Financial Health Network’s Jennifer Tescher and securities litigator Carl Volz discuss the GameStop short squeeze and the implication for fintech regulation.
- The now-infamous GameStop trading frenzy of January 2021 is (mostly) behind us, and it’s time to assess its impact.
- In a brash squeeze play spearheaded by a Reddit community as a grassroots uprising against billion-dollar hedge funds, hordes of retail investors went on a GameStop stock buying binge, which led to major losses for the hedgies.
- Financial Health Network President and CEO Jennifer Tescher and Carl Volz, a securities litigator and founder of Pontem Law, join host Dara Tarkowski to discuss the implications of the incident, particularly in light of a new administration and SEC chair.
Even if you don’t really follow the stock market, you’ve probably heard a bit about the infamous GameStop (NYSE: GME) trading frenzy that peaked in January 2021.
It was an epic, crowdsourced short squeeze. The price of a share of GameStop ballooned by 1,700% and several hedge funds, including Melvin Capital, suffered huge losses.
The fallout was swift and dramatic. Alexandria Ocasio-Cortez grilled Robinhood’s CEO in a Congressional hearing. Melvin and Reddit’s CEOs testified, too. So did one of the most active Redditors, a financial educator and YouTube personality known as “Roaring Kitty.”
Weeks later, the Senate approved Gary Gensler as President Biden’s new chair of the Securities Exchange Commission. Unsurprisingly, the GameStop saga featured prominently in his confirmation hearings.
Now that the dust has settled (somewhat), it’s time to dissect the chaos. What are the implications for the financial services industry?
To break it all down, I’m joined on an episode of Tech on Reg by Jennifer Tescher, President and CEO of the Financial Health Network and host of the EMERGE Everywhere podcast, who recently wrote about GameStop for Forbes. I invited my former colleague Carl Volz, a securities litigator and founder of Pontem Law, to join us as well.
How it all started + a quick primer on short selling
GameStop was valued at $3.25 per share about a year ago. On January 26, 2021, the stock closed at $145.60, rocketed to $345 the next day, and finally peaked at $469.42 on January 28.
How did a company with an outdated business model become the most talked-about stock on the planet?
It began where much viral content does: Reddit.
The subreddit WallStreetBets is a hyperactive, meme-a-minute group of retail investors that noticed several hedge funds were heavily short-selling GameStop –– a beloved (although seemingly doomed) brand. The $13 billion hedge fund Melvin Capital was a particular object of WSB’s ire.
When most consumers buy stocks, they play the long game, purchasing stocks they think will rise in price over time –– ideally, to buy low and sell high.
Short selling is the opposite approach. An investor anticipates a decrease in a stock’s price, and placing a sort of bet on that expectation.
Here’s how: They sell shares they don’t own –– they borrow them from a broker, with the understanding that they must return them eventually. Hopefully for the investor, they can buy that stock at a lower price and make a profit. But if the stock price goes up, they still have to purchase the stock at that higher price (plus interest and fees).
The latter is what happened with Melvin Capital, Citron and other hedge funds that are “notorious shorters,” says Carl. “They got caught in the pinch, which exacerbated the rise in the value of the stock.” It was the short-selling that WallStreetBets wanted to disrupt.
That proved “disastrous” for the hedge funds that had to cover their short positions. And at some point, retail investors can only do so much before they’re called to do so, Carl adds.
Big funds can generally hold out longer, but everyone has to pay the piper. That’s why hedge funds and amateur investors alike lost a ton of money.
Reddit, Robinhood and rebellion
A decade ago, short selling was, in part, what drove the real-estate bubble that led to the crash and Great Recession of 2008-09.
The GameStop saga is a different set of players and began from a different perspective. But “what happened in the (‘08-09) crisis still looms large for a lot of people,” says Jennifer.
“The government bailed out Wall Street, but left Main Street out to dry while Wall Street made a ton of money betting against the American consumer.”
Reddit’s WallStreetBets sparked the frenzy. But it wasn’t solely responsible for it. Once its efforts to drive up GameStop broke through to the mainstream, it seemed like everybody, including people who had no beef with hedge funds, wanted in on the action.
Enter Robinhood, which is easy to use –– and fast to connect to your bank account. It’s also pretty fun.
“It’s like Candy Crush for investors,” Carl says. “You get a little digital confetti shower and congratulations when you make a trade, no matter what the size. … It’s exciting.”
Robinhood’s ‘frothy’ ride
Like any other broker, Robinhood doesn’t actually make the trades themselves.
“They go to Citadel, which actually performs the trades,” Carl explains. “Then there’s a clearinghouse where regulated stocks [in the U.S.] are cleared, which takes a couple of days.”
The clearinghouse asks members to put funds on deposit to cover potential trade withdrawals. That means every day, every brokerage (including Robinhood) gets a notice from the clearinghouse telling them how much it needs to have in the bank that day.
It doesn’t vary all that much. “It’s typically within a couple of percentage points of the previous day,” says Carl.
But what ended up happening was that Robinhood’s CEO, Vladimir Tenev, got a phone call at three o’clock in the morning. He was told the company had to have $3 billion on deposit –– within hours.
That was much more cash than what had been deposited the previous day.
