The GameStop Bubble

National Review Online

Sunnday, January 31, 2021

 

After the army of day traders that populates Reddit’s WallStreetBets forum started piling into GameStop stock, the company’s share price went from $40 to $400 in the span of a week. The brick-and-mortar video-game retailer garnered so much attention that it ranked as the single most-traded stock in the world on Tuesday. Meanwhile, a handful of prominent, multibillion-dollar hedge funds suffered heavy losses in their bets against GameStop. Two days later, in the face of chaotic, speculative trading activity, retail brokerages Robinhood and Interactive Brokers halted trading in 13 stocks favored by retail investors, sending GameStop shares down more than 40 percent.

 

Among the surprising byproducts of this saga is a rare moment of bipartisan agreement that someone, somewhere, did something wrong. Representative Alexandria Ocasio-Cortez and Senator Ted Cruz blame Robinhood. In light of what looks to them like another attempt by tech firms to police the activity of everyday Americans, the two lawmakers called on Congress to investigate the trading halt.

 

Days earlier, when the stock was soaring, politicians chastised the traders, not the brokerages, for alleged market manipulation. On Wednesday, the White House press secretary told reporters that Treasury secretary Janet Yellen was monitoring the situation, and the SEC reportedly began investigating trading activity, too.

 

For all the complaints of lawmakers, though, it was the retail brokerages that took away the punch bowl, not the regulators. For a few days, it looked like the market had broken. The rally in GameStop, AMC, Blackberry, and other stocks handpicked by Reddit was based on nothing more than sentiment. In a functioning market, smart money should correct overvaluation driven by dumb money.

 

Although it took a few days, that’s exactly what’s happening. Robinhood and other brokerages halted trading not due to some shady desire to help Wall Street, but because they could not afford to shoulder the risks their customers were taking. A sizable portion of retail traders’ speculative investments in “meme stocks” were made with money borrowed from brokerages on margin. In response to increased volatility, Robinhood twice issued “margin calls,” decreasing the amount of borrowed money customers were allowed to invest in GameStop — first to 20 percent, then to zero.

 

In the meantime, the brokerages had to wait for customers to put up cash while their trades were settled by central clearinghouses. Like the brokerages, the clearinghouses did not want to take the risk of lending to speculators, so they increased the amount of collateral required to settle transactions in high-risk stocks. But Robinhood and other brokerages wouldn’t have that cash until their many millions of customers met margin calls. They faced the choice of either putting up their own cash, and exposing themselves to the risk of a meme-stock meltdown, or pulling the plug. Though the Reddit rally is far from over, it began to unravel in a matter of days thanks to the rational decisions of market participants.

 

That doesn’t mean the brokerage’s customers shouldn’t be angry. One could argue that it is Robinhood’s responsibility to manage liquidity risks and ensure that trades get executed. In response, Robinhood would argue that it has no obligation to execute excessively risky trades. We’ll leave it to the courts to settle that dispute.

 

The bottom line is that the decision of brokerages and clearinghouses to stop transacting in speculative stocks represents an organic, albeit incomplete, correction of a short-lived bubble. And despite the hysterical headlines, that bubble was limited to a handful of small stocks with minimal impact on broader market conditions. Even as GameStop shares jerked up and down, major stock indexes had a relatively normal week.

 

When the dust settles, some will have made money, and some will have lost money. Regulators may even uncover fraud. But the Reddit rally is not going to bring down the financial system, and it does not require new legislation.