What Happens Next in
the GameStop Showdown?
Whether it’s retail investors, hedge funds or
intermediaries, the implications are not straightforward, and that’s before
regulators and politicians get involved.
By Mohamed A. El-Erian
January 30, 2021, 3:57 PM EST
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
groups 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.
This column does not necessarily reflect the opinion of the
editorial board or Bloomberg LP and its owners.
To contact the author of this story:
Mohamed A. El-Erian at melerian@bloomberg.net
To contact the editor responsible for this story:
Daniel Niemi at dniemi1@bloomberg.net
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