Gamestop’s Short Squeeze & How to Solve the Issues it Revealed
In the minds of many retail investors on the Reddit forum WallStreetBets, market manipulation by hedge funds and MMs (Market Makers) has been a common and expected occurrence for years now. Users on WallStreetBets believe that through coordination with the media, massive market orders, and other barely legal tactics, stocks are manipulated on a daily basis for profit. The purpose of this article is not to verify or refute their prevailing theory, but simply to provide insight into the culture of how these investors function. As a disclosure, I have been a member of the WallStreetBets forum for two years and I did invest in GameStop around December 2020.
Before detailing the actions, it is important to understand how Reddit and this forum works. Any user can submit text, images, and links, to a subcommunity (subreddit) in the form of a post that has its value judged by upvotes and downvotes. When one upvotes a post, it is able to reach more people, and if one downvotes a post, it is received by fewer people. In addition, users are able to form sub discussions underneath these posts, discussing the content of the post, and forming their own opinions on other similar topics. This leads to something of a herd mentality which favors posts that are clearly popular and echo the sentiments of users at the time. The more popular an idea is, the more people will upvote it, leading to more people being exposed to the idea, leading to more people agreeing with it. If what is being described here sounds like an echo chamber to you, then you are absolutely correct. Reddit, by design, breeds echo chambers within communities, causing extreme ideas to easily propagate if these ideas are appealing to many. This is not a critique - but simply an observation in trends of how the upvote downvote system works in practice. The effect of this on a subreddit like WallStreetBets, a self-described “trading” (but closer to gambling) community, is that once an idea takes hold, it can circulate among hundreds of posts that reach thousands of people and create a feedback loop.
The GameStop stock situation occurred to other stocks to a lesser degree, but for the purposes of this article, I will focus on GameStop. In early December, a growing number of users began noticing that hedge funds and market makers had given GameStop a short interest of more than 100%. By shorting more of the stock than existed through sub shorting and short lending, hedge funds created the perfect conditions for a massive short squeeze. A short squeeze is, ironically enough, an effect similar to an echo chamber. A short squeeze occurs when a stock jumps in price, forcing shorters to buy the stock to prevent losses, which in turn pumps the stock even higher due to increased purchase activity, over and over again.
The unique situation was exacerbated when we combined the echo chamber that is WallStreetBets pumping out thousands of posts about purchasing GameStop shares with an Elon Musk tweet and attention from the media. The user base grew from 1.8 million to nearly 9 million in the subreddit. This only continued the pump of GameStop to an all-time high of $483. In fact, hedge funds that had short positions began losing increasingly absurd amounts of money. Melvin Capital, a fund that bet heavily against GameStop lost 53% of its entire portfolio in January. One would assume that this is acceptable under free-market capitalism and that companies should simply move on. Unfortunately, the truth is far more sinister.
Brokerages decided to help out their hedge fund allies and engage in open, blatant, and clear market manipulation. These brokerages decided to stop allowing retail traders from purchasing any shares of GameStop. The only allowed action traders could take was to sell their stock. There are no two sides to this coin. Only allowing traders to sell a stock cannot be misconstrued as anything other than market manipulation. Combined with the already prevailing theory of manipulation and the intricately woven ties that many brokerages have with Melvin Capital and partnering companies such as Citadel, people had no choice but to believe the theory that all the hedge funds worked together to manipulate the markets. People did try and hold their shares as long as they could, echoing in their echo chamber, but when dismembered so brutally by brokerages, they had no chance in holding out longer than multibillion-dollar hedge funds.
How should the US Government respond to this clear crisis in how the market functions? An optimist will tell you that the government’s institutions are strong and that they will work to protect retail traders from this type of manipulation in the future. This optimist will tell you that the SEC and courts will launch cases against these hedge funds and brokerage firms for their clear actions of manipulation in the market. They may even hope for the democratic trifecta in government right now to pass sweeping legislation to protect and strengthen the rights of individual investors. The pessimist will tell you that a hearing or two may occur, but no real changes will be made, and the foundation of the issue will remain.
Finally, the realist will remind you that the same brokerages that were at the center of this crisis of the big guy vs. the little guy are the same brokerages that fund the reelection campaigns of an overwhelming majority of US politicians. Why would any politician that relies on corporations for their election contributions even consider a vote for any legislation that reduces their powers? This realist will tell you that the only way to solve issues like these and many others would be to remove corporate money from politics. Almost any other solution would be at best a farce to make the masses complacent in the fight for better politicians.