The battle between retail investors and hedge funds burst seemingly out of nowhere last week, and many people are now spending the weekend wondering how it will end. The answer depends in part on two things: First, who will be first among the three group of actors — hedge funds shorting the handful of stocks, retail investors buying them and the intermediaries enabling both sides to trade— to surrender, especially if done through a disorderly unwinding of their book? Second, how will regulators and politicians react?
What has been colorfully, and not that inaccurately, labeled as the uprising of the little guys reflects the confluence of information platforms, data, and easy-to-use products and trading apps — all of which have been helping the more general phenomenon of democratizing finance. In addition to technology, big data and some relatively simple forms of artificial intelligence, the fuel also involved an accumulation of years of the everyday small investor feeling marginalized and disadvantaged by a finance establishment that appeared to have co-opted the Federal Reserve and other agencies.
The catalyst — helped by the availability of cash and, in some cases, stimulus checks — came in the form of the discovery of a strategy in which the usual power brokers, led by the so-called smart money (the term historically used to refer to hedge funds), were significantly vulnerable. This strategy involved an ad hoc movement to buy the stocks of the most heavily shorted companies in the hope of triggering a short squeeze and forcing the bears to scramble and cover their positions. It is a strategy that worked especially well in the case of GameStop Corp., where the accumulated shorts were equivalent to around 140% of the outstanding stock.
The hedge funds shorting were not the only ones exposed to what in markets is known as a pain trade. The intermediaries also found themselves under growing pressure, scrambling to safeguard their balance sheets and maintain prudential guidelines, being forced to cough up cash, draw on credit lines or both.
By the end of the week, all three actors were still in the game. Who will be knocked out first is far from straightforward.
Historically, small investors pushing up a handful of stocks would be at most risk of being picked off because of their limited individual capital, especially when squaring off against professional hedge funds. Under that outcome, the implications for the financial system would be relatively small notwithstanding the losses incurred by these investors.
But, similar to a phenomenon that first came to global attention during the Arab Spring in the early 2010s, social media, and in this specific case Reddit, has enabled usually dispersed investors to become more of a strong collective force with a common purpose. To confront this new force and stay in the game, hedge funds have already been forced to raise cash to meet higher margin calls, with some also stopped out of their short positions. This compelled a few of them to sell some of their long holdings, with the inclination to dispose of their most liquid ones. With that comes an element of marketwide contagion, the extent of which will depend on the strength of what, at least until now, has been a remarkable countervailing “buy the dip” conditioning.
Such damage to general asset prices, producing the worst week for the S&P 500 Index since October, pales in comparison to what would most likely happen if one of the intermediaries were forced into a disorderly deleveraging, whether it be a broker or central clearinghouse. If not handled well, this could have much broader effects, especially because the nonbank segment of the financial system has been in an unprecedented period of rapidly rising debt, leverage and risk-taking, aided and abetted by too many years of excessive policy reliance on experimental central bank measures and regulatory/supervisory gaps.
Regardless of which of these scenarios plays out — and, to make things, even more interesting, they are not mutually exclusive — regulators and politicians can be expected to become involved in some capacity. Harder to predict is what particular element they will focus on most; some can have competing effects on asset prices and market functioning. Among the targets could be small investor protection, investment suitability criteria, margin limits, possible collusion and price manipulation, and market structure.
What started out as a market curiosity — small investors taking on the Wall Street establishment using what had been periphery platforms too easily dismissed by the traditional market powers — has both broader origins and implications. This is not just an epic David versus Goliath story that has now attracted worldwide media attention. Potentially in play is the democratization of finance, tech-led disruptions to market hierarchy, the overall valuation of markets, regulatory and political responses, and the market structure itself. -Bloomberg
Also read: The GameStop story — how a group of investors on Reddit gave Wall Street a wild week