by Marquis Cardwell
The GameStop market disruption has exposed the strength of self-directed investors and the power of online forums, which will force investment institutions to adapt their strategies to the rapidly growing market forces. This market disruption was spurred by r/wallstreetbets, a Reddit forum that actively targets stocks that have a possibility of exploiting structural weaknesses in the market.[1] This forum was able to amass millions of Reddit users (“Redditors”) to invest in GameStop, which was being heavily bet against by hedge funds who predicted the stock prices to decline.
The strategy of short selling, which was being used by these hedge funds and other traders, is applied when there is speculation that a stock’s share price will decrease.[2] In response, traders borrow shares of stock from investors that already hold the stock and then sell them into the market at the current prices; then buy the stocks back when the price decreases and return the stocks to the initial investor while retaining the difference.[3] Although taking a short position can yield high returns, it also comes with high risk because the stock price could increase rather than decrease as expected. This would cause for the trader to incur losses from paying the borrowed investor interest while also purchasing back the borrowed shares at a higher price than anticipated.[4]
A short squeeze is when a stock increases dramatically, forcing traders who speculate that the stock price would decrease to buy the higher priced stock to forestall greater losses.[5] The Redditors deployed this practice when they increased the share price and forced the traders taking short positions on GameStop to buy back the stocks at higher prices to mitigate their potential losses.
This phenomenon increased the upward pressure on the GameStop stock price, leading to disastrous financial losses for hedge funds and traders who bet against GameStop. As a result, GameStop’s stock price increased by 1910% and cost hedge funds $5 billion dollars over the course of two weeks.[6]
The Underlying Influences and Effects of the GameStop Market Disruption
The unrest and market interruption that ensued was a testament to the growing market presence and influence that self-directed investors have on the market. Self-directed investors are viewed as individuals that conduct their own research through digital forums, such as Twitter and Reddit, rather than relying on financial experts to make market decisions.[7] On the other hand, the prominent hedge funds and financial institutions utilize financial analysis and historical market trends to justify their investment strategies, whereas self-directed investors tend to rely more on passion and personal interest to direct their investments.[8] Self-directed investing leads to riskier investments with the hope of a greater return and to the shift away from the notion that a company’s stock price is representative of the expected future cash flows. As a result, there is a growing percentage of investment capital that cannot be calculated through traditional analysis.
The subgroup of self-directed investors were relatively small until internet access and innovative trading platforms became more prevalent over the past decade.[9] The growing estimate of self-directed investors is projected to be around 54 million investors in the United States alone, which is causing hedge funds and other financial institutions to pay attention to the rising counterpart in the marketplace.[10] Furthermore, the accessibility of online trading made available through platforms such as Robinhood, which was used by majority of the Reddit users to invest in GameStop, and other simple application based platforms has raised concerns about the gamification of investing.[11] Gamification is when companies deploy marketing techniques to increase investor engagement without equipping or informing the new investors of the risks and financial consequences that accompany trading.[12] For example, Massachusetts regulators have accused Robinhood of using gamification by stating, “ [Robinhood] used colorful confetti that appeared on-screen after deposits and trades — to incentivize continuous and repeated engagement with the application.”[13] On the flip side, it is important to note that online brokerage platforms, such as Robinhood, have successfully been able to increase access to investment markets that have long been perceived to have locked out individual investors and provide the average investor with a feasible way of trading.[14]
The Current Legal and Regulatory Landscape
Given that the GameStop incident had such a pronounced effect on the stock market, government regulators and the SEC are monitoring the situation for any possible legal ramifications, if any, that apply to the Redittors involved in the market disruption, Robinhood, and any other figures that were involved.
Pump and Dump
A pump and dump is a scheme that attempts to boost the price of a stock through recommendations based on false, misleading, or great exaggerated statements.[15] This scheme traditionally starts when an investor buys a stock in a company and falsely tells others that they have insider information to suggest the stock price is going to increase.[16] Under this assumption, other investors start to invest in the aforementioned stock which subsequently increases the stock price.[17] Then, the initial investor sells the stock at the higher price before the false information is made public, allowing the initial investor(s) to cash in on the profit while the deceived investors suffer tremendous losses.[18] For example, Enron executives used a pump and dump scheme in 2001 by falsely reporting profits and selling their shares at the inflated stock price before the false information was made public.[19]
The main difference between the scenario above is that there were not any purported claims that false or misleading information was shared within r/wallstreetbets. Instead, one of the users, named /u/keyboredwarrior stated, “We just need to hold and bleed them to death…. We got nothing to lose for holding the stock, they have billions to lose.”[20] Instead of stating monetary gains as their primary objective, the Reddit users stated that “punishing” the hedge fund short sellers was their primary motivation.[21] Given these insights, it is likely improbable that a successful pump and dump claim will be proven against the initial Reddit users that corralled other investors.
