Small investors deserve equal access to financial markets, at an affordable cost and with efficient execution. With the democratisation of that access, however, comes the obligation to understand what one is doing and to behave responsibly.
What has happened in the US in the past weeks raises a number of important questions that need to be answered – by individuals, exchanges, regulators and politicians.
Trading platforms like Robinhood and others have offered free execution for some time. This is laudable. Millions of small investors have enjoyed free access to financial markets as a result.
Yet Robinhood is a profit-seeking firm, so how are the bills being paid? By large institutions buying the flow from these exchanges. This may or may not be problematic, but it seems to me to be important that small investors must, at bare minimum, understand how high-frequency stock and options trading can be offered as a free service to them.
Chat services like Reddit, WallStreetBets and others are proliferating, and are now used by small traders in very large numbers. The evolution of social media and digital content empowers participants and provides the ability to socialise views and opinions.
Enabling such an exchange of views can be enormously healthy, but it can also be used to promote aggressive and risky trading strategies – including by creating a herd mentality, with millions of people suddenly following the same idea. That might be just fine. A consensus that it makes sense to buy or sell certain stocks sounds innocuous enough.
However, if instead a consensus emerges that “we are going to squeeze the shorts in GameStop so that a large hedge funds fails, and we might even bring down a large bank”, then to me that sounds pretty dangerous. That is not what the democratisation of market access was intended to deliver.
This sounds more like a form of collusion which, if perpetrated by larger firms, could lead to indictments for market abuse and manipulation, and rightly so.
One wonders whether the purpose of investing to bring down a large bank is really what these investors should want. It may sound “cool’’ to some, but no matter what one thinks of large banks, it is hard to see the reasoning behind investing to push large banks to failure and imagining that to be a winning investment strategy. It is those same institutions that create the liquidity and risk absorption that allow smaller traders to enjoy access to begin with.
Ultimately, common sense will prevail. At some point the outstanding short positions on GameStop involved 240% of the issued shares. So, it was easy to squeeze.
Once the shorts are covered, those still owning the shares will quickly realize that the technical position in the market has changed and they will sell, and thus the value of GameStop will return to its fundamental one.
This is happening now. GameStop traded in December 2020 at $19 per share. In January 2021, it peaked at $347 per share, went down to $193, back up to $325 and stood at $53 when markets closed on February 4.
Clearly not for the faint-hearted! The return to fundamentals happens fast, and most of the remaining paper gains will likely be wiped out quickly, except perhaps for the lucky few who got out early. There is a real risk that the last in will be the last out.
There are serious questions here about whether, and how, small investors like this should be protected, or at least made aware that these types of trading strategies can lead to a 100% loss. The message should be clear: Don’t invest more than you can afford to lose, and be aware that your odds of losing are probably lower in a casino.
A second set of questions follows quickly about how regulators should address this.
Was the democratisation of market access really supposed to facilitate opportunities for small investors to suffer virtually guaranteed total losses? Where are the boundaries between the ability of an individual to freely access cheap execution and the consequences when millions decide together to do the same trade? At what point does that become market manipulation? Should there be enforcement against such large numbers, and if so, how?
The third question is whether the market infrastructure, settlement systems, the ability of exchanges to manage margin calls and that of the liquidity providers to sustain such large volumes can survive all this. At this moment, it seems that the answer is yes.
Robinhood has recapitalized, as has one of the hedge funds that suffered significant losses. And the large institutions that have provided the liquidity continue to do so and may well make good margins on the business.
A fourth set of questions is for politicians. It is easy, and right, to stand in favour of access to financial markets. But what are the necessary guardrails to ensure that we do not create a bubble, like the housing bubble that led to the global financial crisis a little more than 10 years ago?
Should small investors have some protection? What authority do the regulators need in order to deal with a new paradigm where millions of people can come together in what looks like an attempt to manipulate, at the expense of others?
Hedge funds are sophisticated companies that make a living by taking and managing risk. Some will succeed and some will fail. That is just. But no one should fail or succeed due to market manipulation that violates all rules of fairness and without which markets do not function well for anyone.
Some might say that markets are not fair anyway. Perhaps, but as we should learn from the example of GameStop, structural issues need to be addressed – not compounded.
Stott serves as Group CEO and member of the Board of Directors at Quintet Private Bank.
The statements and views expressed in this document are those of the author as of the date of this article and are subject to change. This article is also of a general nature and does not constitute legal, accounting, tax or investment advice.