Why the GameStop stock frenzy is likely to end in financial crisis

The drama unfolding around GameStop is a tale of the internet levelling the playing field between at-home retail investors and Wall Street. The US stock market may become as retail dominated, and as volatile, as the Chinese market

Andy Xie

Published: 7:45pm, 1 Feb, 2021

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A blood sport is emerging on Wall Street. A band of millennials is buying stocks that big hedge funds have heavily shorted. The surging stock prices have triggered heavy losses for these funds. This game of hunting short-sellers may bankrupt many big hedge funds, which could take their financing banks down with them. The potential for a financial crisis is high, and rising.

Specifically, an epic drama is unfolding around GameStop. Wall Street assumed that the bricks-and-mortar video game retailer would die quickly, as the market was moving online. The big hedge funds shorted 140 per cent of the stock. That’s right, the short sellers sold more stocks that they didn’t own than the company had issued. Millennial retail investors coordinated a short squeeze online, pushing up the stock price 20-fold.

The short-sellers have suffered paper losses of around US$20 billion. They are still holding onto the shorts, hoping the “troublemakers” will turn on each other and leave. The internet trading platforms seem to have helped them by limiting buying to one share per person.

The power play by short sellers could backfire. Politicians are likely to intervene to question the motive for limiting buying. It smells fishy, and confirms many people’s belief that Wall Street is rigged against the little guys. If these trading platforms are forced to open up, the price may surge again.

The hedge funds involved may also have to sell liquid stocks like Apple and Google to raise cash. The market could come under heavy pressure in the coming days.

This winning hand is emboldening the merry band of millennials hunting short sellers. Several heavily shorted stocks like AMC and BlackBerry are surging. The big hedge funds could suffer hundreds of billions of dollars in losses. Many are likely to go bust. They may even take down the banks that fund them. This could be the trigger to pop what is possibly the biggest stock market bubble in human history.

The US Federal Reserve has kept interest rates near zero for a long time and signalled that they will remain so for years to come. Hedge funds have taken advantage of the cheap funding and been bidding up stock prices with leverage.

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To justify their fat fees, they have shorted some stocks to show they are hedge funds, not mere speculators. This is turning out to be their Achilles heel. Internet-based platforms are giving retail folk the same tools that big financial institutions have. They too can use leverage to play. When millions work in tandem, they can topple big hedge funds.

What’s happening illustrates that the internet has levelled the playing field between retail and institutional investors. Online coordination is making the retail impact explosive in some segments of the market.

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Is the US economy an oligarchy?

Millennials are the first gaming generation in the digital age. They can spot the vulnerabilities and cracks in the financial system. Financial products are priced on past trends. But millennials have the numbers to change trends and make the big boys lose big time.

The democratisation of high finance is not only transforming the financial system, it is also changing how the monetary system functions. Little guys can exploit cheap liquidity from the Fed, as big banks or hedge funds have been doing seemingly forever.

Why the growing US wealth gap spells trouble for the world

The world has seen decoupling between money supply and inflation, because globalisation has cut labour’s pricing power. Hence, the money supply has gone mostly into financial markets to be used by big speculators and financial institutions. The resulting financial inflation has led to extreme wealth inequality.

As the masses figure out how to tap into the central bank’s cheap liquidity, money spreads around faster, and the benefits from financial inflation are distributed wider. This may recouple money with inflation. When financial inflation is concentrated among a few, it spills into real inflation in small segments like art or luxury property.

Hence, the central banks could pretend not to see inflation. But when millions benefit from financial inflation, the wealth effect will be far more inflationary. Thus, even if the financial bubble doesn’t pop on its own, the resulting inflation could force the Fed to raise interest rates and pop the bubble.

The GameStop story is so gripping because it fits the classic mould of David vs Goliath. In the medieval age, aristocrats had a monopoly on weapon possession, because weapons were expensive. When cheap guns became available, it levelled the playing field, which led to the downfall of the ruling class.

What is unfolding today is similar. The internet has made tools available to every little guy that the financial elite have had for three decades. Millennials grew up with electronic toys. They are very good at using internet tools and are likely to dominate the market in the coming years.

The US market may be on its way to becoming retail dominated, which will make it more like China’s market. A retail-dominated market is highly volatile. Rising volatility makes a levered market prone to crisis. What happened in 2015 to the Chinese market is a case in point.

The margin debt in the US market is at an all-time high. It will keep surging as long as the market keeps rising. As China has shown, this trend has no soft landing; a crash is inevitable.

Andy Xie is an independent economist