Power To the People or Death To the Market?

Published by PolisPandit on January 31, 2021January 31, 2021

There is comedy and a certain amount of “fight the power” when reading about average people like “DeepF—ingValue” squeezing a sophisticated hedge fund’s short position.  After decades of hearing about Wall Street’s woes, and with expanding inequality across America, it is hard not to like these modern day Robinhoods.  But we must ask ourselves – is this the type of activity we want in capital markets?  Bands of people encouraging each other to pump up stocks to squeeze a hedge fund’s short position?  It is basically a modified version of a pump-and-dump scheme.  Although these individuals may not be communicating false or misleading information to encourage others to buy, their touting of a stock that has no reasonable basis in economic fundamentals and appears primarily designed to push its price higher is arguably market manipulation.  Instead of empowering the people, this behavior compromises market integrity and investor confidence.

There are better – and more legal – forms of populist action to stem the tide of inequality and inject more fairness into the market.  The bands of marauders from Wallstreetbets share the same collective disgust of the “system” as the far right extremists who supported the attempted coup on America’s democratic process.  In both cases, there are legitimate avenues for protest that were disregarded in favor of disrupting market integrity or the functioning of democracy itself.  The following explains why (i) these Wallstreetbets populists need to have “clean hands” if they want to highlight inequities in the financial system; (ii) the brokerage platform, Robinhood, should have taken alternative approaches to addressing the volatile trading instead of shutting down buying in certain securities; (iii) the benefits of short-selling actually outweigh its costs; and (iv) the risks to capital markets and individual investors as a whole is significant unless something is done to police populist market uprisings.  

Populists with Unclean Hands

While it’s entertaining to watch guys sitting on their basement sofa in their underwear stick it to “man”, the way they are doing it is arguably manipulative.  There is a maxim of equity under the law called the Clean Hands Doctrine that basically states one cannot make a claim when they have engaged in wrongful conduct themselves.  So while I am sympathetic to arguments that certain areas of the financial industry need reform, advocating for reform by targeting specific market participants with a group of fellow individual “investors” and driving up prices of securities in a coordinated way that purposely disadvantages that market participant is not the way to do it.

If individuals separately or even collectively decided they like a stock and think it has good value or potential, then by all means, invest.  If they band together, however, for the dominant purpose of driving up the stock’s price or to disadvantage someone specifically, there is an argument that the conduct is manipulative.  Whether it can be successfully prosecuted is a separate question.  It would probably be difficult to target any one person if numerous people are in it together.  With that said, just as when everyone speeds on the freeway, the police will pick off someone sooner or later.  

The bottom line here is that the scenario is not as simple as David v. Goliath.  It is not a straightforward tale of the innocent little guy v. the bad big guy.  The little guys here were by most accounts purposely trying to stick it to the big guy who had been backed into a corner.  Was that refreshing to see for many, even people like Elon Musk who has a history of battling Tesla short sellers?  Yes, without a doubt.  But it is hard to argue that Wall Street institutions should be punished until the end of time for manipulation and fraud (both of which are illegal even for them), when the people crying foul are engaging in the very activity they are trying to prevent.  This is about as unclean as it gets.  Anyone who manipulates the price of a financial product – whether Wall St. insider or underwear guy on his couch – should face civil and criminal penalties.  

Robinhood and Other Brokers Were Not Clean Either

Speaking of unclean, the decision by Robinhood and other brokers to halt buying in stocks like GameStop is one they will likely regret for years to come.  First, there were far better alternatives available.  Second, it kind of goes against the entire ethos of Robinhood in particular – they are supposedly a platform for the little guy or retail investor and their decision prevented many of its customers from trading when they wanted to (in turn benefiting hedge funds who were trying to exit their short positions at better prices).  Third, the relationship between Robinhood and Citadel and Point 72 is just dirty in the context of this entire debacle.  No better way to put it.  And finally, they better lawyer up because the class action parade has only just begun.

When it comes to alternatives to halting buy trades in stocks like GameStop, I keep asking myself why Robinhood simply didn’t raise margin requirements.  This move would have basically made it more expensive to trade or put on new buy positions in that group of stocks.  There would have been an extra cost, but customers still would have been able to execute trades if they really wanted to.  With the additional margin, Robinhood would have mitigated its downside risk, accounting for the increased volatility.  This should have addressed the concerns cited when justifying their decision to halt buying in certain securities.  This is not legal advice, but perhaps some enterprising lawyer will raise the point in one of the class actions that follow.

The other fact that reeks of impropriety here is the relationship Robinhood has with Citadel and Point 72.  The latter two firms extended loans to Melvin Capital, the hedge fund that found itself in Wallstreetbets’ crosshairs.  The loans amounted to some $2.5 billion.  Melvin Capital was bleeding losses.  It was in Citadel and Point 72’s best interest to prevent additional buying in stocks like GameStop by retail investors.  In addition to this incentive, Citadel has an ownership stake in Robinhood.  Yes, you read that correctly.  It also pays Robinhood for order flow.  This payment for order flow arrangement allows Robinhood to profit from retail investor trades that it routes to Citadel for execution.  Murky enough for you?  Now when you consider Robinhood’s decision to prevent those same retail investors from buying additional shares in securities that were detrimentally affecting Melvin Capital, it seems damning given the context.  Again, this is not legal advice, but the Sherman Act has a thing or two to say about conspiracies to restrain trade.

