Volunteer writer Maciek Anielski gives us a rundown of the ongoing events surrounding the r/wallstreetbets subreddit and it’s so-called ‘attack’ on Melvin Capital
The Dominant Narrative
It’s likely that in the past few weeks, you’ve seen someone talking about Reddit’s war on Wall Street. Melvin Capital, the hedge fund targeted by r/wallstreetbets, a subreddit, has lost 53 percent in asset value while the shares of a video game retailer, have skyrocketed from approximately $40 per share on January 20th to an astonishing peak $513.12 on the 28th of the same month.
Politicians, journalists, and redditors alike, rushed to paint the incident in a veneer of populism, with small-scale retail investors bringing righteous justice to elitist hedge funds.
But is this really what happened? And what does this incident tell us about the state of contemporary politics?
What even is short selling?
The first thing to understand here is how the bunch of self-described ‘degenerates’ pulled this off.
GameStop has been treated by most on Wall Street as a failing company. The rise of platforms like Steam and Epic Games has made purchasing video games in store increasingly redundant. Betting on the share price of GameStop falling, hedge funds and other investment vehicles have engaged in a practice called short-selling, aimed at making money from the struggling business.
The process involves borrowing shares, which are then sold on the market. If the share price falls, investors can buy back the stock they borrowed at a lower price and make a profit from the difference between the two prices.
Reddit declares war
Reddit users noticed that Melvin Capital had been building up a large portfolio of put options (a type of short selling) and decided to bid up the price of GameStop stock by buying it on mass. As the price of the shares rose, panicked investors at Melvin Capital joined in, trying to minimise their losses as the market price for GameStop stock surged above the price they had sold it previously.
While the price continued to skyrocket, many redditors who had bought shares while they were low were able to make vast amounts of money at the expense of the hedge fund. A Reddit user who had invested $1,000 into GameStop when its share price stood at $40 could have turned this into over $12,000 had they sold at the perfect moment.
Stealing from the rich?
It wasn’t just Reddit users and smaller investors that benefited. Other hedge funds, such as New York based Senvest Management, pounced on the potential gains from rising prices. Senvest Management on its own made $700 million. What started as a David vs Goliath story quickly turned into a typical Wall Street battleground, with hedge funds profiting off the losses of other hedge funds.
While those on r/wallstreetbets were euphoric in their perceived victory, Wall Street was selling GameStop shares at sky-high prices. The fact is that at some point prices were going to drop, and hard.
In comes Robinhood, a financial services company which allows retail (non-professional) investors to buy and sell shares for free. With a user base of 13 million, Robinhood was the primary vehicle through which Reddit users and other small investors bought and sold shares of GameStop. When, on the 28th January, the company restricted the buying of certain stocks (including GameStop) there was an uproar.
The outrage didn’t just come from small investors and redditors. Rashida Tlaib, a United States House Representative, accused Robinhood of “market manipulation” to “protect Wall St. hedge funds”. Fellow Democratic representative Alexandria Ocasio Cortez and Republican senator Ted Cruz also called for an enquiry into the restrictions. Narratives like this play well in an era where populist politics, pitting ‘ordinary people’ against ‘the elite’, is becoming increasingly popular.
But was this really what happened? Did Robinhood rush to protect hedge funds or is there a simpler explanation?
Competing Narratives
On the one hand, the narrative of Wall Street colluding to ‘stick it to the little guy’ is compelling. Robinhood itself paid $65 million to settle charges that it engaged in behaviour which led to trades on its platform being executed at worse prices for its customers.
However, the decision to halt trades makes a lot more sense when we consider just how Robinhood buys and sells stocks on behalf of its users.
Clearing Houses
Trades do not take place instantaneously. It can take up to two days for deals to be legally settled, which creates the risk that a party in the transaction defaults and the trade breaks down. ‘Clearing houses’ exist to minimise this risk. They do so by ensuring that those buying stock have to put up margin (similar to a deposit) to prove that they have the money to engage in the transaction.
This margin may go up and down depending on the volume of trades taking place and the volatility of the shares in question.
Because of the enormous volumes of GameStop stock being traded and the high levels of fluctuation, the margin called for by DTCC (Robinhood’s clearing house) rose from $26bn to $33bn. Robinhood was faced with a $3bn bill for its trades, which left it scrambling for money it didn’t have.
In order to limit further such charges, Robinhood halted purchases of GameStop and reached out to banks and other financial institutions for financial support. They eventually raised the money required to continue trading, but in the meantime left its users unable to buy GameStop shares.
Small investors lose big
Unable to purchase shares, members of r/wallstreetbets and other small investors could either hold what they had already bought or sell. Despite calls to wait out the ban, many sold instead. Those that waited ended up suffering heavy losses as GameStop share prices plunged nearly 90 percent from their peak.
Retail investors are no match for hedge funds. Melvin Capital, the worst affected by far, has received billions in financial support from other financial institutions. It’s unlikely that small investors who have lost their life savings betting against Wall Street will get the same level of support.
We the people
During the events of the previous few weeks, populist politicians from both the left and right directed their anger at elite hedge funds colluding against ‘the people’. The issue is that without a complete understanding of how financial institutions and markets work, any subsequent actions may simply lead to more hurt for small investors.
Hedge funds are able to engage in speculative trades because they know that when things go south, there will be someone there to bail them out. Ordinary people who turn to investing need to know that this sort of protection doesn’t apply to them.
As politicians like Ted Cruz and Alexandria Ocasio Cortez push for regulation and enquiries, they need to be aware that any attempt to push ordinary people further into financial markets will almost certainly lead to further losses for those who can’t afford them.
Policymaking should not be fuelled by populist anger directed at harming hedge funds and Robinhood. Instead, it should focus on protecting the people politicians claim to represent.
Header designed by Christos Alamaniotis – Head of Design
Article edited by Connor Wade – Politics Editor
