Is Wall Street the enemy?

On January 11, 2020, GameStop, a struggling American video game and consumer electronics retailer, announced three new appointments to its board of directors. The market seemed to take this as good news, because the stock rose 13% in the day’s trading session. But then something strange happened: it kept rising. On January 27, the stock, which cost less than $20 at the turn of the year and had been worth as little as $4 in September 2020, closed at $347.

This meteoritic rise, however, in fact had little to do with the new board appointment or indeed anything related to GameStop’s still precarious business. Rather, it was caused by a horde of retail investors who had conspired on the WallStreetBets messageboard of social media site Reddit to go long the stock in an attempt to drive the price higher and pile misery on what they had identified as a common enemy: Wall Street hedge funds that had shorted the stock in a bet that a rise in its price last September, when Ryan Cohen, the founder of the online pet food giant Chewy, took a 13% stake in the company and started pushing a plan to focus on online, would be short lived. As desperate hedge funds were forced to close out their positions and buy shares to cover the shorts, the stock kept going up, culminating on Monday 25 January, where it rose a 145% in less than two hours.

The retail investors were able to cause such an extraordinary upward pressure on the stock by using out-of-the-money call options: for a relatively small amount, they bought the right to buy GameStop stock at a price much higher than where it was trading and as more and more people did the same, the stock started to rise. The dealers who sold the options now needed to buy more GameStop stock to hedge the options they had sold and hedge funds that had bought put options (to bet that the stock would fall) started closing out their positions. It created the perfect storm.

The fallout from this unprecedented victory of Main Street over Wall Street was immediate. Major hedge funds suffered huge losses and one, Melvin Capital, was forced into bankruptcy. Politicians and industry insiders demanded regulation to stop the “retail mob… feasting off each hedge fund kill,” as a Societe Generale analyst put it. The retail broker Robinhood, which had facilitated much of the trading in GameStop, prevented its investors from buying the stock in what many saw as a politically motivated move, but it had more to do with inability to continue to make deposits to clearing houses for the options it facilitated. On Friday, Robinhood was forced to raise $1bn in new capital.

The industry’s reaction united a motley crew of free market libertarians and hard-leftist in a tirade against Wall Street and the hedge funds. The impression was of an industry that is part of the establishment and sought to protect itself and its privileged position. It played into a popular image of the financial community as leeches who enrich themselves at the expense of ordinary people. For once, the shoe was on the other foot. Wall Street bled, and the people loved it.

But is Wall Street the enemy?

Some people have an appreciation for how a functioning capital market is an indispensable part of a global free market, facilitating flow of funds to where the marginal return on investment is highest. But many also have is an innate suspicion of what they call “speculators” – hedge funds and other market participants who place bets purely to make short-term profits. And most prominent among the speculators are the short sellers, presumably because, in the public’s imagination, betting against a stock is the ultimate expression of unconstructive financial speculation. Indeed, this is by no means the first time short sellers have been vilified: during the Eurozone debt crisis, those who bet against the sovereign debt of countries like Spain, Italy and Greece were attacked by EU politicians, who threatened legislation.

But short selling is a legitimate part of a free financial market. Derivates like put options allow tailor made risk profiles to be created, enabling it to be placed efficiently with the most appropriate investors. The problem isn’t the banks or the hedge funds or the products they trade, it is the environment in which they are operating.

Last week, the hedge funds were under attack and sought to protect themselves by the means they know best. And in the financial industry, the first place they look is to regulation, because financial markets are, by some distance, the most heavily regulated of any industry. The power to decide how market function is concentrated in the political realm – so if you want to change anything, that is where you go. As with most regulation, the rules that are touted as protecting consumers do more to create barriers to entry and protect incumbents. The Federal Reserve provides markets with unlimited liquidity and their zero-interest rate policy make traditional banking less profitable, pushing banks to take risks – which are underwritten through the implicit government guarantees placed on major financial institutions (even more gold plated after the Lehman Brothers bankruptcy set of the global financial crisis of 2008) which allow banks to leverage and take much more risk than they would have been able to in a free market.

Financial markets are extremely profitable and attract some of the best brains. That may make them elitist and in the current political paradigm, many on the free market right have become fiercely anti-establishment and anti-elitist. But there is nothing innately bad about hedge funds and short sellers. The problem is the incentives created by government regulation and the corporatism inherent in how financial markets operate today. Banks and hedge funds have become a part of the political establishment, whose leaders cavort with politicians and regulators to gain power and wealth. But Wall Street is not the real enemy. That is the state.