Market Manipulation
Another possible claim is market manipulation, which is when an individual artificially affects the supply or demand of the stock, leading to dramatic shifts in the stock price.[22] In order to prove a claim of market manipulation, the following four-part test must be satisfied: “(1) that the accused had the ability to influence market prices; (2) that the accused specifically intended to create or effect a price or price trend that does not reflect legitimate forces of supply and demand; (3) that artificial prices existed; and (4) that the accused caused the artificial prices.”[23] The public encouragement within the Reddit forum to drive the stock price up to short squeeze hedge funds presents some support for collusion. However, it will be difficult to prove that r/wallstreetbets was colluding based solely on the fact that an investor encouraged others to invest in a stock. For example, this scenario is no different than Elon Musk publicly announcing his stance on Twitter to his millions of followers regarding bitcoin, which “coincidentally” increased the stock price before Tesla announced their investment.[24] Furthermore, Robert Reich, former Secretary of Labor, said, “If Redditors rallying GameStop is unacceptable market manipulation, what would you call it when greedy Wall Street bankers gambled away our entire economy in 2008 and faced no consequences?”[25]
Robinhood: Market Manipulation
Market manipulation has also been discussed in relation to actions taken by Robinhood. On January 28th, Robinhood restricted their users’ ability to purchase GameStop stock and other companies targeted by r/wallstreetbets.[26] The next day, Robinhood allowed retail traders to purchase only one share of each company targeted, while hedge fund investors were allowed to buy and sell the stocks at unrestricted volumes on other select investment platforms.[27]
Robinhood stated that market volatility and regulatory requirements were the reasons for the restrictions. The company stated that they are required to keep a substantial amount of capital to process all trades and the increased trading of “volatile” stocks led to their clearinghouse, an intermediate between the seller and buyer, to request more collateral to secure the trades.[28] In response to this, Robinhood ceased purchases of eight stocks, including GameStop.[29]
This action has been scrutinized by many people as market manipulation because the actions taken by Robinhood to limit retail investing caused drastic shifts within the stock price and disproportionately disadvantaged individual traders. Jill Fischer, a securities law professor, stated, “It’s a little bit problematic to think about banning customers from some brokerage firms from trading the stock while others are free to do so.”[30] She also stated, “It’s much more common if there’s a stock that’s mispriced or a stock that’s unduly volatile for the exchanges to take action so that all investors are treated equally.”[31] The restrictions ultimately favored hedge funds and institutional investors that had access to other platforms to trade, while individual traders, who frequently trade on Robinhood, were stripped of their means to trade.
Robinhood’s actions have also drawn the attention of various politicians and the SEC, who have stated that they are going to review the actions taken that may have disadvantaged investors’ ability to trade.[32] There have also been various class action lawsuits filed against Robinhood that will be decided soon.
The Future Outlook of Investing
The reality of the situation is that self-directed investors are growing at an exponential rate, given the increased accessibility to online trading platforms. This trend will undoubtedly cause traditional financial institutions and hedge funds to account for the unpredictability that comes with self-directed investors. Although some financial pundits believe these market disruptions will have only minor repercussions, traditional investment companies and investors will have to acknowledge the growing presence of self-directed investors and how they will affect their investment practices. Furthermore, as a result of the Robinhood debacle, regulators will most likely impose regulations on online trading platforms to prevent the disadvantaged trading as seen here. The regulations and court decisions made in response will unquestionably shape how financial institutions, hedge funds, and individual investors operate going forward.
[1] Tracy Alloway, How ‘Flows Before Pros’ Is Disrupting Stock Markets, Bloomberg (Jan. 27, 2021), https://www.bloomberg.com/news/articles/2021-01-27/how-flows-before-pros-is-disrupting-stock-markets-quicktake
[2] Katherine Wiles, Is it Legal to Purposely Bankrupt a Hedge Fund?, Marketplace (Jan. 29, 2021), https://www.marketplace.org/2021/01/29/is-it-legal-to-purposely-bankrupt-a-hedge-fund/
[3] Brian Cromwell, What Just Happened? The GameStop Frenzy, Legal Questions, and Lessons for Companies, JD Supra (Feb. 4, 2021), https://www.jdsupra.com/legalnews/what-just-happened-the-gamestop-frenzy-2892854/
[4] Id.
[5] Id.
[6] Chris Arnold, GameStop Mania Likely Won’t Happen Again. Here’s How to Invest Wisely, NPR (Feb. 5, 2021), https://www.npr.org/2021/02/05/963787901/gamestop-mania-likely-wont-happen-again-heres-how-to-invest-wisely
[7] Hamza Mudassir, The GameStop Saga Started A Disruption That Cannot Be Stopped, Entrepreneur (Feb. 1, 2021), https://www.entrepreneur.com/article/364487
[8] Id.
[9] Id.
[10] Id.
[11] Mikhail Klimentov, The GameStop Stock Situation Isn’t About Populism. It’s About Whether the Market is ‘Real.’, The Washington Post (Feb. 1, 2021), https://www.washingtonpost.com/business/2021/02/01/understanding-gamestop-situation/
[12] Id.
[13] Id.
[14] Alloway, supra note 1.
[15] Cromwell, supra note 3.
[16] Id.
[17] Id.
[18] Id.
[19] Pump and Dump, http://thestockmarketwatch.com/learn/pump-and-dump/ (last visited March 23, 2021).
[20] Cromwell, supra note 3.
[21] Id.
[22] Id.
[23] Id.
[24] Christine Lee, SEC Should Monitor Tesla’s Elon Musk for Market Manipulation: Roubini, Yahoo! Finance (Feb. 10, 2021), https://finance.yahoo.com/news/sec-monitor-tesla-elon-musk-063109452.html
[25] Wiles, supra note 2.
[26] Oscar Gonzalez, Robinhood Backlash: What You Should Know About the GameStop Stock Controversy, CNET (Mar. 17, 2021), https://www.cnet.com/personal-finance/investing/robinhood-backlash-what-you-should-know-about-the-gamestop-stock-controversy/
[27] Id.
[28] Id.
[29] Id.
[30] David Brancaccio, GameStop Shares Back Up After Robinhood Relaxes Restrictions, Marketplace (Jan. 29, 2021), https://www.marketplace.org/2021/01/29/gamestop-shares-back-up-after-robinhood-relaxes-restrictions/
[31] Id.
[32] Id.
