The GameStop Episode
What happened and what does it mean?by allan m. malz
allan malz, a former vice president of the New York Federal Reserve Bank, is an adjunct professor at Columbia University. This article is adapted from his Cato Institute CMFA Working Paper, found here, and forthcoming in the Cato Journal.
Published July 14, 2021
To judge by media reports, the speculative boom and bust in the stock of an otherwise unmemorable company called GameStop, was, well, a game stopper. Now, it is true the episode that began in January did display a seemingly unprecedented ability of large numbers of stock traders to organize collective action. But in other ways, it was far from unprecedented.
For while politicians and regulators frothed about “market manipulation” and the usual talking heads took the opportunity to blame an underregulated financial system, the events actually suggest that in many ways the already-dense array of regulations makes equity markets function worse, not better, for investors. Indeed, much of the outrage reflects a combination of paternalism and unwarranted confidence in experts who dominate attitudes toward retail investing in America.
GameStop Goes Crazy in an Interesting Way
GameStop Corp. (GME) is a brick-and-mortar video game vendor — hardly an enviable position in an era dominated by online gaming. By last winter GameStop was widely seen as a failing firm, one of a number of so-called meme stocks popular with retail investors itching for combat with hedge funds that took heavy short positions in hopes of profiting from bad news. Starting in mid-January, GME shares saw a sudden and dramatic increase in price volatility, led by retail investors using the Robinhood.com trading platform and publicized and organized via online discussion groups.
Robinhood responded to the volatility by imposing trading restrictions on January 28-29, barring acquisition of new long positions in GME. And, along with generating howls of indignation among true believers, these restrictions brought political scrutiny: the SEC initiated probes, and the House Financial Services and Senate Banking Committees held public hearings.
The Rise of Low-Cost Trading and Leverage
Robinhood is a new entrant (dating back just to 2015) in the retail investing market, appealing to a young demographic with a mobile app and user-friendly interfaces. It is heir to a host of innovations that have made equity trading cheap and accessible to non-professionals. But back up for a moment; we need a little history here.
Before 1970, few Americans invested in stocks directly, as opposed to owning them indirectly through retirement funds. Over the following half-century, though, a combination of changing regulation, rising household wealth, wider understanding of investing basics and, most important, the digital revolution led to a rapid rise in stock and mutual fund ownership.
Discount brokerages and electronic trading platforms made low- and eventually zero-commission online retail trading possible. Brokers can still make money by earning interest on customers’ cash balances, facilitating loans of stock in customers’ accounts to short sellers and receiving payment for directing order flow (PFOF) to wholesale market makers who execute the trades.
Both long and short positions in GameStop were financed in large part with borrowed funds — no surprise, really, since leverage becomes almost irresistible with near-zero short-term rates enabled by implicit and explicit public guarantees of the banks ultimately doing the lending. By the same token, it’s not surprising that stock margins have grown to record levels in step with the what-me-worry attitude about public and private borrowing that now pervades Washington. The result is buoyant asset prices, suppressed volatility and a sense among investors that risk is low.
Market Manipulation and Short Selling
The term “market manipulation” is vague, with no accepted analytic or legal definition apart from a sense that it’s gotta be bad. In the GME case, the collusion was crowdsourced openly but anonymously via Reddit, the humungous online content aggregation and discussion site. And it gave traders an outlet to express their desire to punish hedge funds for transgressions real and imagined.
In particular, participants in the WallStreetBets “subreddit” group who invested in GameStop seemed as interested in raining on the parade of short sellers as profiting from the runup in the price of GME. In the United States, it’s worth noting, short positioning is legal, but with restrictions. And since that regulation limits the ability of skeptics to make negative bets, the market pricing dynamic is biased toward optimism. The result can be both the overvaluation and the high trading volume observed for GameStop.
It’s far from clear that the sort of regulatory “reforms” driven by the new enthusiasm to restrain “dumb money” would serve the public interest. I, for one, celebrate the reality that investment transactions have become far less costly for non-professionals.
Regulation of Trading Infrastructure and Execution
The alleged evil of short selling isn’t the only misunderstanding brought to light by the GameStop brouhaha. It also focused scrutiny on the complex and heavily regulated organization of trading. Stock trading in the United States is executed in a variety of ways — on exchanges, of course, but also off exchanges in so-called dark pools that escape public disclosure, and by other market makers. Market makers take principal positions, bearing the market and credit risk, and are compensated by being able to profit from bid-offer spreads. Brokers, by contrast, are passive, facilitating trades without taking positions.
