GameStop. Hedge Funds. Wall Street Bets. Robinhood. What was it all?

You can read about the story pretty much anywhere at the moment, so we’ll briefly run through it and then take a look at a few other aspects we think are important and unlikely to see as much attention.

In the last week of January, the price of the stock in GameStop (NYSE: GME) – an ailing brick-and-mortar video game retailer – very suddenly skyrocketed.  Many locals may not be familiar with Gamestop but they might have seen it’s subsidiary EB Games in Napier & Hastings.

Shares in GME rocketed 1,700% in the last three weeks, closing at US$325 per share on 29 January and giving GameStop a market cap of nearly US$17 billion.

Nothing happened within the company to drive the increase; its fundamentals remain unchanged. It was purely a speculation bubble – but with a twist.

A group of people on ‘Wall Street Bets’, a subsection of an internet forum called Reddit, essentially took a dislike to the fact a video game retailer called GameStop was being shorted by a group of Wall Street hedge funds.

Shorting is an investment tactic where a larger investor, like a hedge fund, make money on stocks for which the price is falling. It is called short selling (or going short).

In the case of GameStop, some Wall Street Bets users argued that the stock was actually undervalued, and the hedge fund shorting was unwarranted and unjust. This snowballed into many Wall Street Bets users deciding to buy GameStop stock to push the price higher, hopefully forcing hedge funds to exit their short positions at a significant loss.

At the time of writing this article on 3 Feb, the stock price has been cratering and fell 60% to close at US$92.

What about Robinhood? That’s the free broker many armchair investors’ are using.

How Financial Markets Work

The new apps and trading platforms that have arrived on the scene over the past few years have been termed as democratising financial markets. They are low cost (some even free) and they are targeted at younger investors. Not paying money to trade may feel good, but nothing is free so then the question becomes who is paying? It’s very complex.

These el-cheapo brokerage apps and platforms that are being pushed at young investors aren’t free. They all come with a cost. If you cannot see the risk, then you haven’t found it yet. If you can’t see the cost, then you haven’t found it.

In the case of Robinhood, its customers’ trades were routed through a hedge fund called Citadel. It paid Robinhood for this privilege, meaning it makes the market, taking the order and then flipping it to collect the spread. Robinhood doesn’t charge its users brokerage, but the users pay through Citadel cutting ahead of them, along with the collection of their data.

This is one of those areas where people who hate paying can feel like they aren’t paying because there’s not an itemised line of how much this process costs them.

The other issue, brokerages and platforms cost money to run. There are transaction costs as money is held to settle and a lot of the trades are done on margin. Brokerages require liquidity as credit is needed. Robinhood and other brokers were overwhelmed by what took place and had to halt trading. At one point, users could only sell their positions, which caused outrage. There have been claims of conspiracy, but no one should be surprised when cut-price platforms deliver cut-price results. Cut-price broker systems and their liquidity position likely couldn’t handle the situation as they’re not set up for what is occurring.

During the GameStop episode, Robinhood’s problem was that it had been operating with too thin a margin. When faced with both regulatory constraints (in the form of capital requirements) and demands from its market clearinghouse that it put up more deposits to back its trading, it faced the prospect of being unable to pay off customers who had won their bets.

Robinhood has been able to raise more capital and will survive, albeit possibly in a diminished form. But a capable regulator such as Gary Gensler, if he is confirmed as the SEC’s new chair, might decide to tighten the regulations that led Robinhood to restrict trading – say, by raising capital requirements.

A key part of any investment is understanding custody risk. Financial Advisers act on behalf of investors making decisions, not just in how we invest, but where investments are held. We ensure investors have custodians of the highest quality. The DIY crew are often looking for the cheapest option. It’s great to say you pay nothing. And nothing may ever go wrong, but these are concerns that you want to be eliminated. Brokerages and custodians have failed in the past and they are a nightmare for investors.

The Media

As you’d expect, the media have been covering this extensively. The response, depending on where you look, was confusion, bemusement, or condemnation. It was quick to use the ‘David vs Goliath’ story angle. Everyone gets to shake their fists and take revenge on the big guys. There were plenty suggesting this was a revolution and revenge. There was plenty of focus on a small number of investors who’d made out with big money gains. The reality will be different.

Given what we were talking about last week, getting caught in a wave of emotion is dangerous. People talking about never selling and not caring if they lose money is ridiculous. In the heat of the moment people can readily lie to themselves and believe ridiculous things.

Like always, there will be a select few who make out like bandits. These people will attract the media attention and get interviewed about their gains. Those investors who racked up large losses thinking they were part of a movement will realise there will be no adulation for their efforts and will be quickly forgotten. That was real money they lost.

Despite the media and politicians jumping on the bandwagon claiming there’s a populist revolution going on and the little investor is beating Wall Street, there’s likely a little more to it.

Does any of this matter to you?

Not really. It’s an interesting story, but if you have a boring aka sensible portfolio, it’s just another sideshow on the investing journey. As far as a populist revolution and the little guys getting back one on Wall Street? That happened with the first retail index fund in the 1970s.

• This article is prepared in association with Mancell Financial Group, Australia. The information provided, or any opinions expressed in this article, are of a general nature only and should not be construed or relied on as a recommendation to invest in a financial product or class of financial products. You should seek financial advice specific to your circumstances from a Financial Adviser before making any financial decisions. A disclosure statement can be obtained free of charge by calling 0800 878 961 or visit our website, www.stewartgroup.co.nz