What are the Social Impacts of Gamestop and Automated Trading?
Essentially, Gamestop a brick and mortar company that focused on selling video games in its stores had its stock highly shorted mostly by a number of hedge funds. Meaning that the hedge funds were betting that the price of the stock would go down further and if true they would make a profit once the price dropped. Up to here, this makes sense. Due to the pandemic most brick and mortar companies have been struggling overall, and video game sales have moved substantially towards digital platforms. These two trends would actually lead one to assume that Gamestop, who also hadn’t reported profits for a few years, would have a further stock price drop. (To note however, this overly negative picture was actually debated especially by the reddit community, but for the sake of argument let’s go with this picture)
The issue was that by ‘a highly shorted stock’, we are talking up to 140%. This ‘Naked short’ is actually illegal ever since the 2008 financial crisis, as it acts as a bet against non existing shares of a company. Furthermore, this added downward pressure actually would have helped the price go lower more or less locking in the profits for the hedge funds while further harming the actual business.
The subsequent change in fate happened with the coordination of a Reddit community “r/WallStreetBets” where people share news, memes and personal anecdotes about acting and playing in the stock market. This group of retail investors and meme lovers collaborated and bought shares of Gamestock in massive numbers, forcing the price up, and creating what’s called a ‘short squeeze’ where the hedge funds that were shorting the stock were forced to ‘close’ their positions by buying back into the stock, pushing the price even higher. If you’re unfamiliar with market mechanics its ok, the essential point is that the stock price rose, hedge funds lost money, a lot of it. How much? over 5 billion — Melvin Capital lost 4.5 billion alone in the event.
So smaller retail investors were able to flip the traditional finance script in what’s being called a David vs Goliath moment and have now led to lots of articles, podcast episodes and interviews on how this has changed things and what the repercussions are.
Before I tie this event to automation technology one last point is important to take note of. Both Reddit where these small investors were communicating, as well as the main investment app ‘Robinhood’ (which primarily focuses on enabling smaller purchases for people to get their toes wet in the financial markets) shut down accessibility to communication and trading in an effort to stop the continued short squeeze, with justifications of harmful language, protecting unsophisticated investors and others.
Now, I’ve been loosely following the event and the reason I wanted to touch on it this episode was that in one of the discussions I was listening to, a very interesting and relevant fact was brought up. The majority of stocks are actually only held for a few seconds at a time, as they are actually traded by computers running specific algorithms in what is termed High frequency trading. This essentially means trades can be conducted in as short as one 64 millionth of a second. Or about the time it takes for a computer to process an order and send it out to another machine. Their automated systems allow them to scan markets for information and respond faster than humanly possible. Though there are different estimates, somewhere in the range of 50% to 80% of all market trading is performed by these algorithms.
So what are the implications of this?
Firstly, and most relevantly to the podcast, finance jobs have transformed over the last few decades. For instance Goldman spends hundreds of millions of dollars on this technology and have more people working in their technology area than people on the trading desk. And the trend towards this form of ‘algo trading’ is now being somewhat enabled for retail investors as it is becoming easier and more common to build simple trading algorithms, though the high frequency form requires tremendous investment to be viable.
It has been said that automation of trading systems in financial markets represents the last phase of depersonalizing activities previously done by traders. Algorithmic trading development enabled computers to determine the moment and the way of executing sales orders but still do not make autonomous decisions regarding the choice of instruments to be traded or trading criteria. Overall, some studies claim that Algorithmic trading actually creates more liquidity in the market and accelerates the incorporation of existing information into prices.
But there are clearly negative impacts as well
The most obvious is market manipulation which take a number of different forms from: front-running, back away, painting the tape. But essentially due to the speed at which the trades can be executed the price is manipulated to benefit those who own the faster computer. This has the effect of crowding out fundamental traders’ ability to acquire information to learn from and make efficient investment decisions. But more relevant to the entire Gamestop situation, is that this makes it so that investing at a retail level is more akin to jumping into shark infested waters where you are more likely to lose a significant chunk of your investment.
Finally, the most macro scale issue is a large scale market crash can be caused with ubiquitous algorithmic trading, which is often at blame for both the 1987 crash and flash crash of 2010, where algorithm parameters are continuously triggered leading to rapid market downturns.
There are many others and I recommend looking at the links I have in the shownotes, but essentially what can be understood from this is that there is an understanding that investing in the stock market is becoming more and more challenging for the ‘little guy’ as a direct consequence of this technology being applied.
How does this connect to Gamestop, and what are the possible social ramifications for the future?
Firstly, the script was flipped, the small retail investor, through the use of social media technology had perhaps found a way to retake some form of control (however temporary) from the large institutions that can leverage their resources, and computers to increase their own profits. Many are now claiming that this is going to be the first of many events where communities of retail investors in essence fight back against the larger hedge funds and powerful automated systems.
Secondly, GameStop is drawing a younger crowd into being interested in market and finance issues who otherwise might not have show interest previously.
Finally, with both Reddit and Robinhood cutting off access to its users amid the flurry of the event, there is now a renewed interest in decentralised platforms where users cannot be revoked from participating simply because the central authority deems it to be so.
It’ll be an interesting trend to follow over the course of 2021, especially after the same situation happened to Trump and a number of his supporters when they were banned from Twitter which added more fuel to the decentralised fire.
I’ll be looking to bring on a guest in the next few months which can elaborate on this point in particular as I think it is particularly interesting for the reasons mentioned.