Robinhood is a broker, operating the electronic platform their customers trade on. Orders are routed to external market makers for execution. The aspect of trade execution drawing the greatest scrutiny is the aforementioned PFOF income flowing from market makers to brokers who send trades their way. It raises the suspicion that market makers are “front running” —executing their own trades ahead of their retail customers’ orders and thus not necessarily completing transactions for their customers at the best possible prices.
But some perspective is called for here. PFOF is one cog in the elaborate machine that delivers low-cost trading to investors. And somebody has to pay to keep the machine running. The opportunity to front run is just one incentive for market makers to scale up for efficiency, permitting overall trading costs to decline. If market makers are to minimize principal risk and commissions are zero, the reward for sustaining liquidity in markets for individual stocks has to come primarily from bid-ask spreads. Retail customers can’t get “best execution” at all times; the numbers just wouldn’t add up.
PFOF is one of many examples in finance where there really are conflicts of interest, but also mutual benefits that outweigh the costs of getting rid of the conflicts. Slightly inferior execution is the price of enjoying lower commissions and fees. A less regulated but more efficient market can be imagined in which trade execution is more concentrated, PFOF is less prevalent, retail investors pay for trades outright and overall transaction costs are lower. But one wonders whether Robinhood’s clients would willingly switch to that pricing regime.
Consumer Protection, Paternalism and Public-Sector Investment Advice
Younger investors have been seen by many consumer advocates and politicians as a new source of “dumb money.” Even more than other investors, the argument goes, they must be protected from their own bad decisions and from “gamification” — the behavioral stimuli said to encourage frequent trading and generate PFOF for the brokers.
Never mind that many Robinhood investors see financial markets as a rigged casino in which they knowingly participate in order to seize a just share of the ill-gotten gains. Indeed, their mindset is not that different from the regulatory view that the investing system is unfair and that only professionals can succeed at it. In this view, ordinary investors are impeded by the industry from obtaining the “special” information needed to invest successfully. But in reality, nothing could be further from the truth: the typical successful investor doesn’t “beat the market” by trading frequently on superior information.
The government and consumer-advocacy view of investment and wealth building is largely implicit but expressed in myriad ways. The goal of the paternalists, expressed well by the non-profit group Better Markets, is “democratizing access to the financial markets and creating a level playing field for everyday investors.” Then, the story goes, retail investors can engage in stock picking on an equal footing with the pros. Conspicuous by its absence: sound investment advice emphasizing saving, diversification, a long-term perspective and attentiveness to investment costs and taxes.
A striking example of how this view plays out in public policy is the way federal, state and local governments provide for employee retirement through a combination of defined-benefit pension plans and Social Security rather than through personal initiative. Advocates of defined-benefit plans emphasize the value of professional investment management, disregarding the now well-established shift by nonprofessional investors toward lower-fee passive investing.
Tax policy, for its part, explicitly aims to encourage individual retirement accounts. But the public response depends heavily on the rules. At its simplest level, a retirement account that is untaxed at either the time of contribution or withdrawal would unambiguously reward saving. However, the bewildering complexity of rules and penalties on contributions and withdrawals in the current system surely undermines incentives to save. Policymakers for the most part ignore the consequences of these disincentives, preferring to attribute low savings rates to myopia and prescribing behavioral nudges, such as automatic enrollment in 401(k) plans, to offset it.
Or consider the role of the perennial push for homeownership. For the better part of a century, real estate has been celebrated as the core of any wise investor’s portfolio. It can have advantages over renting, especially if ownership is more satisfying than renting and the arrangement yields intangible benefits such as pride in community. But it has distinct disadvantages for many households — and, in some ways, for society as a whole. One wonders, for example, whether the Great Recession would have ever happened if Americans weren’t pushed so hard to go deeply in debt to own their dwellings.
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Whatever drove Robinhood’s customers to take trips on the GameStop roller coaster, it’s far from clear that the sort of regulatory “reforms” driven by the new enthusiasm to restrain “dumb money” would serve the public interest. I, for one, celebrate the reality that investment transactions have become far less costly for non-professionals. The costs to customers of the conflicts of interest raised by the GameStop affair are trivial compared to the returns that investors forfeit by looking for the “honest” and “superior” manager who can beat the market.
I wish that if the government can’t say “start young, think long-term, save, diversify, lean toward equities, understand your own situation in terms of risk tolerance and take advantage of the tax code,” it would not say anything at all about personal investing.