THE GAMESTOP EPISODE: WHAT HAPPENED AND WHAT DOES IT MEAN?

• Author: Malz, Allan M.

The GameStop stock trading episode that began in January 2021 has been unprecedented in some ways, especially in the ability of market participants to organize collective action openly yet anonymously. In other ways, it's been an unsurprising repetition of past experience. Financial markets are imperfect, they display many frictions, and die imperfect alignment of interests is a perpetual dilemma in designing both contracts and public policy.

The GameStop episode goes to the heart of many regulatory issues in finance. It provoked a flurry of reactions from politicians and regulators, including statements of concern, proposals for new laws and regulations, and investigations of potential wrongdoing, all suffused with expressions of hostility directed at "market manipulation" and speculators, characterizing die financial markets as a "rigged game" or "casino."

Contrary to the cliche of an unregulated and predatory financial system, die actions of the participants and the events themselves shine a light on a remarkably dense array of regulations already in place. But much of today's regulation makes markets function worse, not better, for investors. Much of the reactive call for investigations into wrongdoing and additional regulation was noteworthy for its vagueness. And much of the uproar has reflected a long-standing combination of paternalism, bad advice, and confidence in experts that misleads investors. The GameStop episode has also been just one manifestation among many of financial market buoyancy sustained by low interest rates.

GameStop and Robinhood in Early 2021

GameStop Corp. (GME) is a brick-and-mortar retail video game vendor chain that had its initial public offering in early 2002. By 2021 it was a troubled firm, with steadily falling share prices. It had been closing stores for some time, and the pandemic accelerated its sales decline. A 2019 attempt to find a buyer for the firm failed, and it terminated its dividend. Positions in the stock were concentrated, with a large amount held by active and activist professional investors. A venture capital firm with online retailing experience, RC Ventures, gained a board seat on August 30, 2020.

GameStop Goes Crazy in an Interesting Way

Short positions became a widespread play in 2020, particularly following a fragile late 2020-early 2021 share price recovery. GME became among the most widely shorted U.S. companies, 140 percent as measured by the ratio of short interest to shares available for trading, GME was one of a number of stocks in which long-short hedge funds took heavy short positions, among them so-called merae stocks popular with retail investors. Outstanding shares in institutional hands were largely pledged, and markets were increasingly alert to tire possibility of a short squeeze.

From January 13, 2021, GME shares saw a sudden and drastic increase in price and in return volatility. The run-up was reported to have been led by a large increase in trading by retail investors using the Robinhood Financial platform, organized via social media, in particular the WallStreetBets chat forum on Reddit.

Robinhood imposed trading restrictions on January 28-29, barring new long positions in GME and a few other stocks while continuing to permit unwinding of existing positions. This triggered a furious uproar among its customers and in the press, and many politicians also voiced outrage.

The stock retreated sharply from its late-January high, but then rebounded. GME return volatility remains extraordinarily high and its price much higher as of mid-May 2021 than before January 13 (Table 1).

Background: The Rise of Low-Cost Trading Platforms

Robinhood is a relatively new entrant into the highly competitive retail investing market, offering commission-free trades of stocks and exchange-traded funds since March 2015. It appeals to a young demographic drawn to trading via a relatively simple mobile app and playful devices for making trading attractive, such as the firm's name and digital displays of confetti upon some customer actions.

Robinhood is heir to a half-century evolution making equity trading cheap and accessible to the nonprofessional public in the United States and other countries. Before 1970, individuals and households that weren't wealthy invested in stocks mainly via pension claims and insurance products, rather than direct ownership of stocks and through mutual funds.

From the mid-1970s, changes in regulation, technical progress, rising wealth, and better understanding of long-term investing brought about a shift. The Securities and Exchange Commission (SEC) abolished fixed stock trading commissions on May 1, 1975.

Ownership of stocks has risen rapidly and equity mutual fund ownership even faster (Duca 2005).

