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Hedge Fund vs Retail: GameStop Showdown

By Eduardo David Dana

Last month, an unprecedented financial event took place in which retail investors unified to beat the big, scary hedge fund managers at their own game. The outcome saw the stock prices of GameStop and other heavily shorted companies shoot up to over 1,700 percent in a matter of days. Retail investing platforms such as Robinhood took matters into their own hands, placing restrictions on buying these individual stocks. This resulted in many controversies as it deprived everyday retail investors of freely and fairly trading on the stock market, a right that everybody should have.

About five months ago, users of Reddit, a popular social discussion website, discovered that GameStop, an electronics and video game company was the most shorted company listed on the stock market. Shorting occurs when investors believe that a price of a stock will go down. Thus, they can “borrow” shares of a company from someone else to pay it back and then sell the share at its current value. If the price of the stock goes down, then the investor who shorted the company can buy back the share at a lower price to pay back the original lender. He then gets to keep the profit he made from selling it at a higher price beforehand.

Many hedge fund managers and large-scale investors believed that GameStop was destined to go out of business; the rise of e-commerce has made physical stores unnecessary as downloading video games online is more efficient and less time-consuming. Thus, as Covid-19 brought these concerns to light, GameStop became the most heavily shorted company on Wall Street. More shares of GameStop were shorted than were tradable; 113% of total GameStop shares were held at short positions. A group of Reddit users messaging on the subreddit page, r/wallstreetbets, decided they would legally take advantage of this phenomenon, by buying up shares of GameStop and other heavily shorted stocks. This would cause the price of GameStop shares to significantly rise, leading to a short squeeze; When short-sellers had to pay back their shares to close their positions, they were forced to try to pay this artificially inflated price. However, when Reddit users decided they would hold their line and not sell their shares, shorters had no choice but to offer higher prices for the stock. Higher demand from this caused stock prices to surge even further, causing short sellers to offer even higher prices. This led to even higher stock prices. This cycle continued, causing shares of GameStop to rise from around 40 dollars on January 21st to close to 350 dollars a share just five days later. Shares of other heavily shorted companies such as BlackBerry and AMC Entertainment also surged by over 400%.

Hedge fund managers, the primary short sellers of these companies, were at the short end of the stick; they had shorted an enormous amount of GameStop shares, betting that the stock would go down. When the stock price soared, hedge funds still had to buy back these shares to pay back their borrowers; hedge funds had to pay premium prices to exit these costly short positions. This phenomenon caused hedge funds to lose billions; it is estimated that hedge funds lost nearly $13 billion in January alone. The large hedge fund, Melvin Capital incurred 53% of losses for the month while other hedge funds such as Citadel and Point72 were also hit hard. On the other hand, Reddit users who had unified to buy greatly discounted shares beforehand were winning big. Because they decided they would buy shares prior and not sell, Reddit users were at an advantage when hedge funds kept offering higher prices to exit their short positions. Ultimately, with Reddit users not backing down and selling their shares, the shares of GameStop kept rising. Shares that were purchased at affordable prices before the short squeeze were now trading for over 1000% more; a Reddit user’s $50 thousand worth of GameStop shares bought in 2019 went up to over $22 million in value. Another user shared screenshots of his GameStop shares on the app, showing that he was up nearly $48 million. Many traders claimed they were able to pay off their mortgages and student debts from profits made from investing in GameStop. Thus, there was a stark contrast between retail investors on one hand making fortunes and hedge fund managers, who were losing badly. These big losses put retail stockbrokers such as Robinhood in a difficult situation; Reddit users were primarily using these user-friendly trading platforms in their GameStop raid. The increased workflow, app traffic, and external influence raised issues for these retail stockbrokers.

