Like everyone on the internet, for the last few days I’ve been following the fascinating and hilarious story of the little message board that made a small dent in the quarter-on-quarter performance of a few particularly poorly managed hedge funds. There are plenty of bad and a few good descriptions of the situation out there already, so I’ll assume readers are familiar with the broad outlines: a hedge fund used a combination of short-selling Gamestop shares (where they actually borrowed the shares they intended to sell) and buying some put options. Some folks on Reddit got wind of the strategy and decided it would be funny and/or profitable to filet the hedge fund like a bluefin tuna by bidding up the share price by purchasing shares and call options on the same stock.
To be clear, I don’t think there’s anything particularly novel about these events. Short-selling has been around at least since the 17th century, and options contracts in one form or another for much longer. But that doesn’t mean there’s nothing to learn from these events, taking place as they are here and now, and not in Amsterdam 400 years ago. So here are my suggestions for this week’s lesson plan.
Control is even more concentrated than ownership or wealth
Wealth inequality has been an increasingly popular topic since the Great Recession, but in many ways the common understanding of it understates the true consolidation of power in financial markets:
- Fidelity Investments is a privately held company, with the founding Johnson family controlling 49% of the shares, and Abigail Johnson, the daughter of the company’s founder, serving as CEO.
- Charles Schwab is a publicly traded company, however 10% of the shares are owned by the firm’s founder and chairman, Charles Schwab. It is currently in the process of acquiring TD Ameritrade.
- Blackrock has a slightly more diverse ownership structure (it’s essentially owned by the mutual fund industry as a whole), but its founders in 1988, Bob Kapito and Larry Fink, are currently the company’s President, and Chairman and CEO, respectively.
- Finally, Robinhood is privately held but has received venture capital investments from a small group of venture capital firms, who presumably are exercising some oversight of their investment in the firm.
You might think one exception to this pattern is Vanguard. After all, through a byzantine pyramid structure, the Vanguard parent company is owned by the investors in its funds (technically it’s owned by the funds themselves, which are owned by investors). But there’s a reason Vanguard holds its annual meetings at a satellite office in Arizona instead of at its headquarters in Pennsylvania, or a conference center in New York or Los Angeles: the last thing Vanguard wants is to give the impression that its owners exercise any actual control over the company.
The point of this is not that concentrated control is good or bad, but simply to distinguish it from the idea of wealth or ownership. Every investor has an interest in the performance of the assets they own, but that interest doesn’t translate into control of the actual plumbing of the financial system. That’s in the hands of 10-15 people who have interests of their own.
When you fail to prepare you prepare to fail
In the pandemonium of the last few days, people either wittingly or unwittingly tended to confuse three totally separate and (largely) independent events.
- First, the exchanges (the New York Stock Exchange in this case, where Gamestop is listed) implemented so-called “circuit breakers” in the aftermath of the Great Recession. When those are triggered, all trading in a listed security is temporarily halted. As far as I can tell that occurred on Friday, Monday, and Wednesday, and left everyone temporarily unable to buy or sell shares.
- Second, individual brokerages imposed heightened margin requirements on some stocks. Even for folks who don’t have margin accounts, as a courtesy brokerages will often allow customers to trade with so-called “unsettled funds,” either deposits from a bank account that haven’t cleared yet, or receipts from stock, ETF, or mutual fund sales that haven’t settled yet. This week some brokerages raised their margin requirements for the most volatile stocks to 100%, and required purchases to be made with settled funds.
- Third, Robinhood and, to the best of my knowledge, only Robinhood halted purchase orders entirely for the stocks they identified as being subject to Reddit gamesmanship.
None of these have anything to do with each other, except that they all happened around the same set of stocks. Any stock can be frozen if its price action triggers an exchange’s circuit breaker. Any brokerage can impose higher margin requirements on any stock it likes. Any trading platform can prohibit people from buying certain securities (although Robinhood got in trouble last year when its platform went down and people were unable to sell securities they already owned).
But all three felt to the Reddit day-traders exactly the same: last week they could easily get in and out of Gamestop, this week they can’t. And to be clear, no one is at fault here: if everybody read the terms and conditions in full for every service they used, we wouldn’t have time to do anything else. Ignorance is, in many cases, perfectly rational.
On the other hand, now that they know how this works, hopefully they’ll be better prepared next time. It doesn’t cost anything to open multiple brokerage accounts, and Robinhood isn’t the only free brokerage account anymore: my Vanguard and TD Ameritrade accounts still haven’t shut down trading in the affected stocks, although they have raised the margin requirement (#2 above) and were subject to the circuit breaker halts (#1), as everyone was.
Life-changing bets or make-life-interesting bets
Finally, let me extend an invitation to consider two ways to approach this kind of gambling.
A life-changing bet invariably requires putting up life-changing stakes, and this is mechanically true at all points on the income spectrum. Consider a family that scrimped and saved for years to put together a $50,000 down payment to purchase a new home. If they put those savings into Gamestop at $20 and got out at $467, they turned that down payment into $1.7 million and can buy their new home outright, plus maybe a nice summer place in Maine. That’s a life-changing bet. But that’s only possible because the stakes are so high: a family’s life savings, their chance to own their own home, build up equity in it, take advantage of residential price inflation, etc.
I don’t like life-changing bets. I like make-life-interesting bets. For example, in February 2018 I went in on $100 worth of Bitcoin. Bitcoin’s gone up substantially in price since then, but today it’s still only worth $243. If Bitcoin goes to $100,000 it’ll be worth $737. If Bitcoin goes to $1,000,000 it’ll be worth $7,400. That’s real money, and I’d be glad to have it, but it’s not life-changing money because I didn’t put up life-changing stakes. If Bitcoin goes to $0, I’ll still be fine.
Likewise, years ago after Fannie Mae and Freddie Mac went into federal receivership, I bought $400 worth of their shares, which are still publicly traded to this day, despite being obviously worthless (since the shares are not a legal claim on a stream of income). That bet is now worth just $200. If it goes to $2,000 I’ll be happy, but if it goes to $0 there’ll still be no skin off my back.
Finally, back during the MoviePass extravaganza, I bought a single share of the parent company, Helios and Matheson Analytics, for $3.45. It’s now worth about an eighth of a cent.
The point of this exercise is not to say that my bets are right and anyone else’s bets are wrong. My point is simply that you should figure out up front which kind of bet you want to make, so you don’t accidentally make life-changing bets when all you really wanted was make-life-interesting bets — or vice versa. That’s not an “economic,” “rational,” or “utilitarian” calculation, it’s a calculation about who you are, what makes you happy, and how much you have to lose.
The main thing I want to push back against is the concept that the events of this week have any kind of practical relevance from the perspective of either “class” or “fairness.” On the contrary, the markets seem to me to have functioned exactly as intended. Individual brokerages made decisions to reduce their exposure to unsettled trades and uncleared deposits, exactly as they should. A very few hedge fund investors saw a small dip in the net asset value of their holdings, and a very few hedge fund managers saw a small dip in their projected revenue for the year, which may lead them to shut down their funds in order to spend time with their families, mistresses, or art collections.
On the flip side, a very few Reddit members made small fortunes, and very many Reddit members made a few hundred or a few thousand bucks. At the end of the day, end of the week, or end of the year, all the money and all the shares will be accounted for and everyone will get exactly what they bargained for, whether they like it or not.