$GME = Goodbye Market Efficiency?

Reddit Rules?

My last two notes have been about bitcoin and the stock market, both of which have become perceptibly more volatile. This week continues the theme, betraying the fact that markets are the fulcrum of the intersection of social, technological and economic forces, and that two of the trends mentioned in my December 4th year ahead note – ‘empire builders’ (the creation of new wealth) and the ‘rise of new financial market ecosystems’ are now coming into focus.

The latest market dislocation is centred around a video game retailer called GameStop. GameStop’s share price traded at a level of $3 last April but hit $370 on Wednesday. During that period, GameStop’s underlying business has not changed much, possibly gotten worse. The new development lies in the dynamics of its share price.

Some hedge funds had sold its shares short (selling them now on the hope that they would buy them back at a lower price), however a cohort of retail investors who apparently managed to ‘synchronise’ their trading views on the social media platform Reddit, aggressively bought shares and options on GameStop, creating not only a short squeeze (the hedge funds were forced to buy back the shares at a higher price) but also a mania that has spread to other stocks.

GameStop’s rise from a pedestrian retailer to a company that is at the time of writing worth $24 bn, continues a market theme of the past year where assets (Tesla, bitcoin etc) diverge wildly from their intrinsic value (e.g. Merrill Lynch has a price target of $10 for GameStop), and where for the first time in a very long period, retail investors (or at least stocks held by retail investors) outperform the market and the institutional community.

As one might expect, Wall Street is not happy. The financial press is full of stories about how the ‘little guys’ are beating the billionaires, and of how the triumph of the Reddit crowd is redolent of the political climate in the US. The decision of some trading platforms to stop trading in names favoured by the Reddit crowd has only increased the sense of ire.

To a very large extent, this has been coming. The arrival of zero fee trading, the development of new trading platforms like Robinhood (who by the way sell order flow data to large hedge funds), financial ammunition (free stocks from trading platforms, plus stimulus checks) and the harnessing of crowds through social media have ‘democratisied’ finance, to put it provocatively. In particular retail trading of options has exploded. Notably, Europe doesn’t enjoy many of these factors, including an ‘equity culture’, so it hasn’t seen the same trading boom (a European stock, Nokia, was picked up US traders).

Without repeating arguments made here previously, the financial climate that central banks have created is also a major factor (market liquidity conditions are the most plentiful in decades), both in terms of their portfolio effect, and impact on risk taking. There is also a sense that central banks are on the side of institutional investors, something that private briefings by the ECB’s chief economist to investment banks last year only reinforces.

For the moment I am less concerned with the way the GameStop phenomenon is being portrayed as a struggle between financial insiders and outsiders, but rather more taken by its implications for finance and for regulators.

This kind of development, together with many others (i.e., ETF’s and cryptocurrencies) should begin to erode the primacy of asset and wealth management firms, a vast number of whom use technology platforms, investment processes and business models that have changed little in the last ten years. There should be greater, downward fee pressure on fund managers who underperform, investment processes should be more centered around liquidity and risk appetite (as well as better encompassing data from options markets and order flow) and in time we should see a wider range of assets introduced into portfolios.  

Two other trends may take off. The first is that the banking/asset management industry should give up on trying to run its own technology projects and instead partner with technology firms. Equally, fintech companies increasingly need the help of banking specialists in order to better understand banking processes, regulation and governance.

The second is that ideally, the notion of the ‘democratization of finance’ takes off so that financial institutions become better at meeting the financial needs of specific groups – from millennials to women for instance.

GameStop’s wild run higher is also a challenge to regulators. It is fair to say that in recent years regulators in the US have done apparently little to regulate manifest oddities in the equity futures market, in the trading behaviour of congressmen and women (Nancy Pelosi trades call options on Tesla!) and the way large investors (and companies) have used the options market to drive equity and debt prices. To that end they should ask what is at stake in regulating the behaviour of retail investors.

The key question regulators must ask is ‘what harm is done’. When speculative behaviour spills over into the real world (for instance causing ‘going concern companies’ to go bankrupt) it must be checked. GameStop itself might react and issues more shares to the retail investors – some of whom in coming weeks will lose, as well as gain a lot of money.

There is likely a temptation on the part of the new Biden administration to strike a more responsible and moral chord regarding Wall Street. It may start with GameStop’s day traders but to be consistent it would have to radically reform Wall Street, which I think unlikely. Instead, we will likely see a cooling of margin trading, and adjustments to the structure of the options market.

The final thought goes to the retail traders. If they wanted to strike out at Wall Street, they might try to target the volatility market (read Robert Harris’ The Fear Index), or more ambitiously if they really wanted to take on short sellers the asset with perhaps the biggest nominal short positions is the dollar. The dollar might spike, and the rest as they say, would be history!

Have a great week ahead,

Mike

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