GME: Are Gamers Gaming the Markets?

It seemed innocent enough, at least at first. There was a group of traders eager to learn from each other communicating in an online forum, sharing tips, and offering insights. The subreddit thread, r/WallStreetBets, was rapidly gaining popularity and currently boasts nearly 8 million members. Fine, no cause for alarm there.

Then Steve Cohen, the billionaire owner of the New York Mets and lead investor behind the hedge fund, Point72, shorted GameStop on January 16, 2021. That’s when things started to unravel for the big investors – only they didn’t realize the unraveling had begun – that didn’t happen until a few days later when it was already too late. On January 18, 2021, Joe Feldman, one of the analysts at Telsey Advisory Group, cut his rating to “underperform” which is code for “sell now.” Soon thereafter, Ken Griffin, the investor behind the hedge fund, D1 Capital Partners, also shorted the stock, which was trading under $40 per share at that time.

GameStop, a brick-and-mortar gaming and entertainment retail business, had seen declining sales for years, posting losses over $600 million in 2018 and nearly $200 million in 2020. Analysts started betting against it, foreshadowing its pending demise. After its stock was shorted, things got really interesting as a group of determined and relentless Redditors publicly played out a pump-and-dump scheme. The net effect has driven GameStop stocks up 1700%, transformed thousands of small-time low net-worth individuals into millionaires on paper, spurred hedge fund losses in excess of $20 Billion, brought the brokerage Robinhood to its knees, and forced Cohen off social media and into the arms of an enhanced security detail. Even the celebrity host of The Daily Show, Trevor Noah, got into the act with his viral video parody of Margot Robbie’s famous bubble-bath scene from the movie, “The Big Short.” And that’s just what happened in the past seven days…

Whoa! Isn’t that collusion and market fraud? Indeed, it appears that Redditors are gaming the markets. They’re publicly targeting the big hedge funds as an overt way of holding them responsible for the 2008 Financial Crisis which left countless everyday average citizens in dire financial straits but resulted in essentially no punitive action against those who perpetrated the Crisis. Now, it’s payback time – and these Redditors are just getting started. It’s only Week 2 since their war on Wall Street began and they’ve already moved on from GameStop: today, they’ve started squeezing silver with #silversqueeze now trending on social media.

Isn’t that illegal?

Yes and no. Redditors defend their actions citing how hedge funds “do this all the time;” shorting stocks, buying it en bloc, then the investors collect their profits. The masses on the subreddit thread are arguing that the shorts placed on GameStop by hedge funds were “inflated” and “artificially large.” Posing the question more narrowly, is it illegal to bankrupt a hedge fund? No, it’s not; well, not exactly. However, what it has done is put social media into the crosshairs of regulatory agencies. More on that in a moment.

When analysts or hedge funds “short” a stock, it means that they anticipate that the share prices will soon drop. Traders borrow shares from brokers and sell them back into the market at the price listed at the time of the transaction. Once the shares drop, traders buy them back, return the stocks back to the brokers, and pocket the difference. All that is standard and perfectly legal. But it assumes that the share prices go down – the situation changes drastically if the prices are driven up before that buy-back transpires. And that’s exactly what happened with GameStop which sent all the hedge funds that shorted the stock racing to the bottom, losing millions by the minute.

Using social media or whatever e-Communications channel to broadcast your intention to buy or sell stocks is legal. Nothing untoward there at all with that behavior. The SEC – or the hedge funds – can cry foul only if it can be demonstrated that traders knowingly spread false information to manipulate the stock price. Proving that is not easy to do, even if every opinion and insight is expressed right there, in black and white, on a social networking channel, so it’s unlikely that any Redditors are going to be prosecuted. One of the immediate challenges is sorting through all those DMs and posts, then interpreting the nuances therein to insinuate any contextual reference which supports a claim of market fraud: here, the technology is lagging and only Shield can do this effectively.

Where things enter murky waters is in the behaviors of the retail ‘app’ brokers themselves. Robinhood halted trading which may – or may not have – disadvantaged some investors, small investors in particular. Moreover, the halt may have protected big investors from greater losses. By inhibiting the ability to trade certain securities, brokers may be charged with aiding manipulative or abusive market schemes. And the SEC makes it very clear that doing so is illegal.

That said, the verdict won’t be out on this part of the story anytime soon but it isn’t the first time that Robinhood has faced regtech scrutiny. Watchdogs are currently scrutinizing every move in this battle between amateur traders and Wall Street pros, and they’re now paying close attention to trade discussions on social media and monitoring for lawbreaking. With their IPO pending, Robinhood recently agreed to pay a $65 million fine levied by the SEC because broker-dealers like Robinhood have a “duty of best execution” which means they have to trade based on the best terms available at the time of the transaction  Robinhood also places 39% of its orders with Citadel, a financial firm that is already under regulatory scrutiny for its deal flow. This part is really messy: Melvin shorted GameStop then Citadel, which is backed by Ken Griffin, bailed out Melvin to the tune of $2.75 billion.

What about collusion?

That’s where things get more interesting. Social media and the rise of influencers coupled with increased accessibility (where low-dough investors can chip in and buy stocks together to gain entry – even to exclusive markets) have made it possible for communities to rally around a ringleader. Individuals can choose to become part of the collective or pursue investment independently once they get the “scoop” on which path the majority are inclined to take. And that’s the grey zone that has everyone talking.

Individuals are making a choice whether or not to follow the cues from an influencer on social media. It’s quite another thing to sift through all those emojis and short-hand cryptic messages to correctly assess if individuals colluded to deliberately manipulate the markets as part of a master plan. The other missing piece is that general traffic of the social media channels is not monitored for market fraud; only the e-Comms of registered brokers and traders are monitored. This could change.

Exacerbating the complexity around the legal question of financial fraud that has been committed by the Redditors involved is the issue around identity. Most Redditors use avatars and operate online anonymously, many with untraceable accounts. Some of the Redditors involved have been revealed to be as young as 10 years old. Extrapolating from here, one could argue that a bunch of teenagers had the guile to rally other members of their community to manipulate the markets so quickly that $20 billion was lost before anyone even knew what was happening.

The question is, what happens now that we know silver is the next target of this cadre of online “bandits?” Can the SEC and other agencies in regtech move swiftly enough to legalize the surveillance of social media across all channels to monitor for Collusion and to sniff for potential acts of market abuse before they happen? With technology in place to do so, can hedge funds targeted by such nefarious schemes then charge Big Tech with being complicit for allowing investment conversations to occur between rogue traders and hence, enable market fraud? An even more provocative question is centered on the strength of the Reddit community – is it strong and swift enough that it can “trap” investors with a false squeeze as a diversion tactic to obfuscate some other plan?

We’ll have to watch things closely to see how this war between the “haves” and the “have nots” plays out. For now, what we do know is that a bunch of smart teenage gamers gamed the markets to the tune of $20 billion in losses on Wall Street – and counting.