From: allin
The GameStop frenzy of early 2021 was a significant event that brought to light several vulnerabilities and debates within the financial markets. It primarily involved a clash between retail investors, organized through online forums like the Wall Street Bets subreddit, and traditional hedge funds.
Genesis of the GameStop Saga
The phenomenon began in June 2019 when a Wall Street Bets user, “DeepF***ingValue,” started buying long-dated January 2021 call options on GameStop (GME) stock. He initially invested 25 million [00:03:59]. These online forums, where individuals discuss and promote stock ideas, operate similarly to “idea dinners” held by professional hedge funds [00:04:24].
Further interest in GameStop grew when Michael Burry, famous from “The Big Short,” disclosed a 3% position in the company in August 2019 [00:05:08]. He noted that 90% of GameStop’s 5,700 stores were free cash flow positive and the company was trading at or near net cash levels [00:05:28]. GameStop, a retail store selling video games and consoles, had seen its stock decline due to reduced mall traffic and the shift to digital downloads [00:05:47].
In August 2020, Ryan Cohen, founder of Chewy, acquired nearly a 10% stake in GameStop [00:06:31]. Shortly after, a Wall Street Bets member highlighted GameStop’s 120% short interest [00:06:44], defending the company based on an upcoming console cycle, continued physical game sales, 55 million loyalty program users, a strong balance sheet, Cohen’s investment, and the potential for a short squeeze [00:06:55]. Cohen later wrote to GameStop’s board in November 2020, urging a strategic review to evolve into a technology company that delights gamers, rather than remaining a brick-and-mortar retailer [00:07:26].
The Short Squeeze and Market Dynamics
In January 2021, GameStop reached an agreement with Ryan Cohen, adding him and two Chewy affiliates to its board, causing the stock to rise 13% to about 40 by January 14th [00:08:51].
This ignited a battle between institutional investors who were heavily shorting GameStop, and retail investors who were aggressively buying the stock and call options [00:09:17]. The short interest exceeded the actual number of shares, reaching 140% [00:10:04]. Quantitative and momentum hedge funds also joined the long side, contributing to over $100 billion in GameStop stock traded over seven days [00:10:29].
Citron Research, a firm known for identifying shorts, announced their short position in GameStop on January 19th, predicting a drop to 3 billion into Melvin Capital to prevent its collapse [00:11:39]. This short squeeze forced hedge funds to cover other shorts and sell long positions in other companies (e.g., Facebook, Netflix, Alibaba), causing broader market volatility [00:11:57].
Robinhood’s Trading Restrictions
On January 28, 2021, brokerage firms, including Robinhood and Interactive Brokers, prevented users from buying GameStop and a handful of other stocks, allowing only sales [00:12:34]. This one-way pressure caused a 44% sell-off, though the stock later recovered [00:12:44].
Chamath Palihapitiya argued that Robinhood’s decision was likely due to insolvency and insufficient capital to meet margin requirements from their partners [00:03:34]. He asserted that Robinhood “lied on television” by denying a liquidity crisis [00:18:03]. This decision, according to Palihapitiya, cost individuals hundreds of millions, possibly billions, in economic losses [00:03:48], and was a clear act of negligence or “the fix” [00:29:37]. David Sacks agreed that the effect of the decision was “really bad” because it allowed the hedge funds, who were “on the ropes,” to regroup and save themselves [00:24:19].
Jason Calacanis, while acknowledging the potential for shenangians and market manipulation by hedge funds, urged caution against impugning Robinhood’s motives with partial information [00:16:16]. He highlighted Robinhood’s role in creating a “revolution in retail trading” by making it free and friction-free, thereby engaging millennials in stock trading [00:16:29]. He believed Robinhood would “ride it out” as the situation was an “unprecedented black swan event” [00:19:07]. Friedberg added that Robinhood’s business model, which generates revenue from payment for order flow, makes money when the market is non-volatile, but exposes them to risk during volatile swings [00:20:52].
Robinhood’s Business Model and Conflict of Interest
Robinhood primarily earns revenue through “payment for order flow” (PFOF) [00:13:54]. They monitor user orders, create data files, and provide them to prime brokerage institutions like Citadel milliseconds before trades are executed [00:14:00]. This allows Citadel to potentially profit from the incoming order flow [00:14:15]. Citadel accounts for 47% of Robinhood’s PFOF volume, paying Robinhood almost $100 million in Q3 [00:14:26]. A potential conflict of interest arose when Citadel also provided capital to Melvin Capital, which was heavily short GameStop [00:28:07], leading to questions about whether Citadel influenced Robinhood’s decision [00:28:20].
Criticisms and Broader Implications
Critics argued that Robinhood’s actions constituted “economic censorship” [00:57:47]. The inability to manage their business led to individuals being blocked from transacting in an open market, causing measurable economic damage [00:46:14]. Palihapitiya likened Robinhood to Lehman Brothers or Bear Stearns of 2008 due to its apparent insolvency and its impact on the “little guy” [00:19:01].
The incident sparked a wider discussion on the nature of stock trading. Palihapitiya argued that trading stocks is no longer about investing in businesses but has become a “synthetic casino” or “gambling model” [00:33:05]. He cited the $121 trillion in notional volume traded in US equities in 2020, suggesting minimal capital actually reached businesses [00:34:05].
Proposed Solutions for Market Reform
Palihapitiya suggested several regulatory changes to address market issues:
- Blockchain for Ownership Tracking: Use modern technology, possibly blockchain, to ensure that shares are not loaned out multiple times, preventing scenarios of over 100% short interest [00:36:04].
- Leverage Limits for Hedge Funds: Implement strict leverage limits for hedge funds, similar to banks post-2008, to prevent systemic risk, citing the Long-Term Capital Management collapse of 1998 as an example [00:37:00].
- Improved Disclosure: Force all market participants to publicly disclose their holdings weekly or monthly to allow watchdogs to identify risks faster [00:39:22].
- Open Trading: Platforms should not arbitrarily decide what can be bought or sold [00:39:53].
- Short-Term Trading Tax: Implement a 0.1% tax on every share sold to discourage high-frequency trading and encourage long-term investing. This could generate significant revenue and potentially replace capital gains tax, channeling more capital into businesses [00:41:07].
Social Media and Decentralization
The GameStop frenzy highlighted the growing power of individuals to collectively influence markets and outcomes through social media, akin to political movements or even events like the Capitol riots [00:54:03]. David Sacks drew a parallel between Robinhood’s trading restrictions and the de-platforming of Trump or Parler, arguing that when those in power feel threatened, they use censorship rules to shut down outsiders [00:57:12].
While social networks can enable positive “movements,” they also foster negative “mobs” characterized by rage and anger, leading to “diffusion of responsibility” and mob behavior [01:06:43]. This surge of decentralized collective action suggests a need for centralized systems to adapt and be fairer, or risk people turning to fully decentralized alternatives [01:06:29].
The Future of GameStop and Robinhood
Despite the rally, there was concern that retail investors buying GameStop at high prices might be “left holding the bags” when the short squeeze ends [00:42:39]. As of the discussion, a significant number of shares (55 billion out of 70 million total shares) were still short [01:09:33].
For Robinhood, the path forward involves potentially shoring up its balance sheet with massive capital injections (e.g., a $10 billion investment) [01:00:03]. The company faces potential class-action lawsuits due to the perceived economic damage to users [00:45:42]. The long-term future of GameStop’s stock price remains uncertain, as its value has become “uncoupled from the underlying asset” [01:12:13], driven by collective belief rather than fundamental business value [01:14:07].