“GameStop stock had been trading very, very frothy all night long. It appears that the clearinghouse said, this is just crazy; we can’t be sure they’re going to be able to satisfy these trades,” Carl explains.
So the clearinghouse sounded the alarm. Even though Robinhood had recently raised about $2 billion, “putting $3 billion on deposit at a moment’s notice is a big ask,” he says.
And that’s why Robinhood abruptly halted trading of GameStop and a handful of other stocks on January 28.
A storm at the Citadel
Because it is responsible for executing Robinhood’s trades, Citadel is truly at the center of this crisis. The firm is responsible for ensuring Robinhood meets its liquidity requirements.
Carl makes it clear that he’s not passing judgment. But he thinks Citadel “made a choice to make the hedge funds whole” after the losses they experienced, as opposed to supporting Robinhood users “so they can transact the way they’d like to transact.”
When we look at all the facts, it’s difficult not to sympathize with the Redditors at least a bit. And Robinhood users relied on the representations the platform made to them. Did the platform oversimplify the process –– or not communicate the level of seriousness appropriate to the transactions it hosted?
Robinhood’s site has “a whole section that could not be more transparent, in pretty plain English, about how trades are cleared and who’s paying them,” Jennifer says.
“I say that not to let Robinhood off the hook, but to point out how decades of consumer protection by disclosure has failed.”
Though Robinhood was not hiding how they make money, simply reading that disclosure “doesn’t necessarily mean you have the financial wherewithal to use some of the more sophisticated tools [offered on the platform] and be resilient if things don’t break your way,” she notes. “And it doesn’t mean you understand the implications.”
Financial education isn’t a fix in this context, according to Jennifer.
“I think it comes back to this question: What are the guardrails, from a regulatory perspective, about suitability and requirements? Frankly, this is gambling –– let’s just call it what it is. ”
She’s right: No matter how fulsome or plain-language the disclosure, chances are it isn’t read or understood. This also happens with terms of service for websites — it’s not unique to trading.
Nobody’s actually being protected, and yet industry uses these terms and disclosures like a cozy CYA security blanket.
Last year, Robinhood settled with the SEC for some $65 million as a result of an investigation into whether the company fairly represented the cost of transactions to consumers. Robinhood’s most recent disclosures are a direct result of this litigation.
But even if we’re just looking at the user agreement, it’s a 60-page document if you tried to read it on your phone, says Carl. It’s not realistic to think anyone does.
Many of us applaud fintech innovations like Robinhood for simplifying the complex world of finance through streamlined, accessible user experience. But it’s complicated for a reason.
And that complexity has an impact on users when the sh*t hits the fan.
Most entrepreneurs are optimists by nature, and few think about a Black Swan event like this one. Certainly, the average consumer isn’t.
Lawyers are trained to think about catastrophic scenarios. Then people tell us to stop being Debbie Downers; that we’re standing in the way of business. But our jobs are to mitigate risk for our clients, even in the most unlikely circumstances. Good companies plan for them so they can respond appropriately.
Think of it this way: If you offer people free pizza, and keep supplying it, they keep eating it. If you suddenly tell them there’s no more pizza, they’ll be pissed, because they like it. And who can blame them?
Is bloom is off the rose for fintech?
“Fintech, as a category, sold itself as being for the little guy –– democratizing access, whether to trading, credit, account services or whatever it may be,” says Jennifer. Now “the bloom is off the rose for fintech,” she adds. “And we’re starting to see that from a regulatory and legislative perspective.”
Banks, from a competitive perspective, don’t want more fintechs getting bank charters, Jennifer notes. But there are many ways both banks and consumer advocacy organizations will use Robinhood as an example of why fintech should be more “heavily regulated” – whatever that means. As someone who works closely with these companies on compliance issues, I assure you the regulations are already plentiful.
“Time will tell whether this drives down consumer usage of these kinds of products,” she says.
Carl points out that Gary Gensler “is not a huge fan of the retail investor” and “he’s long been a critic of stock picking.”
His comments in his congressional testimony seem very much in line with that, suggesting “he’s going to be skeptical of a company like Robinhood,” he says.
Carl thinks Gensler will take a hard look at Robinhood and apps like it, and that the remedy will be… additional disclosures. Groundbreaking.
“That’s always what they do,” he says. “But frankly, I just don’t know how much more they need to disclose or what good it will do.”
And it probably won’t hurt Robinhood, which has raised $3.4 billion total since its launch in 2015, $1 billion of which was announced on January 29.
Though the company ended 2020 with a reported $20 billion valuation, it is now valued “at something like $40 billion,” says Carl, noting that it added millions of users in the midst of the recent upheaval.
Now it’s planning an IPO based on that valuation, he adds.
“It’s that old adage: There’s no such thing as bad publicity.”
The SEC isn’t likely to reject that IPO, especially because Robinhood’s hired guns are formidable, Carl says.
“They basically hired half of Wilmer Hale –– and half of the SEC regulatory class of 2006-2007 is on its legal staff.”
And by the time the NYSE bell rings, Robinhood will be a public company “worth $40, $50, $60 billion, no matter what sort of disclosures they make,” he notes.
Why? Because people still like pizza.
“They do,” says Carl.
This article is based on an episode of Tech on Reg, a podcast that explores all things at the intersection of law, technology, and highly regulated industries. Be sure to subscribe for future episodes.