The Cigar breaks down the recent GameStop/Reddit drama. Graphic by Alison Carpino.
This past month, an underground movement originating on Reddit surprised many by raising GameStop (GME) stock, which had been projected to fall by many hedge funds.
Robinhood Markets, a modified investment broker service, launched a mobile app called Robinhood in 2015. Since then, this app has become widely popular among citizens who are interested in making investments. In late January, a group of Reddit used the app to buy GME stocks en masse to raise the price of the stock, with the goal of preventing hedge funds from making money on their short sales.
Gadiel Cedeño, a student at the University of Rhode Island, recalled hearing about the plan in a subreddit called r/WallStreetBets, as early as November 2020. The catalyst of the plan was a post made by user DeepF******Value, also referred to as DFV. In his post, DFV predicted that the stock market would bet against GameStop stock in January of 2021.
DFV’s forecast was so accurate that many have been jokingly speculating that he may be a time traveler. Though comical, this addresses the fact that information accessibility affects the chances of success for an investment.
Before the spike in its stock prices, GameStop’s stock was dwindling because consumers now download and stream games remotely, rather than purchasing games in-store. According to URI economics professor Liam Malloy, observing these patterns can be quite lucrative.
“It all comes down to the cost of information,” he said. “It appears that hedge funds were shorting a large percentage of stock. When you short a stock, you borrow the shares, sell them and then have to buy them back in the future so you can return the shares to whomever you borrowed them from.”
Citron Research, one of the hedge funds that was nearly bankrupted after this event, and other hedge funds decided to short GME stock. As with many professional investors, they used advanced data models to determine their decision. They did not consider, however, that DFV and other Redditors would take advantage of their maneuver.
DFV’s post that predicted hedge funds would short GME stock in January collected substantial attention. He encouraged other users to buy GME stock to increase its stock value, which led to their catchphrase “GameStop to the moon” gaining popularity. As a result of the mass purchase of GME stocks, hedge funds lost money on the stock they had shorted and were instead accountable to pay large amounts of money to repossess those stocks. The Redditor’s plan was based on a core model that is employed by professional investors on a regular basis.
“Essentially, Reddit users pulled an Uno reverse card by observing that hedge funds would bet against GME stock value,” Cedeño said, “and then made investment decisions accordingly.”
In America, every citizen shares equal command over stock market transactions and the profit to be made thereof; the only requirements to invest in the market are citizenship and age. These minimal qualifications to participate in stock exchange are widely known. However, in an article for Business Insider, reporter Ben Winck explains that the hedge fund industry’s assets increased by 7.7 percent in 2020, totalling over $3.5 trillion. For comparison, there are only 1,718 hedge funds globally whose assets are $1 billion or greater. Meanwhile, the 328.2 million people in America share an average GDP per capita of $65,297.
In the same year, hedge fund investments averaged a 12.3 percent return last year, while the aggregate return on investment was 8.94. This economic disparity was the primary motivation for DFV, and other involved Reddit users, to engage with the market in the way that they did.
“For Redditors, it was less about the money and more about hedge funds bleeding,” Cedeño said. “They use these same tactics all the time.”
Shortly after the unforeseen jump in GME stock value, users were unable to purchase more GME shares on Robinhood. According to the app, there were no available shares and therefore no means of executing purchase transactions. The limit on GME stock not only drove the price down but also stopped the Reddit users in their goal.
“The stock market may pause for 20 minutes to an hour due to volatility,” said Malloy, “but I don’t recall that this type of restriction has ever happened.”
It is unclear if Robinhood truly did not have the means to execute transactions. However, this discrepancy has recently come under federal investigation.
“Robinhood Markets, the discount brokerage popular among the investors involved in the rallies, has been subpoenaed for its role in the event along with other brokers,” writes Winck.
In any case, Malloy said that hedge funds have most likely learned from this and they will not advertise their investment plans in the future, as the publication of that is what allowed DFV to devise and execute this plan. However, this may implicate a need for new market regulations.
“A prospective market regulation may be to require hedge funds to publish a certain amount of information regarding stock prices, stock supply, and the extent to which stocks may be over or undervalued,” Malloy said.
This data is useful for making informed investment decisions; a function that all American citizens may participate in, not just expert hedge funds. In addition to that prospective regulation, Malloy also said that brokers should impose qualifications that investors must meet in order to participate in certain types of transactions.
“Brokers have the responsibility to protect investors,” Malloy said. “Certain people should not be able to open accounts capable of margin borrowing.”
Margin borrowing is a transaction where investors borrow money from a broker while using investment as collateral. This type of transaction has a high financial risk.
The advantage of qualification requirements is visible in the case of Alex Kearns, a twenty-year-old from Illinois. According to CBS News, Kearns used the Robinhood app as an investment broker, where he engaged in margin borrowing to make risky investments that he did not have the funds to execute on his own. These investments went wrong and Kearns thought that he had incurred a $750,000 loss, which led him to take his own life in June 2020.
Robinhood, which does not require qualifications for margin borrowing, was sued by Kearns’s parents for not having restrictions that could have prevented the huge financial losses and possibly his death.
Since late January, GME stock has plummeted $298 and its price value lies just $10 above its prior position. Though DFV’s market mania has concluded and stock exchange is functioning with ease, many aspects of the American stock market, including policy implications for the future, remain uncharted.