The GameStop saga was never about the little guy. It’s about hedge funds and big investors making money – at the expense of the amateur trader
For a few days, at least, it looked like a 21st century twist on the David and Goliath story just when we all needed to hear something uplifting. A group of small-time retail investors, many of them motivated by anger at Wall Street over the 2008 financial crash and the subprime crisis, had found a way to take down a big hedge fund – and make millions in the process.
Even better, the efforts seemed to be boosting the fortunes – and share price – of a bricks-and-mortar US video games retailer, called GameStop, a company viewed with affection by many of the online traders.
Using a share trading app named RobinHood and coordinating on the WallStreetBets Reddit forum, these small-time investors had spotted a hedge fund with a huge short position against the company – essentially a bet that its share price would fall.
By coordinating and buying the share in huge numbers, the stock price jumped from $20, to $50, to $100, $200 and eventually over $400. The hedge fund was facing bankruptcy, the retail traders were looking at astronomical profits – it was a scene from the end of a movie.
Until it wasn’t.
“Frank Capra always did the triumph of democracy – the little man [prevailing] over the powerful hidden interests. And for the first week-and-a-half, it looked like the people at Robinhood were going to dominate those short sellers,” says Professor John C. Coffee Jr, director of the Center on Corporate Governance at Columbia University Law School. “Unfortunately, once the tug of war is over, the little guy seems to have lost his shirt.”
A few weeks after the adrenaline rush of the GameStop phenomenon, and the coverage that accompanied it, the story looks very different. Yes, a group of traders had spotted the opportunity to make money from a “short squeeze”, but they had also deliberately or otherwise pulled in many more casual amateur traders convinced they were on to a sure bet – who then lost almost all of their investment overnight as GameStop dropped from $400 to $50 or so.
Analysis of US Securities and Exchange Commission filings, the WallStreetBets forum and input from experts reveals the GameStop phenomenon was, in reality, not a one-off good versus evil battle. Instead, it’s something more complex but perhaps even more important: a rare mass-media display of a new era of trading, in which hedge funds do battle, big institutional investors make money, and amateur traders get caught in the middle, becoming pawns in a bigger game.
The core elements of the story were true: the big hedge fund, Melvin Capital, did have a huge short position on GameStop and did lose so much money it needed a bail out from two institutional investors – one of whom, Citadel, in an ironic sign of this close-knit world is a financial backer of the RobinHood app, too.
Short selling works by borrowing a share (for a small fee) from someone who holds it and agreeing to give it back on a particular date. The borrower – in this case Melvin Capital – then immediately sells the share. They then re-buy the share when it comes time to give it back. This means if the share price has fallen, they buy back the shares much more cheaply, and make a huge profit.
But it also means that if people spot someone has a huge short position that’s due soon, they will soon have to buy potentially huge numbers of a company’s shares. That was the situation some WallStreetBets users spotted. What if, they asked themselves, we kept buying shares ahead of that key date, and all refused to sell them? The stock price could rocket and Melvin Capital would still be forced to buy them.
But while WallStreetBets posters promised one another they weren’t selling their shares – meaning Melvin would not be able to close its short position, leaving its losses virtually unlimited – bigger shareholders were quietly doing just that.
While one hedge fund was losing a fortune, other hedge funds and institutional investors were raking it in, if nothing else for the simple reason that they were the original shareholders of GameStop. Someone, after all, had to own the bulk of the shares in the first place – and like with most companies, these were generally the major institutional investment funds that manage most people’s pensions savings.
These institutional investors had every incentive to sell at huge profit, allowing Melvin to announce it had finally (at great loss) closed its short position, meaning there was no longer any reason whatsoever for GameStop’s hugely inflated valuation.
The South Korean hedge fund MUST Asset Management had owned around 4.7 per cent of GameStop since early 2020 and sold its entire stake during the mad few days of late January – potentially making up to a billion dollars. Another hedge fund, Senvest, made around $700 million in a similar manner – after deciding to sell all of its GameStop holdings after Tesla and SpaceX boss Elon Musk tweeted “Gamestonk!!”.
Musk, notorious for jumping into stock market excitement, was using WallStreetBets slang in a way that was understood to be hyping the stock. Senvest, instead, took it as a good signal the price had gone about as high as it was going to go – and seized their moment.
The professional traders knew the top of the market when they saw it – but many WallStreetBets traders let the moment pass them by: the culture of the Reddit board encouraged people to hold long past the moment that made financial sense. People who held their shares got social credit for their “diamond hands” while those who chickened out and sold had “poop hands”. Posters on the forum kept telling themselves and others stories about why holding made sense – including just wishfully hoping Melvin Capital had lied about closing its short position.
“WallStreetBets, the Subreddit website is where I believe sincere people who have been sucked into this cult, and they drunk in the Kool-Aid,” concludes Coffee. “And the Kool-Aid has now poisoned them.”
In reality, the online traders were not walking into a staid and slow-moving world when they took on the hedge funds – hedge fund traders exist to make aggressive and audacious bets with the potential of huge profits.
Examples abound in business history: George Soros famously made a billion pounds in less than 24 hours after making a huge bet against the UK’s ability to remain in the exchange rate mechanism – leading to a public humiliation of John Major’s government in the early 1990s, from which it never really recovered.
