GameStop frenzy prompts renewed focus on the integrity of US financial markets

Jonathan Watson, IBA Finance Correspondent Friday 11 June 2021

The GameStop frenzy is likely to among the biggest finance stories of 2021. It centred on large groups of small investors who worked together via internet forums to drive up the price of stocks such as GameStop, a US video game retailer. GameStop’s share price rose from under $20 at the start of 2021 to over $480 by late January. The prices of some other struggling stocks also increased.

Since GameStop was often targeted by short sellers – investors that gamble on share prices falling – many were significantly affected when the retailer’s stock price suddenly increased. ‘The interesting thing here is that for once, the hedge funds were victims of market forces rather than using their clout for their own benefit,’ says Benedikt Maurenbrecher, Co-Chair of the IBA Banking Law Committee and a partner at Swiss law firm Homburger.

The most common way of short selling is by borrowing a security from someone else and selling it in the hope that the price will drop. When the agreed moment arrives to give it back, you can hopefully buy it for less than you paid, sell it back to the person who lent it to you, and pocket the proceeds. This creates negative sentiment about the shares that contributes to a fall in price. As John Lanchester says in his book How to Speak Money, ‘This will make the people who own that particular share hate you, because you are, in effect, trying to make them lose money.’

The failure of the agency to appropriately respond to the most apparent deficiencies is not due to a lack of legal authority but a multi-decade lack of courage and imagination

Dennis Kelleher
President and CEO, US campaign group Better Markets

It can also make other people hate you. Many of the small investors driving up the value of GameStop were motivated by a desire to make the ‘hedgies’ lose money. They compared their achievement to David felling Goliath.

In this scenario, ‘the small investors, organized around online trading platforms, would have formed a sort of armed phalanx, challenging the great speculative hedge funds,’ says Filippo Ferri, Vice-Chair of the IBA Business Crime Committee and a partner at Italian law firm Cagnola & Associati.

According to Goldman Sachs, retail investors represent approximately 25 per cent of the overall volume of the Wall Street stock market, and this is increasing. ‘Meanwhile, some analysts say that a small group of hedge funds have earned approximately $16bn through the GameStop operation. It’s dog eat dog out there,’ says Ferri. In addition, many of the small investors lost money when GameStop’s share price eventually fell.

It’s also worth remembering that the vast majority of hedge funds do not thrive long-term. ‘Ninety per cent of all the hedge funds that have ever existed have closed or gone broke,’ says Lanchester.

One key question is whether US financial regulator the Securities and Exchange Commission (SEC) should require more transparency of short selling and the opaque network of stock lending and borrowing that facilitates it. Many have asked why this hasn’t happened already, since the US Dodd-Frank Act 2010 required the regulator to do so.

Another aspect is the role of online platforms used for trading shares. The Robinhood app was one of several brokerages that halted purchases of GameStop and other securities at the end of January, arguing that they couldn’t post enough collateral at clearing houses to execute their clients’ orders. The decision attracted criticism and accusations of market manipulation from prominent politicians and business people.

Robinhood did not respond directly to Global Insight’s request for comment, but in a late January blog post, the company highlighted that ‘the required amount we had to deposit with the clearinghouse was so large – with individual volatile securities accounting for hundreds of millions of dollars in deposit requirements – that we had to take steps to limit buying in those volatile securities to ensure we could comfortably meet our requirements.’

The decision was not taken because Robinhood wanted to stop people from buying these stocks, the company said.

In a mid-February blog post, Robinhood rebutted claims it had capitulated to powerful players in the market, explaining that the restrictions were enacted in ‘an effort to meet increased regulatory deposit requirements, not to help hedge funds. We don’t answer to hedge funds.’

Some argue that this should not prevent the regulator from taking appropriate action. ‘The failure of the agency to appropriately respond to the most apparent deficiencies is not due to a lack of legal authority but a multi-decade lack of courage and imagination to take meaningful actions based on existing authorities,’ says Dennis Kelleher, President and Chief Executive EOfficer of US campaign group Better Markets.

Kenney says that when he has dealt with market manipulation, such as ‘pump and dump’ schemes, any wrongdoing has been relatively easy to prove. ‘But what’s going on in the markets now is unknown to me,’ he says. ‘And it’s unknown to the SEC, I think. The markets are recognising there’s a new cat in the house.’

At a hearing held by the US House Committee on Financial Services in mid-March, Kelleher claimed US markets were not a level playing field. ‘They are rigged to advantage the sell-side against retail investors, pension funds and the buy-side generally,’ he said. ‘Put differently, these markets are too often a wealth extraction mechanism to enrich the few at the expense of the many.’

Image: / Tada Images