Fake news: Robinhood conspired against small investors in halting purchases of GameStop

15 Feb 2021 | 3 mins

Professor Ray da Silva Rosa, UWA Business School provides an explanation on the trading halt to purchases of GameStop by retail investors.

It seems fake news isn’t the province of Trump supporters.

Whilst many bemoan the nonsense of Trump supporters who believe the US election was rigged they readily subscribe to the view that the halting of trades in GameStop is a conspiracy by “big money” to defraud the small investor notwithstanding there is a fairly straightforward – albeit arcane to the layperson – explanation.

What happened with GameStop is entirely consistent with normal business practice but appreciating this point involves some attention and investigating. 

Sure, the explanation entails esoteric concepts but many phenomenon are difficult to understand and when they result in bad outcomes we don’t immediately conclude there has been a conspiracy. 

As it turns out, what’s happened with Gamestop  – ostensibly sophisticated rich investors being thwarted by contrary market moves– is quite common.  It occurs so often there is a term for it in finance theory: “noise trader risk”.  

“Noise traders” are those who trade on the basis of irrelevant or wrong information, that is, they trade on noise rather than signal.  Noise traders are also known as sentiment traders.

Of course, classification is subjective:  You and I are smart investors; those with a different view are noise traders.  It’s good they exist otherwise us smarties would have no one on the opposite side of our trades.

On occasion, the volume of sentiment driven trade is such that it persistently pushes share price away from what “smart investors” believe is true value so the smarties lose money. 

As John Maynard Keynes, who never doubted his own brilliance, sagely noted early last century, “markets can remain irrational longer than you can remain solvent”.

The thing about sentiment trading is that it is virtually impossible to predict the duration and extent of its influence or even systematically harness it.

Sentiment trading is an explanation we resort to when we don’t understand why prices have reached a particular level.  It’s a tautology invoked to cover our ignorance.

What’s different about GameStop is that the Reddit WallStreetBets site has made it seem like the little guys have mounted a coordinated attack on the supercilious hedge funds who shorted the company.

The popular narrative is that retail investors have piled into the GameStop shares pushing them higher and heroically and gleefully hung on regardless of risk or true value thereby handing smug hedge fund short sellers a humiliating, costly defeat.

It’s what one might call the Kamikazi approach to investing and, if you think, as many seem to do, that it’s a fine thing for unsophisticated investors to risk their shirts in order to show up hedge fund managers then it’s worth cheering. 

Inconveniently, the data don’t support the Kamikazi narrative.  One of Bloomberg’s ace reporters, Daniel Levine, points out that the best available evidence indicates retail investors were, overall, slightly net sellers of GameStop shares most trading days in the week beginning Monday 25th January.

The point here is, it’s not been the little guys who have been driving GameStop shares up. They have been fairly even in their buying and selling.

Regardless, why did Robinhood put a halt to purchases of GameStop by retail investors (i.e., those who are its clients)?

It wasn’t, as many believe, to help out the hedge funds.

Given that the success of Robinhood’s business relies on giving retail investors the impression that they can compete on equal terms with the professionals that would be a self-inflicted own-goal. 

Robinhood did it for the mundane but compelling reason that the non-instantaneous share trading settlement process requires brokers to guarantee buyers’ capacity to pay for the couple of days it takes to settle a trade.

The settlement risk is usually very manageable but when a stock becomes as volatile as GameStock so that its prices varies by 50% or more in the course of a day then the broker needs to put up more collateral to cover its risk. 

Until it gets the collateral, it reduces its exposure to risk by restricting purchases. 

As Bloomberg Intelligence analyst Larry Tabb is reported saying, “it’s not really Robinhood doing nefarious stuff. It’s the DTCC [Deposit Trust and Clearing Company, a key part of the settlement process] saying ‘This stuff is just too risky. We don’t trust that these guys have the cash to be able to withstand settling these things two days from now, because in two days, who knows what the price could be, it could be zero.’”

The breakdown of market service just when most needed is not unusual; toilet paper stockouts during a pandemic being a topical example.
There are many different risks to manage in investing. 

The risk that the market mechanisms you rely on to deliver your profits will fail just when you are about to make a killing is one of them.

Many professionals know this to their cost.

It’s what happened to Long Term Capital Management Fund, the fabled money-making machine that included two Nobel Prize winner amongst its co-founders.

LTCM failed spectacularly in 1998 when the Russian government defaulted on its domestic local currency bonds. 

LTCM had assumed a sovereign government wouldn’t default but rather print more money.

As has been pointed out, Robinhood implicitly promised retail investors a professional quality experience.

They delivered, warts and all.

Media references

MEDIA REFERENCE:

Professor Raymond da Silva Rosa (UWA Business School), 6488 1719

 

Share this

Related news

 

Browse by Topic

X
Cookies help us improve your website experience.
By using our website, you agree to our use of cookies.
Confirm