From: allin
The GameStop saga in early 2021 brought to light several vulnerabilities within the financial system, sparking debates about market structure, regulation, and the impact of decentralized collective action versus centralized control [00:01:53].
The GameStop Phenomenon
Background and Short Interest
The situation began in June 2019, when a user on the Wall Street Bets subreddit, “deep f***ing value,” started buying long-dated GameStop (GME) calls, betting the stock would rise by January 2021 [00:04:07]. By August 2019, Michael Burry, known from “The Big Short,” disclosed a three percent position in GameStop, highlighting that 90% of its stores were free cash flow positive and the company was trading near net cash levels [00:05:17] [00:05:31]. In August 2020, Chewy founder Ryan Cohen took a nearly 10% position in GameStop [00:06:31]. A Wall Street Bets member then noted that GameStop had 120% short interest, meaning more shares were shorted than actually existed [00:06:50]. This individual predicted a “big squeeze” due to factors like a new console cycle, GameStop’s loyalty programs, a strong balance sheet, Cohen’s stake, and the shorts being underwater [00:07:02]. Melvin Capital, a hedge fund, had been synthetically shorting the stock for over four years by buying long-dated puts [00:08:04] [00:08:17].
The Short Squeeze
In January 2021, Ryan Cohen joined GameStop’s board, causing the stock to rise 13% [00:08:28] [00:08:45]. Increased activity on Wall Street Bets, Discord, and StockTwits followed, driving the stock to 100 billion in GameStop stock traded over seven days, far exceeding what retail could support [00:10:29] [00:10:35]. This created a “gamma squeeze” [00:11:35]. By January 25th, Citadel and Steven A. Cohen injected nearly $3 billion into Melvin Capital to keep it afloat [00:11:40].
Robinhood’s Action and its Consequences
On January 28, 2021, brokerage firms like Robinhood and Interactive Brokers prevented users from buying GameStop and other stocks, only allowing selling [00:12:34]. This one-way pressure caused a 44% sell-off, which was later reversed [00:12:44]. The decision by Robinhood and other platforms was likely due to insufficient margin to cover customer trades, suggesting potential insolvency if they had allowed continued buying [00:13:23] [00:15:31]. This decision reportedly caused hundreds of millions, possibly billions, in economic losses for individuals [00:03:48]. The firm’s communication regarding this decision was criticized [00:20:01]. The incident highlighted how fragile the whole system is [00:13:46].
The Role of Payment for Order Flow
Robinhood’s business model relies on “payment for order flow,” where they sell data on customer orders to prime brokerage institutions like Citadel milliseconds before trades are executed [00:13:54]. This allows Citadel to potentially profit from front-running these trades [00:14:20]. Citadel accounted for 47% of all payment for order flow volume, paying Robinhood almost $100 million in one quarter [00:14:26] [00:14:48]. This relationship raised questions about conflicts of interest, especially as Citadel also injected capital into Melvin Capital, a firm shorting GameStop [00:27:52] [00:28:07].
Financial System Vulnerabilities
The GameStop event underscored several financial system vulnerabilities:
- Insolvency and Margin Requirements: Robinhood’s business model provided free trading by making money on spreads and leverage [00:20:20]. However, during periods of high market volatility, their exposure to losing money increased [00:20:58]. The firm faced a liquidity crisis and had to scramble to raise capital [00:21:12] [00:30:31]. This was attributed to being “under equitized” relative to the risks they allowed customers to take, particularly with options trading [00:32:10] [00:32:24].
- Excessive Leverage in Hedge Funds: The ability of hedge funds to short more than 100% of a company’s shares was highlighted as a significant problem [00:06:50] [00:10:10]. An example is Long-Term Capital Management (LTCM) in 1998, which borrowed 4.8 billion in capital, leveraging themselves 26 times [00:37:55]. This created 60,000 trading positions worth $1.4 trillion, leading to a system-wide bailout orchestrated by US regulators [00:38:38] [00:39:03]. This demonstrates the systemic risk posed by highly leveraged entities [00:37:17].