More recently, prominent hedge funder Bill Ackman made a huge bet against the company Herbalife, saying it was little more than a pyramid scheme, eventually losing more than $1 billion after his rival Carl Icahn helped the company fight him off.
Hedge fund traders live for this kind of cut and thrust. Taking them on is a little like challenging Roger Federer to a game of tennis – it’s absolutely possible you might win, just don’t expect many people to be betting on you.
Against that backdrop, the idea that traders who look for every informational advantage, every edge they could possibly get might be unaware of a major trading board seems an unlikely one.
Such was the anger at the losses that many of the forum came up with conspiratorial explanations – fuelled by RobinHood suspending the ability to buy shares at several key moments during the week. In practice, it was merely having to raise more funds to meet regulatory requirements against its vastly increased trading volumes.
But that explanation seemed hard to swallow for many forum users – especially as they discovered RobinHood’s investors included hedge funds and its business model relies on selling hedge funds information on its deal flow – the trades its users are making – in real time. The practice is publicly announced and completely within the rules, but to some on the forum it clearly felt like Robin Hood had become an informant for the Sherriff of Nottingham.
In practice, it is clear professional traders were at the very least monitoring WallStreetBets to see what the retail investors were doing and whether there was an opportunity for profit therein. That would be completely within the rules – but the Wall Street Journal reports federal prosecutors are investigating whether professional traders may have manipulated the board, which could be a criminal offence. They have not named any particular traders or funds that are under suspicion.
The forum is, in practice, a mix of professional traders – people who can tweet screenshots from Bloomberg terminals which cost tens of thousands of dollars a year – small-time stockbrokers, semi-professionals and amateurs.
Media coverage of the forum seemed to also pull in complete amateurs: analysis by payment provider Cardify found 60 per cent of people who bought GameStop in January had never bought a share before. Some day traders are sophisticated operators who know the risks they’re taking – but some clearly are not.
How, then, do we regulate a market to protect people, while not interfering with either their free speech to say what they’d like about a company – and buy and sell as they wish – without leaving them open to exploitation?
For Professor Coffee, part of the answer lies in the fact professional traders are already regulated – noting that one of the most prominent GameStop boosters on WallStreetBets, Keith Gill, was a professional broker.
“Okay, he has a broker’s licence,” says Coffee. “The rules that apply to him and that can be most easily enforced are the rules not of the SEC [Securities and Exchange Commission], but of Finra [Financial Industry Regulatory Authority]. The advantages to Finra is in theory, a private club… It’s not subject to the Constitution and the Bill of Rights.”
He continued: “They have rules, restricting the kind of enthusiastic statements and promises you can make. So Finra could impose what are called moderate sanctions, they are not going to be able to put you in prison, but they could bar you from the industry. And most brokers don’t want to be barred from life or even six months from the industry. So they have the ability to say ‘calm your speech’. Do not, as a broker, tell anyone there’s going to be 100 per cent gains or anything like that.”
Others think the world is changing so much that we may need to go further. The traditional (and best) advice when it comes to investing is to buy an index-linked stock fund with the lowest fees possible, and then don’t touch it for years – ideally, don’t even look at it.
Day trading is the hope that you can outsmart the collective trading expertise, ruthlessness and house advantage of the entire world. The overwhelming majority of people who try it fail.
But that’s not stopping ever-more people doing so: the coronavirus pandemic means many people who were already well off have money sitting doing nothing, accumulating no interest, and lots of them have too much free time on their hands. Coupled with apps which incentivise frequent trading – and make it in many ways like a game – and westerners are day trading like never before.
Professor of Accounting Alex Preda, of King’s College London, says that in recent months around 25 per cent of all US trading volume has been from retail investors – a new phenomenon for the country, though a longstanding one in many Asian countries, where retail investors can make up around 35 per cent of trading.
Preda suggests a world in which regular people are trading regularly and in large volumes might need different rules to the ones that already exist – perhaps even trying to find a way to silo day traders and amateur investors away from the huge movements of the hedge funds.
“In boxing, you have heavyweights, and you have a bantam category, you don’t pitch them against each other,” he says “because they’re not symmetric – you know?”
What was presented as a David vs Goliath narrative seems to have had a much more complex underlying reality: online traders might have created an opportunity for profit, but it was the professionals who had the ability to capitalise on it, while the amateurs got crushed in the machinery.
Hedge funds are increasingly automating their trade and their research: algorithms – and perhaps in the next few years, more fully-fledged AIs – monitor the markets, but also anything that moves the markets. For several, that includes social media. The house has every advantage: more money, more connections, more tools and more information.
GameStop perhaps does serve as a parable – but not a biblical one. Instead, Preda suggests, we should maybe look towards science fiction. “It’s a utopian narrative, it’s a populist narrative to be very honest with you, to have the small guys here against Goliath … we know that picture is much more complex,” he concludes.
“It sends me more in the direction of Philip K. Dick – I won’t say Blade Runner, but it’s a world where robots or artificial intelligence play a more prominent role.”
Photographs Getty Images and YouTube