Robinhood shows social media should be feared by both the bad and good

The GameStop short selling saga showed the power of social media in organising a ragtag group to take on Wall Street hedge funds.
It might seem a triumph for both merry men and the common man, but this power poses a danger beyond the finance industry, writes Neil Newman

Neil Newman

Published: 7:00am, 8 Feb, 2021

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POWER UP

2021 has been exciting and full of surprises, and it’s only the start of February! A huge dump of snow in Spain led to a severe shortage of out-of-season vegetables in Britain and even dropped flurries in the Sahara Desert; the retired shorts-clad rockers in AC/DC hit No. 1 on Billboard’s Hard Rock Songwriters chart; and there has been astronomical inflation in the price of pedigree puppies in Britain leading to a severe shortage of stray dogs to adopt. So we’re not short on anything to talk about over a beer in the pub – if only we could.

Covid-19 has wrecked people’s social lives, and the mood among my friends and family, particularly in Britain and the United States, is one dominated by boredom. Even the gamers who are usually inseparable from their souped-up PCs and favourite online games are running out of patience. Having perfected their skills in popular combat games such as Counter-Strike: Global Offensive (CS: GO) and spent hours glued to League of Legends competitions, they’re now back online with virtual arms fixed on a new target: the stock market.

This has led to the highly bizarre and potentially very dangerous practice of gamers messing with investment professionals, squeezing them until they choke on their shorts through free or low-cost trading platforms – the most notorious being the non-commission-paying “ Robinhood”.

The GameStop logo and trading app Robinhood. Photo: AFP

LITTLE JOHN WAS A BIT ON THE SHORT SIDE

Before 2021, Robin Hood was a 15th century heroic English outlaw who was “feared by the bad, loved by the good”, wore green tights and shot arrows into bad guys along with his sidekick “Little John”. Hundreds of years later, Robinhood is the slayer of hedge fund managers who sell short the good guys.

Investing in a business with no growth, or potential of a turnaround, is something we try to avoid. But there is a group of investors that make it their business to do this – and it can be very profitable. They bet on failing businesses by “going short”.

Short-selling is at first a tricky concept to grasp because it runs counter to how most people think of investing. Whether directly putting up some of your hard-earned cash to fund a friend’s new business, or buying shares in an IPO in the stock market, the goal is for the value to go up. The purpose of the investment is to support a company’s growth by providing the necessary cash to fund business development – this is worth bearing in mind as there are rumours of a Robinhood IPO next quarter.

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When you as an investor decide to change your mind and sell your investment on, it is an easy task if your shares are traded on a stock exchange, which introduces buyers to sellers and provides a record of who owns what.

So, here I am, and I would like to sell you my shares and you would like to buy them. We “discover” the price on the stock exchange and we do the deal, typically settling up a few days later.

A short sale is no different, except that as the short seller, the shares that I sell to you, the investor, were borrowed from someone else on a promise that, at some point, I would return the same amount of shares to them. I reckon there’s a good chance that the business you now hold shares in will fail, and that I can buy those shares back from you a lot cheaper than I sold them for.

Whether I’m right or you’re right, one of us will make money and the other will suffer a painful loss. Although short sellers profiting from a company going down seems rotten, it is a helpful tool to remove market risk on a position, or “hedging one’s bets” – hence “hedge funds”.

KEEPING YOUR ARROWS SHARP

Forum users online discovered through crowdsourced public information that hedge funds were profiteering from the misery being inflicted by Covid-19 on bricks-and-mortar retailers, in the first instance on GameStop Corp shares (GME: US). GameStop store sales fell 31 per cent in the first nine months of 2020 due to Covid-19, and the stock was heavily shorted. The merry men of Robinhood decided to come to the rescue and started to buy the stock.

Shares in GameStop were driven from US$18 before the coordinated action began, to a record high of US$483 – which threatened to wipe out the hedge fund Melvin Capital, which had to be bailed out by two others to the tune of US$2.75 billion. Severe pain was inflicted on numerous other funds who had copycat trades on the books.

Meanwhile, the gamers involved and many a member of the general public who joined in found this hilarious. Seeing Wall Street getting a taste of its own medicine resonated with people who’d experienced the destruction of their savings, pensions and jobs in the last financial crisis. Tax payers bailed out Wall Street which got off with a slap on the wrist even as it concocted the next dodgy scheme. The taste of vigilante justice was oh so sweet.

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ROBIN HOOD, ROBIN HOOD, RIDING THROUGH THE GLEN

Following this ride to GameStop’s rescue, Robinhood’s band of merry men moved on to some 20 other stocks.

There’s already a taste of blood in the water, with signs of a liquidity crisis emerging for Robinhood whose operations team woke up on January 27 with a US$3 billion settlement obligation and not enough cash; while Elon Musk, who hates hedge funds for shorting Tesla, was egging the internet crowd on and throwing in some money of his own. In the end, Robinhood had to secure cash from the big banks on Wall Street to keep the plates spinning.

Elon Musk: no fan of hedge funds. Photo: Reuters

US securities market regulators are looking into the trading frenzy to determine if it is illegal. Schemes to manipulate markets generally are, but it would be difficult to pin this on individual traders. Even as the saga unfolds, it seems perhaps the damage has been done, and we can draw a few conclusions at this point.

•Hedge funds and Wall Street continue to be broadly disliked by everyone who is not working in the financial industry. The introduction of low-fee exchange traded funds (ETFs) that sidestep the hedge fund club and are traded on inexpensive platforms could soon finish them off anyway;

•The power of social media to organise a ragtag group of forum users to take down Wall Street rock stars is remarkable. It is also extremely dangerous, and not just to the finance industry. Anywhere there is a huge divide in opinion, be it financial social or political, large numbers can be quickly organised;

•The US addiction centre quickly voiced concerns that Robinhood’s app design, with promises of unknown prizes, green confetti on successful trades and “lottery ticket” design interactions triggers dopamine responses associated with causing addiction. If this is indeed addictive, it will not be going away any time soon unless regulators mandate it away and we are certainly not immune to it in Hong Kong;

•A company’s fundamentals suddenly matter a lot less than the behaviour of a crowd of investors. Would you short Robinhood shares on day one if you believed it was a fad? Ordinarily, probably yes; now, definitely no.

•The speed with which individual investors can jump on the bandwagon and swamp the trading of a stock is frightening. This has already been witnessed in grubby markets, such as Bitcoin, but we are now talking about the core of business finance – global stock markets.

Short-selling is nothing new, it was invented in the very early 17th century, and by mid-1772 had precipitated its first major financial casualty – the collapse of nearly every private bank in Scotland and a huge liquidity crisis in the major banking centres of London and Amsterdam over excessive negative speculation in the shares of the East India Company. The activity today remains a thorn in the side of market regulators.

To suggest that this could be the beginning of the end of short-selling is perhaps a bit extreme, but fund managers will have to think about short positions much more carefully, even considering the potential of public opinion. Melvin Capital certainly did not consider offending the gaming community or the nostalgic general public who still use bricks-and-mortar stores when shorting a gaming stock.

Neil Newman is a thematic portfolio strategist focused on pan-Asian equity markets