Popular trading platforms such as TD Ameritrade, E-Trade, and Robinhood saw a much higher volume in trading. Many new retail investors who wanted to get in on the action even opened up trading accounts for the very first time. Over six million accounts were created dumping large sums of money into incredibly volatile shares of GameStop, AMC, and others. The increased trading on these apps led to various issues and responses. Specifically, for Robinhood the increased cash flow and trading activity caused key problems; to “meet deposit and collateral requirements” Robinhood placed trading restrictions on stocks at the center of this hype, including those of GameStop and AMC. When Robinhood users purchase a stock, Robinhood outsources the market transaction to a third party, Citadel Securities. Citadel then pays Robinhood a return from bringing in this business. Robinhood is then required to cover the tab and payback Citadel for the shares it outsourced in the form of deposits. Due to the increased traffic from eager traders, Robinhood was processing much more orders than usual. Thus, they were required to pay Citadel a heavy sum in deposits for facilitating these orders; according to Robinhood CEO Vlad Tenev, Tenev received a call from Citadel that he had to put up over $3 billion in deposits, which he did not have; his only choice was to temporarily restrict users from buying these hot stocks to reduce the workflow so Robinhood could meet its deposit and clearing requirements. Thus, Robinhood users were temporarily unable to buy shares of these companies and could only sell their existing positions. This angered many users since only being able to sell led to a drastic decrease in stock prices, making their positions significantly less valuable. Because of restrictions on the buying of GameStop, shares of the company fell more than 44% in a single day. This greatly harmed retail investors as their goal was not to sell so that hedge fund managers would have to offer higher prices to exit their short positions. Ideally, this would cause GameStop to continue rising. However, since traders could only sell their positions, share prices dropped significantly, greatly harming many retail investors who got in late on the action. On the other hand, lower stock prices now meant that hedge funds could clear their shorts at a more affordable cost, which they did.

Thus, many traders were infuriated at Robinhood for disabling them from buying shares. Retail traders felt they should have the same opportunity to buy shares as hedge funds and large corporate investors do. Many retail investors lost money because of this phenomenon leading to widespread disproval of Robinhood’s one-sided response; many people accused Robinhood of favoring big hedge funds at the expense of everyday retail traders it is supposed to protect. Many think Robinhood purposely manipulated stock prices, a financial crime, to stop hedge funds from losing too much. The interesting part is that Citadel Securities is also a large hedge fund largely invested in GameStop short positions. Thus, when hedge funds like Citadel were losing big, many believe that Robinhood faced pressure from them to restrict trading. Some commentators believe Citadel along with other hedge funds colluded with Robinhood to halt the buying of certain stocks like GameStop and AMC. Robinhood claims they took these measures solely to meet “deposit and collateral requirements” and that there was no market manipulation or collusion of any sort. This did not stop these commentators from taking to social media to express their outrage towards Robinhood.

The world’s richest man, Elon Musk, grilled Robinhood’s CEO, Vlad Tenev on the audio-chat app, Clubhouse. Musk questioned Tenev on the true motives behind Robinhood’s trading restrictions; he even directly asked Tenev if there was anything mischievous or shady happening, which Tenev denied. David Portnoy, the founder of the popular digital media company, Barstool Sports, expressed his anger on Fox News, even calling for people on Wall Street to go to jail for collusion. Thousands of angry traders took to the Apple store and Google Play store to write negative reviews, giving the app a one-star rating. US congresswomen, Alexandria Ocasio-Cortez, tweeted that she would support a hearing and full investigation into Robinhood’s decision to block traders from buying stock. This occurred, as Robinhood was bashed by US lawmakers at their congressional hearing on February 18th. Politicians left, right, and center grilled Robinhood and large hedge fund CEOs, questioning the purpose behind Robinhood’s restrictions. Thus, there was a consensus casting hedge funds and Robinhood as the evil villains; Corporate America was at war against everybody else.

Regardless whether Robinhood did or did not purposely obstruct trading to bail out hedge funds, a capitalistic society should never restrict its citizens from competing in the free market. An indispensable pillar of capitalism is freedom of opportunity for everyone based on merit. Under Laissez-Faire capitalism, it is fundamental that people have the opportunity to move up the socio-economic hierarchy. Whatever other pressures Robinhood could have been faced with, preventing people from buying shares of a company, is a completely unacceptable response; just because some people are losing money by taking financial risks, it does not mean Robinhood should have prevented its users from trading in the open market. Regardless of where one begins in life, capitalism should offer a way for people to rise above their current state to innovate and provide for themselves. Not allowing people to fairly compete in the free market completely excludes this possibility. It is in society’s best interest that people compete in the free market; this allows for entrepreneurship and innovation. Most of the world’s innovative breakthroughs were incentived by people’s personal desire to move up the societal class structure.

In conclusion, this January retail traders went to war against corporate investors and hedge fund managers, in an unprecedented event. Retail stockbrokers such as Robinhood reacted by restricting trading from average Americans to save hedge funds from heavy losses. This response was refuted by many believing everybody should have the right to compete in the free market; it is a capitalistic society’s duty to ensure everyone has the opportunity to trade fairly and equally in an open market.

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