Permanent distortion, p.22
Permanent Distortion, page 22
Permanent distortion drove scores of younger investors into the markets because of their inherent distrust of what seemed to be a clearly rigged system. But it was the Robinhood app that allowed the eruption of social-media-based retail trading. Robinhood provided an easy avenue for anyone with a smartphone to get in on the game. A key ingredient in this process was Reddit, the discussion and content aggregator, which provided an online platform on which they could confer.2 The r/wallstreetbets (WSB) Reddit subgroup offered a thread, or community, for those who wanted to learn more about markets or work together to formulate trade strategies. Such trading blasted off in the aftermath of the COVID-19 pandemic as many desk jobs moved online and working remotely became the norm (often from the comfort of home). Workers and the unemployed from all backgrounds were driven by the motivating desire of not wanting to remain on the sidelines. They had seen a rush of wealth and central bank support being funneled to the highest-income earners and major corporations. Retail investors would fight for a piece of the pie and put their own money on the betting table, alongside the giants, or “whales” as the biggest market participants were dubbed.
What ultimately captured financial news headlines and prompted Congress to wake up to the possibility of new sheriffs in town wasn’t an overnight occurrence. With financial markets and the real economy so astronomically disconnected from each other, social media became an equalizing medium that could host the equivalent of localized street protests using communication and money as a weapon. Retail investors transformed into online financial revolutionaries. No longer was investing relegated to Wall Street and the mega asset managers that didn’t always get it right. It was time for more of Main Street to play its hand.
The phenomenon wasn’t unique to the United States. Around the world, fintech (financial technology) companies that developed innovative technology for financial activities outside of traditional banks and brokerage firms were booming. Fintech provided less cumbersome and less expensive ways to bank and invest online. Its ability to connect through mobile and digital mediums presented an escape from the dominance of large institutions (though some of them were either funded or bought up by these institutions along the way).
Some major fintech companies, such as PayPal in the US and Alipay in China, existed before the financial crisis but grew exponentially as electronic transactions rose in popularity and scope.3 In Latin America, fintechs such as Nubank in Brazil offered banking services to millions of Brazilians who had never held a bank account before.4 PicPay, the largest digital wallet app in Latin America, offered a hybrid of financial and social interaction services, with 41 million Brazilian users in 2021, more than double its 2020 figures.5 Globally, these applications allowed consumers to chip away at the dominance of the big banks. They allowed start-up businesses to enter the once cordoned-off financial arena and turn sizeable profits in the process.
The revolution had its origins in the fact that an entire generation had experienced a wealth transfer driven by the political and monetary elite. By supporting those at the upper echelons of finance and power, the Fed had neglected the retail investors struggling with student loans and oppressive credit card debt carrying interest rates near 30%, in contrast to the 0% banks paid the Fed to borrow money. The most influential banks got the equivalent of a slap on the wrist for the egregious practices that had kneecapped the economy after the 2008 financial crisis, only to see their risks and losses subsidized by central banks. So in the face of the pandemic, a certain degree of defiance against the richest members of society—along with greed, opportunity, and desperation—spurred this revolution.
Robinhood monetized the angst of the dispossessed. It provided a route for those whose entire experience in the job market had been shadowed by some financial crisis to attempt to make money another way. Robinhood users and the initial members of r/Wallstreetbets shared a common goal: they were both on the outside of the tent. The markets were humming and someone was making money. Why not them?
This seismic shift in the mechanisms of finance had begun years before the pandemic. The Reddit WSB thread itself had been created by entrepreneur Jaime Rogozinski in January 2012.6 At the time, the US and global stock markets were handily digging their way out of the early 2009 abyss, while economies were struggling to avoid a recession and unemployment figures were escalating.7
From its inception in 2013, Robinhood targeted younger investors armed with mobile phones and a desire to make money and take risks. Robinhood’s founders claimed to have developed the idea for the platform based on the Occupy Wall Street movement. They wanted to fix the “rigged” financial system.8 The initial app enabled users to track stocks or “paper trade” them. Within six short months, Robinhood received Financial Industry Regulatory Authority (FINRA) approval to be an online stock brokerage. By the time it arrived in the Apple iOS App Store in December 2014, Robinhood had a waitlist of over half a million people.9 As an app, it turned trading into what felt like a game—and crowdsourced new members by giving away stock shares as an incentive for referring others, something numerous cryptocurrency platforms and apps would replicate. During a 2014 tech start-up conference in San Francisco, Robinhood cofounder Vladimir Tenev proclaimed, “The purpose of Robinhood is to make buying and selling stocks as frictionless as possible. If we make money as a side effect of that, that’s great.”10
Robinhood challenged major online brokerages, like E-Trade, by offering transaction services at no cost, rather than charging fees or commission. However, it gained traction by collecting and selling customer data through a common but controversial practice called “payment for order flow” (PFOF), which converted the actions of legions of new traders into discernible patterns that could be sold to the highest bidder and exploited for strategic gains.11 Robinhood exposed the bold truth of the social media era: when a product is free you are not only the consumer but also part of the product.12 Still, with trillions of dollars of cheap money sloshing around the financial markets in the background, established and start-up online brokerage firms fell over themselves to compete with Robinhood.
