After the furious divisions that followed the US presidential election in November, it is heartening to see a new spirit of unity among the country’s political class.
Ted Cruz, a Republican senator from Texas, and Alexandria Ocasio-Cortez (AOC), a Democrat representative from New York, can come together on the big issue of the day.
It is, they both agree, unacceptable that the Robinhood trading app should prevent retail investors from buying additional GameStop shares and driving up the price even further, breaking some more hedge funds in the process, but giving the rest of us our daily entertainment.
Reddit’s WallStreetBets crowd had only just got going, having driven the video game retailer’s stock from $17.25 at the start of January to $347.50 on January 27. Robinhood paused the game on Thursday, though it was set to resume limited buying on Friday.
The pressure is now mounting for the SEC to do something before … Gary Gensler takes office
By the time the app had limited purchases on GameStop and several other names, the Reddit buyers had already moved onto other shares also heavily shorted by the hedge funds, making the latter tremble at the losses they might suffer.
Cruz and AOC clearly both realize that many of us are in lockdown and that watching this has been the most fun we’ve had since, well, long-term capital management (LTCM).
The fantasy in the GameStop story is that this was the little guys taking on the big guys and winning for once – that is how they will try to make it look in the movie.
Robinhood, like all the other discount brokers, charges the Reddit bros zero commission for their trades. Somebody else is paying it. If you don’t understand what the product is, then you are the product.
In this case, the large market makers, including high-frequency trading (HFT) firms, are paying Robinhood for that vast retail order flow because they can make big money from it.
Give to the rich
Small investors may have convinced themselves Robinhood was on their side in this adventure – its marketing is all about democratizing finance, after all – and that they were somehow sticking it to the man together. But the broker’s whole business is payment for order flow.
Its two founders, Baiju Bhatt and Vladimir Tenev, built the trading technology for hedge funds and then founded a brokerage to feed them with trades. The market makers and HFTs will have extracted big profits from executing the high volumes that Robinhood routed to them at wide spreads that may not always have given those small investors the best price.
The bros presumably didn’t notice, as the stock was soaring anyway, although one or two may have dimly remembered Robinhood’s $65 million settlement with the Securities and Exchange Commission (SEC) way back in December 2020.
The little guys were only ever mincemeat being ground into the Wall Street machine. It was ever thus.
It is also always more tempting to believe in conspiracy theories than in facts. Not only were Robinhood’s true customers the big HFT firms – some associated with hedge funds – it also lists hedge funds among its owners.
Did these firms conclude that while it was nice to make money off all that retail volume and the spread, the damage to the hedge fund side had become too much?
Bad calls
The whole game became so big on Robinhood because, as well as zero commission stock trading, it also allows zero commission options trading, bringing an added leverage to the contest between the army of small buyers and the big hedge fund short-sellers.
Retail investors were buying calls from someone. Certain fund managers like to invest in stocks and then add premium income from selling calls against them so that they are already hedged. Others will sell the options first, perhaps taking a view that a stock widely shorted by hedge funds is unlikely to melt up, and only start to hedge in earnest if it does.
However, both listed and over-the-counter (OTC) options trading require regular revaluation and margin calls, which go up as the volatility of the underlying also increases.
When it prevented customers buying GameStop shares on Thursday, Robinhood said: “As a brokerage firm, we have many financial requirements, including SEC net capital obligations and clearinghouse deposits. Some of these requirements fluctuate based on volatility in the markets and can be substantial in the current environment.”
It added: “To be clear, this was a risk-management decision, and was not made on the direction of the market makers we route to.”
Here’s the problem. We live in a post-truth age. Even if this is the full story – and the statement makes no mention of direction from regulators or shareholders, including the hedge funds in Robinhood’s capitalization table – few small traders will believe it.
The first lawsuit fell within hours.
The pressure is now mounting for the SEC to do something before its newly nominated chair Gary Gensler takes office.
Popular rage
It is bizarre, meanwhile, that politicians appear to be defending the rights of small traders to manipulate the stock market on the grounds that the hedge funds and big Wall Street traders have always done so.
Large sections of the US population are today animated by rage: and rage against imagined injustices is every bit as powerful as rage against real ones.
Fury at the financial industry has run deep since the sub-prime mortgage crisis that began 14 years ago, when ordinary people got hurt and Wall Street got bailed out. There was never a reckoning.
The pandemic has fostered further inequality, more desperation, more anger.
Where that deep, popular rage now flows and how it impacts financial services will be the story, long after GameStop falls back into obscurity.
Rumours were rife in the first weeks of this year that Robinhood was preparing to list. It is almost a shame that it hasn’t already reversed into a Spac.
If it had, the hedge funds would now be going short.
