Events on the US stock market in the past two weeks have bewildered experts and casual observers alike. It was a microcosm of disruptive innovation: what appeared at first to be a joke – Reddit users inflating a video game stock, creating memes as they went – soon provoked serious questions about the stability of financial markets in the face of a new influx of digital investors. How US regulators respond will shape the future of investing – and will reveal how much digital disruption the finance sector will tolerate.
The first sign that something unusual was afoot was a spasmodic spike in the share value of GameStop, a videogame rental provider who was not expected to flourish amid growing downloads. The company’s share price shot up from $39 to $347 in a matter of days, and then fell back down to $90.
This, it emerged, was the result of a ‘short-squeeze’, in which short-sellers who have bet on a company’s share price falling have to buy more of the stock to stem their losses, which in turn accelerates the spike. This was reportedly co-ordinated among users of commission-free investment apps Robinhood and EToro, in part through the Reddit forum r/WallStreetBets. Assets held by hedge fund Melvin Capital fell by $4.5bn in value as a result.
The episode took the financial establishment by surprise, says Suranga Chandratillake, a general partner at London-based venture capital firm Balderton Capital. “I don’t think the market realised that there were 12-year-olds in LA borrowing money from their parents and buying stocks and trading derivatives.”
Unsurprisingly, it has prompted calls for regulatory intervention. Yesterday, US Treasury Secretary Janet Yellen summoned the Securities and Exchange Commission (SEC), the Federal Reserve Board, the Federal Reserve Bank of New York and the Commodity Futures Trading Commission to discuss how the various regulators might collaborate on a such a response.
In a statement last week, the SEC said it was “closely monitoring and evaluating the extreme price volatility of certain stocks’ trading prices over the past several days to protect investors, to maintain fair, orderly and efficient markets and to facilitate capital information”.
The SEC’s statement suggested it was examining the role of hedge funds in stoking volatility, as well as looking for signs of market manipulation on social media. “We will act to protect retail investors when the facts demonstrate abusive or manipulative trading activity that is prohibited by the federal securities law,” it said.
How should regulators respond to Robinhood?
Nevertheless, Robinhood will be squarely in the regulators’ sites. It already has a reputation for attracting young and vulnerable investors. In June 2020, Forbes reported that a 20-year-old user committed suicide after suffering what appeared to be a $730,165 loss, saying in his final note that he had “no clue” of what he was doing.
Robinhood’s business model is comparable to social networks: the platform is free to use but it sells aggregate data to interested parties; in this case, professional investment houses, which stand to gain an advantage by seeing where the retail market is going.
Alistair Newton, the research vice-president and banking industry services director at Gartner, believes that a lot of users might be put off if they knew how the platforms make money. “If you explained to the general public what actually happens when you’re using one of those trading apps, the amount of data sharing that goes on, the way that data is used by third parties, that they really are fighting the big guys as a sole trader, I think a lot of people would be put off.”
One way to make the market safer for retail investors would be to require the platforms to be transparent about their business models, Newton says. “You could argue that some degree of regulation would make a level playing field, or at the very least would point out to participants in that space that you’re not playing on that level.”
He adds that, left unregulated, the free investment apps would extract all the value from the retail investment market without having to pay for the infrastructure that enables it. That would in turn disincentivise more established institutions from maintaining that infrastructure. “They won’t invest in the core technologies and then none of the core infrastructures will work because nobody’s invested in them.”
But Chandrattilake argues that cracking down on free investment apps – and the generation of investors they bring with them – would leave the markets poorer. “The more participants there are, the more sensible investors there are knowing what they’re doing, the healthier that market is and the more value that market will generate.”
And because the market stands to benefit from having more varied participants, it is within its interest to educate new players about its dangers. “It’s on the market to encourage widespread adoption and usage, and to do it in a safe, educated way. If it didn’t have all these investors doing this sort of thing, then hedge funds wouldn’t have a business, so it’s actually in everybody’s interest.”
Hedge funds who have lost billions of dollars are unlikely to see it that way. But the trend in regulating digital markets leans towards protecting consumers, Norton says. “If you look at the direction of travel for most regulatory things like GDPR, you look at PSD2 that came into Europe and open banking, most of it has ultimately been about the end consumer.”
He adds that the extent of the losses triggered by the GameStop episode mean some kind of response is inevitable, although it might not be immediate. “I think it gives more of an impetus for regulators to move.”