By January 2017, WSB had amassed more than 100,000 subscribers and Robinhood topped 200,000 active new traders daily.13 The two may not have started out together, but the trend of financial autonomy and freedom from the established corporate trading paradigm was the tie between them. By the end of 2017, Robinhood added options trading to its arsenal of services.14 By late 2018, the WSB user base had reached 300,000 strong. Interest from and communication among retail traders accelerated once fractional trading was introduced. This feature enabled retail investors to buy pieces of shares, rather than have to pay the full amount of an entire share, which meant they could purchase what they could afford. Square’s Cash App and Charles Schwab first introduced the feature in October 2019. Two months later, Robinhood added fractional share buying, too.15
Then came the pandemic. COVID-19 catalyzed the WSB Reddit thread; it passed the 1 million user mark in early 2020.16 Robinhood’s user base leapt from 2 million users in 2017 to 13 million by the middle of 2020.17 A whole new chapter to the story of financial independence was unfolding. Interest in the Robinhood trading community from the media and other financial service providers and wannabe providers boomed as insiders-turned-temporary-outsiders sought to understand what retail traders were doing under their noses. The retail trading trend also captured Wall Street’s attention—in a different way. By December 2020, Robinhood had secured Goldman Sachs to navigate its path to becoming a publicly traded company.18
Meanwhile, with all the attention and momentum, the WSB community flourished. Members sought to deploy a strategy that would change the nature of retail trading. If Robinhood was on the path to “democratize finance,” then WSB’s actions served to reveal the casino of financial markets for what it was—a game controlled by the largest players—and siphon off some of Wall Street’s money in the process.
What ultimately catapulted these user groups into mainstream consciousness was not a new strategy or platform. It was a demonstration of how effective an old strategy could be when it was fueled by new technology. The focal point was the company GameStop, a video gamer’s paradise built for Main Street. The video game outlet offered gamers the chance to buy and sell used games at a discount. But as qualitative technology evolved, the physical shop became a relic. GameStop’s stock price was correspondingly unimpressive. The company was nearing the end of its life cycle—or so it seemed. Sensing blood in the water, certain elements of Wall Street wanted to bet on and profit from its demise (and help along that demise) by shorting its stock. (Short selling involves a trader selling shares that he or she does not own to bet on a drop in the stock price. The idea is that an investor using that strategy hopes to buy them back at a lower price later in order to lock in the profit of the difference. This activity accounts for nearly half of all daily trading.) By early January 2020, GameStop stock was trading at $4 a share.19 It was the single most-shorted name in the US stock market at the time.20
Yet a swarm of rebellious retail investors had other plans for the firm. On January 14, 2021, WSB won its first major battle against GameStop short sellers by sending GameStop stock up 27% through its recommendations and purchases. Five days later, marquee short-selling firm Citron Research was tweeting insults at the WSB crowd, accusing them of being “suckers at this poker game” and “an angry mob.”21 Those barbs fueled the flames. In the following week trading in GameStop shares became so frenetic that it was halted by the New York Stock Exchange several times due to excess volatility.22 The story leapt beyond financial media and infiltrated mainstream news coverage as well. Suddenly everyone was talking about GameStop.23
The siege against the shorts (short sellers) pressed on, causing GameStop’s share price to shoot up to $159.19 on January 25, 2021, as WSB longs (buyers of stock) fought to “squeeze” the hedge-fund shorts and force them to buy shares at rising prices, further pushing share prices upward. On January 27, 2021, Fed chair Jerome Powell, a former attorney for a major private equity and leveraged buyout firm, was asked for comment on the GameStop situation.24 Rather than discuss specifics, he offered what appeared to be a deliberately vague response: “I think the connection between low interest rates and asset values is probably something that’s not as tight as people think because a lot of different factors are driving asset prices at any given time.”25 This seemed to indicate he didn’t want to issue any public verdict regarding the Fed’s role in the matter of distorting asset values in general because of its ample supply of cheap money to the markets.
The buzz surrounding WSB grew so intense that by January 28, the number of subscribers totaled upward of 5.2 million.26 However, things between the retail army and the institutional one got increasingly ugly as Robinhood and other retail-oriented brokerages slapped limits on trades involving GameStop. That action signaled to retail traders that Robinhood was siding with the wealthy, hedge-fund-driven short-sellers and its large hedge-fund backers against them.27
As it turned out, major Wall Street institutional backers had been supporting part of Robinhood’s business by purchasing its trading data. Their intent was to use that data to maneuver their high-frequency trading algorithms and positions in such a way as to effectively “game” themselves against retail Robinhood trades. It had been a century since Ponzi’s scam, but behemoth hedge funds, like Melvin Capital, Citron Capital, Point72, and others, offered a promise that was not too dissimilar. Only they weren’t relying purely on a steady stream of individual customers for their profits. Instead, larger financial firms could leverage PFOF agreements to gain prior knowledge on positions taken by retail investors. Through this practice, “market makers,” or big brokers, could profit by being intermediaries between buyers and sellers, even as they were collecting information and establishing access to data that could help them determine what might happen next in the market.28
That intel gave certain companies a significant edge. On its website, Citadel LLC, the parent of Citadel Securities, one of Melvin Capital’s main backers, claimed to be “driven by a thirst for knowledge, the conviction to move faster and the confidence to be bolder.” The slogan was meant to describe Citadel and not the army of retail investors that had attempted to trade against certain positions in its orbit. Citadel was sideswiped by the determination and perhaps greater “thirst for knowledge” of the retail traders. The firm had to pony up an emergency investment of $2.75 billion into Melvin Capital Management to help “stabilize” the situation and avoid being caught on the wrong side of a tidal wave of retail trades.29 Melvin Capital would suffer a 49% loss in the first quarter of 2021. Its investors lost 51.8% from 2021 to March 2022. Point72 lost 15% of its profits in 2021 relative to 2020. Citron lost billions of dollars due to its GameStop positions. In that regard, it was score one for retail.30 The casino had been temporarily beaten.
