platform abusing from its power on users even block some trades that weren’t in their interest disregarding their user’s willingness to sell. This led to more than a hundred complain to the FTC over the past week. Some clients claimed they were unable to liquidate holding and move to other brokerage firms.
The gamification of our financial markets exposed
These events only highlight the complexity of financial markets today. There are so much different structures, products, and brokerage firms that active investor ( or day trader ) doesn’t anymore know where does their money go. Financial markets aren’t as they are supposed to be: People used to invest in a company and hold a share of it, collect dividends, and business owners use this money to grow their expenses. Now with all financial products, derivates, swaps, … it isn’t the case anymore.
As Rawi Abdelal from Harvard Business School suggested this could be a metaphor for what’s going on around us: A lot of people cling to the idea that there are rich people who work on Wall Street and evolve in markets most people don’t understand and might manipulate in some non-transparent ways. Retail investors aspiring to the same result of wealth, try to do the same thing excluding the fact that they don’t have the same knowledge of the financial markets.
Over the years there has been gamification of the financial markets, reinforced by the Robinhood and zero commission platform which brought retail investors as a new actor. Unlike other actors, they lack information and background in economics and finance. They see the market as a game where they can win money by speculating without knowing exactly when and how, forgetting the possible loss of such action.
This action will only result in one thing: The market will do what it has done for centuries, reallocate wealth from the uninformed to the informed. It is the reason explaining that 85% of retail investors trying to speculate lose money in the process.
The question of legality
Insider trading as well as manipulating the stock market is prohibited by almost all the countries in the world and is known to hurt the economy. However, even though Wall Street bet achieves the same results of manipulating the stock market, it is not prohibited to post random thing on social media about the stock market. So there is a loophole in financial regulation enabling such a platform to manipulate a stock with bumping and pumping group action.
If nothing is prohibited, and fundamentally wrong, the situation is going to last. This will only be solved by what Mehir Desai from Harvard Business School calls “self-correcting”: people get damaged, get hurt, they retrace and rethink the way to do things. But there isn’t any regulations or institutional ways to solve this issue, we can only let the market regulate itself: It is only when each individual realize after a loss that this « day trading » and especially speculating on a company they don’t know is absurd and therefore they would retrace.
However, Robinhood's action to act against its clients' will, should be investigated by the FTC in the next month, and clearly result from an abuse of power and shouldn’t at any instance be allowed.
What’s at stake for the economy?
Even more is at stake for the real economy, and this part is usually underestimated by the media. Let’s recall the purpose of the financial markets: to allocate funneling capital from savers to firms that need that capital to enables both people who want to invest and entrepreneurs to make a profit. At a macroeconomics level, it is what enables the market to achieve its full potential.
Gamification only reduces those functions of the financial markets, as the investor doesn’t anymore know where they are investing, they no longer invest which prevents the economy to achieve its full potential. As retail investors reckon with their losses because of the clear lack of information on what they are investing in, they will lose faith in the valuable functions financial markets provide.
Furthermore, when people invest their money in a business, they help develop it, help it create jobs, and in this way serve the economy. When they speculate, they don’t bring any value to society: There is always a people behind a bet: One might be winning but the other could be losing. At the end of the day, it is usually institutional investor winning and day drawer losing. Hurting the economy by creating a context of volatility where investor feels unwelcome to invest.
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