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Free Market Economy

The GameStop short squeeze, explained

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In an age of extreme political polarization, the GameStop short squeeze of late January 2021 has managed to bring together prominent figures and commentators of opposing ideologies behind a single cause.

The situation developed as retail investors on r/WallStreetBets, a subreddit dedicated to discussing stock and option trading, initiated a short squeeze on GameStop.

Several controversies have emerged following the short squeeze, particularly in relation to the decisions of financial services companies to restrict trading. Such decisions drew significant condemnation from political figures.

While the motivations and tactics of the GameStop short squeeze have drawn criticism in some circles, it would appear as though the retail investors responsible have enjoyed widespread praise and support from across the political spectrum.

As such, it is interesting to consider how this unusual scenario came to be, as well as what potential legacy it may have in terms of the democratization of the stock market.

GameStop: a once-thriving company that has struggled to adapt

GameStop is a video game and consumer electronics retailer founded in 1984, operating under its current name since 1999. The company enjoyed considerable success before falling into decline, since the mid-2010s, due to changes in market conditions. With the rise of online services, demand for physical games has decreased dramatically.

Despite efforts to turn the company’s fortunes around, GameStop has struggled to adapt and has incurred significant financial losses over the past five years. Correspondingly, the value of GameStop stocks had been decreasing.

Institutional investors, predicting this downward trend to continue, began short selling GameStop shares. This process involves borrowing and selling shares before subsequently buying them back at a lower price, or covering. Investors then return the borrowed shares having made a profit.

However, these investors did not take into account the affection held for GameStop by many in the r/WallStreetBets community, who saw their shorting of the company as a predatory attempt to profit off a struggling company while running it into the ground.

Furthermore, after Ryan Cohen, an activist investor, bought 10% of the company and joined the board, retail investors became increasingly confident that GameStop’s fortunes would turn around and that the hedge fund shorts would be proven to be wrong.

The short squeeze: Main Street vs Wall Street

In response to the short selling of GameStop shares by hedge fund managers, the retail investors on Reddit started to invest en masse. They drove the price of shares up to as high as $347, on January 27, after these same shares had been traded steadily for around $4 for much of the past year.

Many small investors have made significant profits from the GameStop short squeeze, at the expense of hedge fund managers who have hemorrhaged billions of dollars. However, since GameStock shares cannot remain at such an inflated price indefinitely, as with any bubble, those retail investors who do not sell soon enough will face losing the bulk of their investment.

Nevertheless, many retail investors are resolute in their determination to hold on and deliberately cause the Wall Street establishment to lose as much as possible, regardless of the risk they incur. It is this combative attitude towards the short squeeze and its characterization as a war between Main Street and Wall Street that has captured the imagination of commentators from across the political spectrum.

The economic devastation brought about by COVID-19 lockdowns has placed many individuals in situations of unprecedented financial insecurity. These circumstances have only added to the widespread frustrations aimed at those who have been deemed as thriving at a time crisis through opaque means at the expense of ordinary individuals.

As such, the idea is that If long-holding retail investors refuse to sell their shares, the hedge funds involved in short selling will have no choice but to sell other shares in their portfolio in order to cover and buy GameStop shares to fulfill their obligations.

A broad coalition of supporters

The actions of the retail investors have been widely supported by observers from a variety of ideological positions. The short squeeze has been seen as an important moment for the democratization of the stock market, an appealing idea to many libertarians, conservatives, social democrats, and others. Furthermore, many on the political left have viewed recent events as a sort of popular uprising against the wealthy Wall Street establishment.

Political figures as far apart ideologically as Ted Cruz and Alexandria Ocasio-Cortez have expressed support for the r/WallStreetBets investors, with business figures such as Elon Musk also voicing approval. Given the intense polarization that currently exists, particularly in light of the fraught presidential transition, the level of unity among political factions over this single issue is striking.

To many of the independent investors involved, this attempt to drain the wallets of Wall Street’s hedge fund managers represents a form of revenge for their targeting of GameStop and similar struggling companies through short selling. It has even been argued that the short squeeze serves to “punish” the Wall Street establishment for their role in the origins of the Great Recession, as well as a general lack of transparency.

Financial services companies criticized for restricting trading

Robinhood is a financial services company whose purported mission is to “provide everyone with access to the financial markets, not just the wealthy”. However, on January 28, along with Interactive Brokers, an electronic trading platform, Robinhood decided to restrict trading on some stocks, including GameStop options.

This move was met with widespread criticism, with observers and amateur investors accusing Robinhood of betraying their mission due to pressure from the Wall Street establishment. Essentially, the restrictions meant that retail investors using Robinhood would only be able to sell their GameStop shares, without the possibility of purchasing more, while hedge funds continued to enjoy unfettered access to the stock market. Political figures such as U.S. Representative Rashida Tlaib, a progressive Democrat, called for an investigation by the House Committee on Financial Services, alleging “market manipulation.”

Robinhood’s controversial decision prompted a surge of disgruntled users leaving one-star reviews of their app on the Google Play store. However, Google subsequently removed 100,000 of these reviews on the grounds that they were “inorganic.” prompting further outrage.

The move has been characterized by some as an effort to protect Citadel, one of their largest companies, from further losses. However, Robinhood’s CEO, Vlad Tenev, recently spoke with Elon Musk on the social media app Clubhouse and explained that he had ‘no choice’ because it was a matter of following “regulatory capital requirements.”

He asserted that it was instead because Robinhood simply did not have the capital to meet their brokerage obligations, and that one of the terms for obtaining the necessary additional capital was to restrict trading.

Short sellers and their role in the market: a counterargument

Support for the retail investors may be widespread, but it is not universal. Some commentators have argued that short sellers are not responsible for many of the issues the Redditors wish to exact revenge over, and lament the unusual rationale behind the mass purchasing of GameStop shares.

Another issue raised is that of the role short sellers play in the market. It has been argued that short sellers provide a service to the market in being the first to identify weaknesses in companies. Thus the short sellers would be contributing to a divestment of capital away from these companies and instead towards those which show greater future potential.

Short sellers have also been instrumental in unearthing instances of fraud in companies. As such, although some of the practices involved can be predatory, it is important to note this as a benefit of the legality of shorting. For instance, The China Hustle, a 2017 documentary, highlights the case of firms making a fortune from finding fraud and deception in Chinese companies and shorting their stock.

The impact on Wall Street and the future of stock market democratization

Undoubtedly, the GameStop short squeeze has proved to be somewhat of a shock for the Wall Street establishment. For instance, the investment firm Melvin Capital which was heavily involved in short selling GameStop shares lost 30% of its value in January, with short sellers in general having lost billions. However, despite certain hedge funds suffering significant losses, this latest episode is unlikely to result in a major shake-up of the professional investor’s business model. As of February 1st, GameStop has already gone down 35% due to the growing limits on trading.

Although retail investors lack the ability to pose an important enough long-term threat to the interests of hedge funds, this short squeeze has created some unease in the financial sector. Yet, perhaps the most significant outcome of the GameStop saga will be an increased interest in stocks and shares among the general public, and among younger generations in particular.

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This piece solely expresses the opinion of the author and not necessarily the organization as a whole. Students For Liberty is committed to facilitating a broad dialogue for liberty, representing a variety of opinions.

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