Background on capital markets
Capital markets exist to create liquidity. Theoretically that means that economic resources don’t go to waste but are instead redeployed productively. In practice: if you have some extra savings, you can click a button and redirect that cash into the capital markets, where it will change hands until it can be used to build or grow something. Ideally, it pays for cancer research or food for hungry nations; in reality it probably gets spent on Instagram ads for some pseudo-scientific, multi-level-marketing fish-oil scam. Either way, the end result is that your extra cash creates economic value for someone and you get to participate in that by earning return on your investment. When you actually need the money later on, there’s more of it. It’s a win for everybody.
The alternative is that your extra money goes under your mattress and earns nothing. Prior to the Capitalist world order, Europe operated under a system called Mercantilism, in which the global economy was a contest to see who could amass the most gold. Economic resources were spent digging up metal and then reburying it near a castle. Eventually people realized that reinvesting gold made more sense than burying it. This idea - reinvesting - led to the creation of modern capital markets, which facilitate the reinvestment process. How easily wealth can be reinvested is essentially what liquidity means. What has developed over the last few centuries is an incredibly sophisticated feat of financial engineering that allows resources to be continually reinvested - the capital markets. The result has been a positive feedback loop of growth: resources fund innovation that creates new resources that fund new innovations, rinse and repeat.
At its core, the capital markets are just a bunch of rules that some suits made up a long time ago and everyone has been following since. What is a stock? It’s ownership of a company. What is a company? Just a bunch of property that everyone agrees belongs to one owner. What is property? It’s stuff that’s mine because I called dibs, or because we both wrote it down on paper, signed it, and then shook hands. Business isn’t a physical science. You can’t put a company under a microscope and look at the individual cells. Business is like baseball. Once upon a time people were swinging sticks at rocks and everyone liked it, so they started formalizing the game. Today, there are so many layers of rules and rituals that outsiders can’t even tell what’s going on. However, the rules, no matter how absurd, bring order to the sport, make it playable. Much the same, the capital markets are a shared fiction, but one that has been amazingly successfully at multiplying shared wealth.
While the goal of capital markets is to create liquidity, a byproduct is money - lots of it. Capital markets are jet fuel for economic growth, and money spews everywhere. In the capital markets, everything is amplified; people make a shitload of money for even a simple service. Most of it is made legitimately, meaning that its made in accordance with the rules. It’s like the money professional baseball players make. These people may be overpaid jocks trotting around in circles like lobotomized show-horses but they do it according to the rules. Follow the rules, create some sort of value, get compensated at market prices. It’s stupid, but it’s supply and demand.
Money is amplified at the center of capital markets, and therefore, so is the incentive to break the rules. Rules do get broken, but the fact that the system works is evidence that rules are usually followed. People wouldn’t participate otherwise. Having said that, some rules are poorly defined and/or hard to enforce, and malevolent exploitationists tend to pop up where rules are weakest.
One such rule is market manipulation. It is illegal, under any circumstances, to act with the sole intent of changing stock prices. For example, it’s illegal to plant a fake news story saying that Beyond Meat’s secret ingredient is dirty socks. That story would drive the stock price down temporarily (until it was proven false), creating an opportunity to make a quick buck on the rebound. Coordinating with people on the internet to buy or sell a stock at the same time in order to drive the price up or down - that’s also illegal because it’s market manipulation
The problem is, market manipulation is incredibly hard to prove. Every action in a marketplace inherently impacts prices. What if Ebay had a rule that said “you’re allowed to bid, but you’re not allowed to bid just to move the price up.” What’s the difference? Every bid moves the price up; how do you prove intent? The result is that criminals hide behind a carefully curated trail of evidence to maintain plausible deniability. To prove market manipulation prosecutors literally have to have the perpetrator admit their nefarious intent on a recorded line. Sounds like something only a Bond villain would be stupid enough to do, but amazingly, it happens. People do get busted and jailed for illegal market activity all the time.
To recap: capital markets = liquidity = rules = economic growth = cool
What’s happening now?
Ok, let’s get to the point here: GameStop and the Robinhood revolt.
Without getting into detail, a bunch of regular people identified a few hedge funds that were exploiting regulatory loopholes. As in, the rules were so poorly written that they either weren’t being followed or couldn’t be enforced. The regular people realized that by coordinating on social media they could manipulate the stock price of GameStop, screw over the shady hedge funds and, possibly, get rich. Amazingly the plan worked, although it’s unclear how many regular people will actually get rich off this when the dust settles. Still, at least one hedge fund has lost billions, and suits everywhere are going bonkers. The response by the aforementioned unethical hedge funds has been even more unethical/illegal behavior: market manipulation, convincing RobinHood to restrict their userbase from investing in GameStop, and more. That brought the ire of the general public, and it now seems as though market manipulation is a new form of protest, a social movement. If so, it will be a really effective one. The unbridled rule-breaking has brought the attention of regulators, more mature financial institutions (if there is such a thing), congress, and the rest of the establishment.