Households and individuals now not only invest directly but are also more frequent traders. Nonprofessional investing has grown as a share of trading volume. Discount brokerages such as Charles Schwab, E*Trade, and Ameritrade arose in the 1970s to serve the retail market. More recently, retail investors have become part of the rapid growth in equity option trading. (1)

As brokerage volumes grew, low- and eventually zero-commission online stock trading became feasible. Index funds, which first appeared in the 1970s, were particularly cost efficient. The introduction and widespread adoption of electronic trading further massively cheapened trading. Zero-fee mutual funds and exchange traded funds (ETFs) followed, and recently, brokerages have begun offering zero-commission stock trading. Robinhood is a market innovator in this process.

The move to zero-fee and zero-commission trading has been enabled by a shift in the sources of brokerage revenue. The decline in trading fees and commissions is offset by net interest on customers' cash balances, stock lending fees, and payment for order flow (PFOF) by wholesale market makers that execute the trades.

Legislative and Regulatory Actions

Regulators had cast a suspicious eye on Robinhood for some time. The Financial Industry Regulatory Authority (FINRA) had fined it in 2019 for failing to fulfill its obligation of "best execution" of trades, a charge closely related to PFOF. Robinhood's platform had experienced service interruptions during the early pandemic period of high stock market volatility in March 2020, leading to investigations by the SEC, FINRA, and authorities in several states. Massachusetts' chief securities regulator had brought a consumer protection suit on December 16, 2020. It alleged that Robinhood had been providing financial advice through its efforts to make its platform attractive to users, without subjecting itself to the legal duties of a financial advisor and failing to maintain an adequate infrastructure. (2) Robinhood had on December 17, 2020, settled an SEC complaint, alleging its failure to fulfill an obligation to disclose PFOF to clients, and to satisfy a duty of best execution. A number of individual customers had also sued Robinhood.

The trading restrictions Robinhood imposed on January 28, 2021, were a turning point, bringing wider political scrutiny on it and other financial intermediaries. The SEC initiated new probes into the trading restrictions the next day. Regulators and legislators also focused on the GameStop episode and more broadly on retail investing. (3) The Financial Stability Oversight Council (FSOC) held an informal meeting to discuss GameStop on February 4. The House Financial Services and Senate Banking Committees held public hearings in February, March, and May, summoning a Robinhood founder, an investor active on Reddit, the head of Citadel Securities, a market maker making PFOF to Robinhood, and others to testify. The SEC chairman testified that it was considering new rules governing retail investing apps and PFOF.

Public Policy and Regulatory Questions

A key background factor in the GameStop episode is the low level of interest rates and associated very high degree of leverage in the United States and the world. Long and short GameStop positions are financed in large part with borrowed funds, or expressed through options, which have embedded leverage.

Impact of Low Interest Rates

Leverage becomes more attractive with near-zero short-term rates, as has been the case since 2008. Changes in the underlying asset price have an amplified impact on both profits and losses of leveraged positions, and relatively small changes in price bring about large changes in the rate of return on the investor's equity. Leverage also adds a limited liability floor under losses. Investors with long positions financed with borrowed funds or long option positions can lose at most their own equity.

It's not surprising, then, that there's been a steady increase in leverage since the advent of the low-rate and low-inflation environment. The unobservable natural rate of interest, or inflation-adjusted equilibrium rate, has been very low, as a result of low expectations of both future economic growth and inflation.4 Borrowing costs as well as hurdle rates or required returns are thus very low by historical standards.

There had been a steady increase in the ratio of debt to GDP in the United States prior to the crisis, led primarily by households and the financial sector. Since 2008, the increase has continued, now as a result of large-scale borrowing by the federal government and nonfinancial corporate sectors, and, most recently, the sharp increase associated with the COVID pandemic.

The U.S. debt-to-GDP ratio, at near 400 percent, is currently more than double what it was in 1980, and well above its previous peak during the global financial crisis (Figure 1). (5) There has been a steady increase in stock margin for years, and its rate of growth has accelerated in the past year (Figure 2). The appetite of option sellers and buyers for the risk-return profiles and the embedded leverage of options and other...