Madison Grady is a staff writer for Brief Policy Perspectives and a second-year MPP student.
During the last few days of January, traders rallied together to buy up shares of GameStop Corporation stock. The trading frenzy spurred from the popular message board website, Reddit, where investors posted about their profits and encouraged others to buy more shares. Retail traders drove up the price of GameStop Corp. stock more than 10-fold over the course of a few days, prompting complaints of market manipulation.
According to Nasdaq.com, GameStop stock closed at $325 per share on Friday, January 29, 2021.
This scheme is known as a crowd-sourced pump and dump, where traders pool small trades and buy as many shares as they can in a short amount of time. This market manipulation, as some have called it, caused a “gama squeeze.” Reddit traders were able to drive up the price of GameStop Corp. stock which leads to more buying, and as a result, the investment banks and other financial institutions that shorted the stock lose money.
Hedge funds will bet against a stock, or speculate a stock or security price is on the decline. They will then borrow shares of that stock and sell the shares to buyers willing to pay the market price. The shares must be returned by a future date, but hedge funds are betting the stock will decline further, meaning they can repurchase them at a lower cost. In the case of GameStop, the stock increased in price rapidly, causing hedge funds that shorted the stock to lose billions.
But why GameStop? First, the company was going under; think the Blockbuster of video game stores, because video game purchases are mainly digital downloads and streaming now. Second, the company has a wide base of customers with lots of reward points members and an upcoming release of a new console generation that would generate an inflow of money. For these two reasons, the ringleaders behind the GameStop trading frenzy bet against the hedge funds that believed the stock was primed to go down. As a result, hedge funds suffered great losses and internet traders became millionaires.
However, those who invested early in GameStop Corp. need to be aware that the same effects that made them millions can also cause them to lose their investment just as fast.
Current Market Manipulation
However, market manipulation is illegal. The U.S. Securities and Exchange Commission (SEC), which regulates the stock market, states “a scheme to manipulate the price or availability of stock in order to cause a short squeeze is illegal.” In the case of GameStop, if regulators can prove that any of the investors tried to manipulate the price and had enough money to do so, those individuals could be in a lot of trouble. One needs both intention and means to be guilty of manipulating the market, however, it seems that none of the GameStop investors can be proven to have both.
Following the GameStop chaos, Robinhood responded by stopping all buying of GameStop stock and a few other companies, citing a “significant market volatility.” Users were only allowed to sell after this decision. Frustrated traders flooded Reddit with comments of a class-action lawsuit against Robinhood on the basis of market manipulation. Both Republicans and Democrats agree that Robinhood’s decision, along with TD Ameritrade and Charles Schwab, to freeze certain stock trading is cause for concern and should not be taken lightly.
Future Market Regulation
U.S. Senator Elizabeth Warren (D-MA) sent a letter to the SEC after the Redditt frenzy, asking the commission, “what steps will the SEC take to ensure that securities markets better reflect prices that are in line with the intrinsic and fundamental value of underlying companies?” The SEC issued a statement saying it was “closely monitoring” the recent activity after the Redditt scandal.
On the other hand, the Financial Industry Regulatory Authority (FINRA), which regulates brokers and broker-dealers, has put trading apps with “game-like” features on notice. Most of the investors involved in the GameStop scandal bought and traded on apps such as Robinhood. Currently, 56% of Robinhood users own stock in GameStop. FINRA is very concerned about the “gamification” these apps bring to trading and may cause investors to trade excessively and make investments that are not suitable for the risk they want to take.
Some are now worried that investing on gamified apps could become just as addictive as video games have become in recent years. Investing apps now integrate social networking as a way to increase the “fun factor” of trading stocks. Traders are celebrated with bursts of animated confetti on their screens after making their first trades and getting friends to sign-up increases a trader’s chance of buying ‘hard-to-get stocks.
Trading apps may face stricter regulations soon, and any apps that include ‘game-like’ design features may be shut down. This begs the question, should gamified investing apps be regulated to protect investors? Reddit users are skeptical of whether or not all this regulation talk is really in their best interest. One user wrote, “They are scared that the young generation is changing the game.” On the other hand, Ross Gerber, CEO of Gerber Kawasaki Wealth & Investment Management, argues “it’s regulators jobs to protect investors… Nothing wrong with the markets at all. Just corrupt Robinhood.”
Exactly what regulation will emerge in the future is yet to be seen, but regulation of investing apps is coming. The case of GameStop highlighted the potential danger these apps pose to market manipulation and new ways retail investors can play the stock market.