GameStop: What is Happening and Why it is Important
You cannot turn on the financial news this week without hearing what is happening with GameStop. While this will be a short-term blip in the market what is happening is significant. Essentially what we are seeing are the small individual investors trying their best to fight against Wall Street and enjoying themselves as they do it. After years of Wall Street having advantages in the market, from high frequency trading to massive short selling the time has arrived for Wall Street to pay the piper.
WHAT IS HAPPENING
What is happening with GameStop is what they call a “short squeeze.” For those that are unaccustomed to the way the market works when an entity shorts a stock, they are borrowing shares of stock from a broker at a set price with the hopes that the price drops and they can give those borrowed shares back that they bought at a lower price, profiting from the difference. The squeeze occurs when investors purchase the stock in large numbers to make the price rise, forcing the short sellers to purchase the stock back at a higher price.
An example of this would be an investor would borrow 100 shares of XYZ stock at $10, if the stock price drops to $5 the borrower would purchase 100 shares on the market at $5 per share and give them back to the broker with a $500 profit. The issue for the short seller happens when the price goes to up to $15 and the investor must purchase the 100 shares at $15 to give back the shares they borrowed at $10 taking a $500 loss.
In the case of GameStock an investor that shorted the stock on December 31st, 2020 did so at the price of $18.84 per share. As of this writing the pre-market share price of GameStop is $373 per share which is a per share loss for investors who shorted the stock being $354.16 per share. To put this into the context of the whole market there are 71.79 million shares that were shorted on GameStop. That is a total combined loss of $25 billion by short sellers, which are mostly hedge funds.
One of the main issues that is being lost is that there are only 69.75 million shares of GameStop stock currently on the market. That means that over 100% of the outstanding shares of GameStop were shorted by Wall Street firms who are ultimately the investors who are currently taking massive losses.
MANIPULATION
What started all of this was a group of people on Reddit that banded together to drive the stock price up to hurt the short sellers. Once it made national news and investors saw that they had the chance to make money and stick it to Wall Street, more and more individual retail investors jumped on the train. Because of the way that this started there are claims from Wall Street that this is stock manipulation which is illegal.
Because of their outcry yesterday, for a time, some trading platforms minimized who could trade GameStop stock. Investors could sell their positions, but they could not buy anymore. This halted the upward trend momentarily, currently GameStop stock is on the way back up, the price has doubled in pre-market trading which brings up another issue of manipulation. How are these actions not manipulating the share price? You cannot have a free market when one side of traders are limited in what they can do regarding buying and selling. By closing purchasing of additional shares, the price has been manipulated. However, because this was done by Wall Street, we will never hear calls for hearings to figure out why they manipulated the stock in this way. The market must be free, if someone loses it all so be it. As long as no one is committing a crime people should be allowed to buy and sell stock as they see fit. It will be interesting to see what comes of this wrinkle in the story.
Another question regarding price manipulation is how is this different than banks and investment firms appearing on CNBC or Fox Business and discussing stocks and where they see them moving to? While it is not as nefarious as what we are seeing on Reddit, there is no real difference between the two. In both cases investors are sharing tips on what to do in the market, the difference is one is an accepted practice and the other is obviously not.
REGULATION
One of the free market implications from this is that there are bound to be regulations that are going to be put in place once the dust settles. I do not believe that Washington will ignore this and will use this as an example of what is wrong with the market. They will show the flaws in the system that have caused this and find a reason to further clamp down on investors. One of the ideas already being floated is a transaction tax. If implemented this would charge investors a tax each time that they place a trade. While this tax would have implications for the big banks, it would also harm the small retail investor and really do nothing to make a change besides make trading more expensive.
The issues that caused this are not issues with the market, the issue is that Wall Street firms took too much risk and got caught. With short selling the issue becomes that these firms are using this tactic to keep the price of the stock artificially low. The stock price is not down because of inherent weakness in the stock but because they want to make money on a price drop which they are partially causing, and they got caught. Not caught doing anything illegal but caught making risky bets and they are now being punished for it.
WHERE DOES THIS LEAD
Where does this all lead? In the end some retail investors that climbed on this trend will lose their shirts. While it was fun to watch, there will be real would consequences for small investors that saw an opportunity to make quick money. There will be some that will take profits, but there are a lot that will sell as the stock tanks, well below their purchase price.
What is not clear is what the government response to this will be. If the past is any indication there will be increased regulation to ensure that this does not happen again. While this instance does not prove that there is an issue with the market, the government will find a reason to further regulate investors.
One of the still unknown facets of this story that could have huge implications is how much were the banks exposed to this trade? As we have seen in the past when large amounts of money are lost by Wall Street firms there will be cries for a bailout. The old term from 2008, “too big to fail” will be rolled out as a reason why banks, if exposed, will be assisted. Bailouts are wrong regardless of what the business is, companies should not be rewarded for taking on too much risk. If a company made bad decisions and took too much risk the market says they should fail. Sadly, the supposed free market that we operate in will not allow that to happen. We will hear cries that this is the reason why capitalism is flawed, and changes will be made.
If we do see bailouts, we will see questions on why this happened. One of the reasons why this has happened in the past and continues to happen is because of the bailouts. The market is very good at punishing those who take on too much risk. With bailouts the taxpayer assumes some of that risk and there is less reason to be cautious because in the end the banks will be bailed out. The banks cannot learn their lesson in the end if there are not consequences for their actions and by not intervening it is a start to that lesson.