Short Selling Provides Transparency

Most of the arguments to justify the actions of Wallstreetbets highlight or center on the “unfair” practice of short selling.  Many people unfamiliar with financial markets, however, misunderstand the purpose of short selling.  Without going into too much technical detail, its primary purpose is to help provide transparency to markets.  It is a corrective tool when the environment gets too frothy.  

A good example of how short selling provides transparency is the Enron case.  This fraud was first discovered not by law enforcement, an accounting firm, internal audit, or any other control group that was supposed to check for these things.  The alarm was first sounded by an activist short seller.  Another good example is the “Big Short.”  Although most of their shorts were executed with derivatives, not equities, the concept was similar.  Shorting a security or betting on a financial product’s value to go down, is a necessary component to any efficient market.  

And in this case it was justified.  While the practice of naked shorts is debatable, shorting a stock like GameStop makes all the sense in the world from an economic and long term perspective.  Yes, new consoles have and are coming out, which GameStop will benefit from, but in a pandemic world where most people were not going to malls even before COVID-19 struck, it’s hard to imagine a largely brick-and-mortar business thriving in any modern environment.  I buy and download any of my video games online, just as I do movies and music (apart from my love for vinyl).  Markets don’t and shouldn’t care about your nostalgia for buying your video games there as a kid.  Welcome to capitalism.  Adapt and innovate, or die. 

Hedge Funds Are Not Only For Rich People. 

Another common misnomer I keep hearing as a justification for the behavior of Wallstreetbets is that hedge funds are elitist institutions for rich people.  A classic example of Haves v. Have Nots.  The truth is more complicated.  

While most hedge funds only deal with accredited investors (i.e., rich people), they also manage money for pension plans and not-for-profits, among other organizations that impact the lives of everyday people.  While I’m not sure who Melvin Capital, the primary target of ire here, counts as its investors, most hedge funds not only manage Wall Street money, but Main Street money too.  So maybe think twice about your populist pitch next time you celebrate screwing over a hedge fund on a short squeeze.  Yes, you took money from the Steve Cohens of the world, but you also may have ripped off a firefighter, teacher, police officer, or anyone else with a pension plan (think union labor).

Apart from the pension money most hedge funds manage to some degree, why is it acceptable to screw over accredited investors?  The SEC’s definition of who qualifies includes large swaths of upper middle class America.  Hedge funds are more than the manager that is typically the face of them.  There are underlying investors to consider as well.  

Someone Will Drown From This Populist Wave

While it may be fun and games now for Wallstreetbets as the price on most of these stocks continues to rise (as of this writing), a wave will come crashing down shortly.  Someone will be left thinking they can ride it.  They will drown.  It is not a question of if, but when.

Like catching a falling knife, there are few winners in a pump-and-dump scheme after the dumping begins.  And even if the Wallstreetbets contingency collectively agrees when to sell, what are the odds they inspired other retail investors to throw a few dollars in?  Pretty high.  Given the amount of attention this has received in the media recently, it’s fair to say that many other retail investors have confidence they can ride the wave too.  You know it’s time to get out though once the furnace guy is telling you about his day trading strategies and how he plans to go longer $GME.

When the day of reckoning on some of these pumped up stocks does come, it won’t be Wallstreetbets that most people will blame.  It will be Wall St.  Whether you are Bernie Sanders (who thinks ALL of Wall St. is fraud) or AOC (who is more focused on Robinhood than on the day traders who created the conditions), fingers will be pointed at the system that did nothing but operate in the way it was designed.  Short selling is not illegal, and as noted above, the strategy actually has numerous benefits to a well-functioning efficient market.  

What is most important to remember is that real people could be detrimentally affected here.  Many may have felt compelled to invest money they cannot afford to live without – savings, COVID relief funds, etc.  In their attempts to ride the wave fueled by the Wallstreetbets hysteria, they could easily lose their shirt if not more.  And even if you are not sympathetic about the hedge fund target of this populist uprising, what about the next person?  Where is the line?  Is any institutional market participant fair game?  It won’t look great for these renegade Wall Street pirates when they raid the wrong treasure chest with police officer and teacher pension funds in it.

While the coronavirus and no commission trading undoubtedly exacerbated the conditions that led to this activity, this is only the beginning.  The SEC, DOJ, and every other financial regulator needs to consider these events closely.  Anyone who engaged in market manipulation must be brought to justice.  Capital markets must have integrity and reasonable stability that promotes investor confidence.  As much as I love chanting power to the people, if it comes at a cost of death to the market, it is power that nobody should have.