By Christopher Tan (PZ ‘21)
Consider a brief thought experiment. An influential investor owns a number of cheap shares. They begin spreading lies about why they think these shares will rise and use their influence to sell the shares at an inflated price to others. Before they are caught and the stock’s prices fall, the investor would have profited a considerable amount of money. This is illegal because lying to make money amounts to an act of fraud.
Consider another dimension. What if the investor climbs up on a pedestal, and without lying, commands their audience to buy the same cheap shares while inflating share prices and profiting off the stock’s rise. While these actions have manipulated the market, the absence of lying in its spread makes it difficult for regulators to pinpoint its illegality.
Problems with regulating this form of market manipulation were brutally exposed recently after GameStop, a failing brick-and-mortar retailer, saw its stock soar over 700%. The reasons for this frenzy can be rooted to r/WallStreetBets (WSB), a niche but growing community of retail traders on Reddit who have banded together to ‘squeeze’ Wall Street firms and hedge funds who made big bets that shares in the loss-making GameStop would continue to fall. In layman’s terms, short selling is an investment strategy that speculates on the decline of a stock’s value that can reap great profits for traders if their bet pays off. This also carries substantial risks. After several members of WSB discovered that hedge fund Melvin Capital had made short selling positions that bet against GameStop, the Reddit page became flooded with posts calling for traders to buy the gaming retailers stock in the hopes of ‘squeezing’, or pushing the stock’s value higher, the hedge funds’ positions and force them to accumulate substantial losses.
Buoyed by the millions of members of WSB, on January 14, GameStop’s stock surged by more than 27 percent in one day, sparking an unprecedented frenzy of stock buying. Amateur traders, hoping to leverage the stock’s volatility, made substantial profits off its rise. Meanwhile, hedge funds who had bet against GameStop saw devastating losses. Wall Street firms shorting GameStop’s stock saw losses that amounted to over $19 billion. Melvin Capital, the key target of the WSB campaign, was forced to accept a $2.75 billion financial lifeline from larger hedge funds in order to avoid bankruptcy and, according to the Wall Street Journal, lost 53% on its investments in January.
In the past, trading on Wall Street had been limited to firms armed with platoons of mathematicians and economists. These days, trading platforms like Robinhood and AmeriTrade have lowered these barriers and have allowed almost anyone to purchase and sell shares of companies. The case of Jaydyn Carr, a 10-year-old from San Antonio, exemplifies this democratization of trading. In December 2019, Carr, an enthusiastic gamer, was given 10 shares of GameStop as a Kwanzaa gift from his mother. This past week, Carr saw his investment pay off as he pocketed over $3,000 by closing his position – a 5000% return off his mother’s initial investment.
Amidst the rapid rise in GameStop’s stock, the WSB subreddit became flooded with posts using mantras like “this is the way,” the catchphrase of Disney’s The Mandalorian, and encouraging members to invest in stocks of poorly performing companies like AMC, GameStop, Nokia and Bed, Bath & Beyond. On 28 January, several trading platforms, including RobinHood, halted purchases of retail shares in GameStop, citing the “market’s volatility”. This sparked outrage among investors and politicians, who accused brokerage companies of siding with Wall Street investors who were losing out to amateur traders.
“This is unacceptable,” tweeted Alexandria Ocasio-Cortez, a Democratic member of Congress from New York. “We now need to know more about @RobinHoodApp’s decision to block retail investors from purchasing stock while hedge funds are freely able to trade the stock as they see fit.” Amidst the backlash, Robinhood later eased restrictions and allowed users to freely trade GameStop’s stock again. The circus continued. GameStop’s stock surged again.
The fiasco over GameStop cuts to the heart of regulatory issues between Washington and Wall Street. Section 9 of the Securities Exchange Act of 1934 made it illegal to “induce the purchase or sale of any security” by claiming that the price of the security “is likely to rise or fall because of market operations…conducted for the purpose of raising or depressing the price of such security”. This raises questions over whether ‘inducement’ in this sense would qualify posts on the subreddit or on Twitter that encourage others to continue to invest in GameStop or AMC. To Redditors, what may appear to be fun and games could amount to a serious case of illegal market manipulation. Nevertheless, even if these actions were to be deemed illegal, prosecuting individuals may prove to be beyond the scope of authorities given that Reddit users rarely ever disclose personal details online.
Many have argued that WSB’s actions mirror what Wall Street firms have been undertaking for years. Senator Elizabeth Warren, a Democrat renowned for supporting increased financial market regulations, noted that the market’s volatility demonstrates how “years of distortion in securities markets have allowed the wealthy few to artificially inflate and deflate share prices and reap short-term profits while exacerbating wealth inequality”. To Warren, regulations ought to restrict the trades of both amateur traders and hedge funds, with regulators playing an important role in ensuring that markets “reflect real value, rather than the highly leveraged bets of wealthy traders or those who seek to inflict financial damage on those traders”. What Warren is arguing is that Wall Street finally caught a glimpse of what it means to be on the other side of the market. The Redditors’ plan to drive up the price of stocks with the aim of profiting off of them amounts to what hedge fund managers have been doing for decades – shorting stocks and driving down their prices for their own profits.
The U.S. Securities and Exchange Commission (SEC), the nation’s main securities enforcer, announced it would review actions that may “unduly inhibit” the trading of certain securities while also stating that it was closely monitoring potential wrongdoing amid the price volatility in the U.S. stock market. Given that the agency’s role concerns dishing out punishments for those who break rules meant to protect investors, the SEC has a shoddy record. Rather than implementing a broad and muscular approach to market regulation that deters corporations from work arounds, the SEC draws up narrow rules that are too literally enforced and easy to be evaded. This has allowed Wall Street lawyers and investment bankers to find clever loopholes that can evade regulatory enforcement. After the 2008 financial crisis, the SEC faced heavy accusations that it was being too timid and fearful to hold Wall Street accountable for its misdeeds. Despite substantial evidence of fraud and dishonest behavior in the lead up to the 2008 financial crisis, only a single trader at Credit Suisse, a bank, was arrested and charged for inflating the value of mortgage bonds.
Under the guise of supporting market stability, the SEC’s actions in the past have consistently sided with Wall Street. As such, any regulatory changes from this saga seem more likely to afflict amateur traders on discount brokers like Robinhood than Wall Street itself. The rise of Robinhood’s popularity has raised particular intrigue and concern. Their practices have already raised concerns from regulators and lawmakers in Congress. Similarly, others worry that the app has ‘gamified’ finance and gotten vulnerable users hooked on nefarious trading practices. Both the House Financial Services Committee and the Senate Banking Committee have announced that they will be holding hearings about the firm’s decision to halt trading.
At the minimum, trading practices on digital trading platforms will likely come under the purview of more restrictions, if not being outlawed altogether. This points to a deeper problem with regulating Wall Street. As 2008 has proven, Wall Street is already no stranger to the kind of herd behavior, price manipulation, insider trading and reckless risk-taking that amateur WSB investors used to reap substantial profits for themselves. The key difference this time is that it is not the regular mortgage investor that is being hurt, but Wall Street institutions instead. In this regard, the issue lies not with WSB, but with the regulatory system itself.