- Lack of Transparency: Current SEC rules are seen as discouraging disclosure [00:39:26]. This lack of transparency makes it difficult for watchdogs and others to identify risks faster [00:39:44].
- Market Manipulation: Hedge funds were accused of manipulating markets through tactics like spreading disinformation on message boards or weaponizing censorship rules [00:24:47] [00:24:52] [00:57:03].
- Trading as a Casino: The significant volume of stock trading, totaling $121 trillion in notional value in the US in 2020, is argued to be a synthetic gambling model rather than actual capital allocation to businesses [00:34:05] [00:34:52]. This “leech on the system” draws capital away from productive investments that could drive job growth and innovation [00:33:21].
The Impact of Decentralization and Social Media
The GameStop saga showcased how social media enables collective outcomes that would not have happened through centralized systems [00:54:16].
- Collective Action and Market Dynamics: Retail investors, organized on platforms like Reddit, engaged in a “trade mob” against hedge funds [00:25:32]. This demonstrates the power of “swarming behavior” where individuals in aggregate can believe something and make it true [00:53:23]. Examples include the rise of Tesla’s stock based on belief in Elon Musk’s vision [00:53:30] and Bitcoin’s value based on collective belief [00:54:03]. This “collective ouija board moment” means no individual can predict the outcome of millions of people acting together [01:13:51].
- Censorship and its Implications: The blocking of trading by Robinhood was seen as analogous to the de-platforming of Trump and Parler, implying that powerful institutions use rules to shut down outsiders when threatened [00:55:13] [00:57:27]. Discord also kicked Wall Street Bets off its platform [00:56:17]. This raises concerns about freedom of speech and economic censorship, potentially driving people towards more decentralized systems [00:57:47] [00:58:04]. While social networks can enable positive movements, they also foster negative “mob behavior” characterized by rage and the “diffusion of responsibility” [01:06:48] [01:07:27].
Proposed Solutions
To address these vulnerabilities, several solutions were proposed:
- Technological Infrastructure Reform:
- Utilize modern technology to ensure a stock share isn’t loaned out multiple times, preventing scenarios where more than 100% of a company is shorted [00:36:04].
- Consider blockchain as a solution to reconcile beneficial ownership in nanoseconds, preventing borrowing without proof of ownership [00:36:31].
- Leverage Limits: Implement strict leverage limits for hedge funds, similar to those imposed on systematically important banks after the 2008 financial crisis [00:37:00] [00:37:05].
- Improved Disclosure Requirements: Force all market participants to publish their holdings weekly or monthly to improve transparency and allow watchdogs to identify risks faster [00:39:20] [00:39:32].
- Open Trading Principles: Ensure platforms cannot arbitrarily decide what stocks can be bought and sold, advocating for open trading principles [00:39:53] [00:40:07].
- Short-Term Trading Tax: Impose a 10 basis point tax on short-term trading to reduce high-frequency speculation and encourage longer-term investment in companies [00:41:12] [00:41:07]. This could generate significant revenue for the federal government and potentially replace capital gains tax [00:40:24] [00:40:52].
Broader Societal Implications
The GameStop situation highlighted a larger “populism versus the elite” war, where social media serves as a tool for people to organize against powerful elites [01:00:30]. The societal benefit of hedge funds and their immense profits was questioned, particularly when they receive bailouts during losses [01:01:02]. There is a perceived political realignment where both the left and right agree that “something is wrong here” [01:02:10].
The incident also served as a “moment of truth” about leadership, particularly in unpredictable times like a pandemic [01:22:24]. The need for leaders who can synthesize economic, social, and health information, rather than just delegate, was emphasized [01:21:13]. The existence of career politicians was also critiqued, suggesting a need for outsiders who are not dependent on re-election cycles to make changes for the long-term interest of their communities [01:23:07] [01:23:51].