Dear friends, dear interested,
It is a battle between David and Goliath that has been unfolding around the GameStop share for about a week now. On the one side: big players in the financial sector, first and foremost American hedge funds. On the other: a swarm of internet-savvy retail investors who want to beat the hedge funds at their own game. With a kind of financial flash mob, the small investors are driving the share price up to hurt the big funds – so far with success. While many have sympathies for the apparent triumph of the underdogs, parts of the financial sector are appalled. Former American presidential candidate Elizabeth Warren aptly commented: “And all of a sudden, the billionaires and some hedge funds are yelling because they’re not the ones, the only ones who make money when the manipulation works”. How the crazy spectacle will turn out remains to be seen. Yet, the events raise significant questions. On my initiative, the Committee on Economic and Monetary Affairs of the European Parliament will soon deal with the issue in an expert hearing. In particular, we will ask the European Securities and Markets Authority ESMA to investigate the events of the past few days and to make an assessment from a European perspective.
What has happened? At the centre of the developments is the American video game retailer GameStop. On 21 January, Gamestop shares were still trading at just over 40 dollars on the New York Stock Exchange. Only one week later, almost 500 dollars were paid for the share. This unprecedented price explosion was arguably triggered by retail investors that rushed into the stock. Prior to this, buying the share had been promoted in internet forums, most notably on reddit, and in social networks. The stated goal: if a large number of small investors act together, they can drive up the price of the share. If the price rises high enough, at some point the hedge funds, which have bet on a crash of the stock using so-called short sales, will be in trouble. In the case of GameStop, an exceptionally large number of short sellers had made such bets. To stop losses, the hedge funds have to buy shares themselves at some point – and thus further boost the share price. This creates a self-reinforcing effect that can drive the share value to dizzying heights. This is called “short squeeze” because the short sellers are literally squeezed out. At the same time, GameStop’s ever-growing hype on the internet attracted a steady stream of new retail investors. According to estimates, hedge funds lost almost 20 billion dollars within a week just because of the GameStop stock. The swarm of small investors has long since turned its attention also to other stocks with large short positions. Among others, cinema operator AMC, Nokia and Blackberry have since seen significant price increases. How this will play out remains to be seen.
One thing is clear: the price movements of the past few days cannot be justified by fundamentals. If it were an odd one-time event, this would not be a big issue. However, the GameStop frenzy reveals systemic deficits in price formation. This is bad because financial markets have an important role to play in informing investors and business partners about companies. While the belief in efficient markets has always been illusory and information efficiency limited, some recent developments seem to affect market integrity in particular ways:
Massive short selling: A crucial role in the events surrounding GameStop is played by short selling, which large institutional investors, for example hedge funds, use to bet on falling prices. To do this, they borrow shares from other investors, such as investment funds, which they must return at a later date. Instead of simply keeping the shares, the short sellers sell them on the market and hope to be able to buy them back later at a cheaper price. The cheaper the share when the borrowing expires, the greater the profit. Conversely, large losses can occur if the price of the share rises. In principle, short selling can be an important corrective for the stock markets. Excessive short selling, however, creates instabilities. In the case of GameStop, the data show that investors had sold more shares short than were actually in circulation. This is possible because shares can be lent and sold multiple times. However, this of course means that panic is inevitable when prices rise and many short sellers have to cover their positions in a market that is far too small. I will suggest that we consider introducing stricter limits to make such short squeezes less likely in the future.
Speculative trading by retail investors: The enormous participation of retail investors was made possible by a new generation of online brokers such as Robinhood or Trade Republic, which offer their clients commission-free securities trading via apps. Their number of users increased massively during the Covid-19 crisis, because lockdowns worldwide provided small investors with free time and unused funds. The fact that young companies are stirring up the market with attractive offers is, of course, very positive from the consumer’s point of view. But there are also critical aspects. Why many of these brokers have repeatedly suspended trading for retail investors in recent days should be investigated. Moreover, the commission-free model is based on indirect fees embedded in execution prices, which is not understood by many users. What is new about the GameStop case is that uninformed retail investors have made their investment decisions en masse based on an internet phenomenon. The line between legitimate investment recommendations and market manipulation is blurred. In the medium term, this harms both market efficiency and the small investors themselves. Price discovery, which is the primary task of stock markets, gets distorted. The current GameStop price is also a clear bubble that will burst at some point. My fear is that professional investors will be more likely to exit in time and the bulk of the losses will be borne by retail investors. I believe that small investors should have the right to make risky or irrational investments. However, it is important to me that they make this decision freely and are not lured by financial service providers who earn commissions. From this point of view, we should take another close look at the business practices of the new online brokers.
Liquidity glut in equity markets: Continued activist monetary policy and the low interest rate environment have led to unprecedented liquidity in equity markets in recent years. Investors searching for yield invest in virtually anything that promises returns. The ever-growing importance of rule-based investments such as ETFs is also creating significant demand. In the case of GameStop, for example, more than a quarter of the shares are owned by the major asset managers BlackRock and Fidelity. From an investor’s point of view, ETFs, which track the performance of an index, are a good product because fees are low and risk is widely spread. However, what these forms of investment have in common is that they reduce the information efficiency of the markets because they are little oriented towards fundamentals and often drive prices on the stock markets through sheer demand.
The GameStop demonstrates once again how inefficient financial markets often are. They actually have an important economic role to play in price discovery. But excessive speculation, the dominance of rule-based investments or, more recently, the financial flash mobs of internet-savvy small investors distort the picture. Giant asset managers like BlackRock own significant shares of the overall market and thus have enormous market power. Many are calling for a democratisation of financial markets, and rightly so. But to ensure that this does not happen at the expense of market integrity and market efficiency, we need to set the right guardrails. The GameStop case shows where we need to take another closer look.
With green European greetings
Sven Giegold
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