On Wall Street, hedge funds offer clients their services and expertise for a 1.5% to 2% management fee and up to 20% of any profits the fund makes (most hedge funds pocket the fee whether or not their funds turn a profit).31 Because of the 1999 repeal of the 1933 Glass-Steagall Act, which had separated bank deposits from speculative banking activities, Wall Street banks had access to all the leverage and cheap money they needed. In turn, they could lend it out to the large hedge funds as leverage to plump up their bets. These behemoths could bag profits on the back of trillions of dollars of Fed subsidies that were at their core driven by central bank support.
Understanding the key difference between the institutional players and individuals is important. When retail traders invest or speculate in the markets, they are generally doing it with their own money. They don’t carry the advantage of size, or the ability to see trends in the massive pools of financial data that larger firms could access. They don’t have quant-driven trading algorithms or the muscle to readily impact markets by sheer force. However, they do have the ability to be flexible and resourceful. What they learned through the GameStop experience was that when they band together it was possible to push back against established players, if only for a short period. Though the name and ethos of WallStreetBets reflected the same sort of greed found on Wall Street, as long as the community wasn’t discussing trades based on insider information it was legally in the clear. By circulating strategies in an online forum, they were doing what Wall Street and corporate CEOs do every time they tout the success of their company on any financial media outlet. The difference was they achieved amplified results through the echo chamber of the internet.
Ultimately, the big boys didn’t want anyone else playing in their sandbox. They didn’t just fear that retail investors could aggregate strategy and trade against them, causing them to lose money; they were also concerned that their customers might leave them for the greener pastures of trading on their own.
The GameStop story provoked a stir from Wall Street to Washington. Politicians of both parties oscillated between advocating for the retail investor and wanting to “protect” them against losses and from their “naivety” regarding risk. From polar opposite sides of the US political spectrum, both Senator Ted Cruz and Representative Alexandria Ocasio-Cortez proposed an investigation into why Robinhood had blocked certain retail trades. In the era of massive partisan divides, it was an odd alliance against the financial elites—even if it proved a temporary one.
What Reddit traders did by uniting against the Melvin Capitals of the financial world was the equivalent of collective action by labor unions. It was a form of Occupy Wall Street 2.0. But it was also about the desire to make money like the big boys. Calling multibillion-dollar hedge funds out on their massive influence in the markets and their ability to gain market advantage by buying up individual trading data was a start.32 A bonus was the extent to which retail traders might be able to force them to change their more egregious, market-destabilizing practices such as naked short selling.33
Naked short selling entails brokers effectively lying about the ability of large short-selling clients to borrow those shares in the normal two-day window required in order to settle or close out those trades. If these clients can’t find the shares to settle the trades, they have two options. First, they can buy them from the market at higher prices and lose money in the process, or they can “fail to deliver” on the trades. In the case of GameStop, as much as $359 million of GameStop shares “failed to deliver” in what became an epic short squeeze, as retail investors’ purchases lifted share prices.34 The Securities and Exchange Commission (SEC) had banned naked shorts in 2008, but—as is the case with so much in the realm of finance—rules are often ignored or bent beyond recognition.
The dark secret revealed by the war between supposed “smart money” and small retail investors is that the stock market has relatively little to do with productive investment. It was the Federal Reserve that ultimately killed the notion that fundamentals, or objective metrics related to the value of a company, drive stock prices. Cheap money or ample liquidity stemming from loose monetary policy does. The White House (under either party), the Treasury Department, and Congress have been complacent at best and negligent at worst in reducing the amount of effectively rigged activity in the markets. By not resurrecting the protections offered by the Glass-Steagall Act after the financial crisis of 2008, the walls between consumer deposit and loan activities and the riskier activities of trading or fee-intensive asset management services remained flimsy. That meant that it remained easy for Wall Street banks to keep transforming their depositors into customers who paid higher fees for their asset management services, which tended to be more popular when there was more activity in the stock markets. Massive deregulation relative to the structure of the banking industry, on top of tons of cheap money, rendered the Wall Street casino a larger speculators’ playground than ever before, as more money was available to be used toward trading. Perhaps that’s why millions more spectators were demanding a seat at the table.