The real story
Warren Buffett calls excessively risky activity “picking up pennies in front of a bulldozer.” Make a little bit of money here and there until one day, splat: fatally smooshed into the pavement. In this case, the people buying GameStop (or AMC or whatever) are picking up lottery tickets on Tatooine while the Death Star warms up its cannon. A few people might get rich, but this whole thing is going to get blown to pieces.
As explained before, the global financial system does not work when people break the rules. GameStop is a tiny, tiny piece of the financial markets. However, the activity here is illegal. If coordinated market manipulation is allowed, it will spread. People will make money by cheating, others will observe and imitate. If this behavior isn’t stomped out, then it is a legitimate threat to the social order. That seems like an overreaction now, but this movement is rapidly gaining momentum. The global economic system is dependent on reinvestment via capital markets, which are dependent on liquidity, which is dependent on rules that are followed. That’s why the establishment has acted aggressively to curb this behavior. It’s not a matter of class warfare, it’s a matter of keeping peace. Leaders of the economy are not going to mess around here.
A lot of what’s being talked about in the media is hedge funds vs. Robinhood investors as some kind of epic battle. That’s kind of besides the point. Most of the world - establishment and otherwise - doesn’t care if some hedge fund goes bankrupt. Maybe small-time investors outsmart hedge funds, maybe not. The bigger issue is financial stability in the capital markets (see the below section on the 2008 crisis for more on that).
The best-case scenario here is effective regulation. These hedge funds never should have been able to get into this precarious situation. Robinhood and other trading apps should be regulated and they shouldn’t be allowed to unilaterally decide what's best for everyone. At the same time, coordinated market manipulation by the masses can’t continue and also needs to be stomped out.
There will probably be criminal charges too. Individuals at hedge funds and big firms need to be held accountable for illegal activity. Charging social media users with crimes is probably not palatable for any District Attorney, even with unimpeachable evidence in the form of social media posts, but there are other ways to shut down mass market manipulation going forward.
Hopefully, in a decade, these events are looked back at as an awesome and successful protest, not the violent dismantling of the capital markets. Public sentiment is clearly on the side of curbing behavior of “investors” who extract value without creating value. Despite what is portrayed in the media, most “insiders” agree with the general public. The rich and powerful need the rules of capital markets to stay rich and powerful. The rules need to be fixed and they need to be better enforced.
Speculation: are we missing anything?
Right now, the narrative is that the GameStop movement was pure grassroots, a coordination of regular people unifying under a just cause. What if that’s not the whole story?
Recent history has demonstrated that social media can be used to manipulate large groups of people. Google and Facebook are worth over $1 trillion combined, and they exist for that express purpose. The past two political elections are evidence as well. Beyond that: remember the wave of ISIS-inspired terrorist attacks a few years back? At first, these people were viewed as “lone-wolfs” who were inspired by others. Eventually it came out that there was actual coordination with real ISIS members. This kind of behavior is happening all the time. An orchestrated wave of misinformation and online activity can trigger real-world results. If someone or some entity figured that out and realized how much could be gained by applying that logic to capital markets, that could also partially explain the events of the past few weeks.
Liquidity and the 2008 financial crisis
Here’s a very simplified explanation of the 2008 crisis. A lot of major financial institutions that participate in capital markets owned a ton of real estate assets. When the real estate market crashed, there was a period of time where it really seemed like the capital markets were going to collapse because the banks couldn’t provide liquidity. If that happened, the whole global order would have collapsed: credit cards don’t work, checks bounce, payroll systems collapse, retirement funds go to zero, total nightmare scenario. This is called a liquidity crisis, and was basically solved by the government writing a blank check to keep things moving.
This is relevant today because if bad behavior isn’t stomped out immediately, then the current situation could develop into a major liquidity crisis. If the rules don’t work, then nobody will participate, which means no liquidity and complete collapse. That’s why I think government and business leaders will act quickly.
Another interesting parallel to the 2008 crisis is the public sentiment. Wealth inequality and the perception (probably the reality) of unfair rules of play led to turmoil. The crisis and the turmoil led to financial regulation that has been somewhat effective. I spent a few years working for a big bank on this regulation, and I can tell you that it helped improve behavior. Back to the baseball analogy, pre-2008 finance was the steroid era; the main chunk of post-2008 regulation is basically random drug testing for big banks to make sure they are behaving. Critics rightfully point out two things: (1) the regulation didn’t go far enough, and (2) regulation was targeted explicitly at large financial players, the banks known as “too big to fail.” As a result, bad behavior was squeezed out of big banks into unregulated areas of the markets: hedge funds, private equity funds, and similar entities. Hence why hedge funds are the villains in the GameStop saga. Notice that, for like the first time in like 100 years, Goldman Sachs or any big bank hasn’t been implicated In a major scandal. That’s progress, kind of, right?
The bottom line is that the rules aren’t defined or enforced well enough. The law needs to evolve, and it needs to do it faster. While public opinion is aligned on that, it will be an uphill battle because changing the rules means forcing wealth transfers from people who have tremendous resources. Plus, drafting effective financial regulation is crazy hard. The alternative, though, is a mass financial revolt.