Wall Street Never Saw the Redditors Coming

(Bloomberg Opinion) -- Wall Street should have seen the GameStop Corp. saga coming. Easier access to information, the proliferation of trading apps, zero-fee commissions, the ability to buy fractional shares, and U.S. government stimulus checks to individuals have all led us to this moment. And let us not forget the actions by the Federal Reserve and government during the early days of the pandemic crisis that not only supported financial markets, but made everyone forget that investing does carry potential risks.

The rise and newfound clout of retail investors has been evident for all to see if they just opened their eyes. First, this cohort of investors embarrassed Warren Buffett after he sold his airline stocks in May and “wished them well.” Led by Dave “Davey Day Trader” Portnoy, airline stocks almost doubled the next month and are still well above the levels when Buffett exited his positions. The retail investor tugged on Superman's cape and won. Which is why Buffett should understand what is happening.

Stuck at home, retail investors recognized trends were changing and found a way to profit. They opened brokerage accounts by the millions last year to buy the risky stocks that professional money managers avoided because they believed they were overvalued. These stocks are not in the broad market indexes that popular exchange-traded funds mimic. These stocks went on to double and triple in price, with some gaining by even more. The brokers and money managers should understand.

Now it is the retail trader's turn to take centerstage. This crowd is a little different from those the retail investors highlighted above. They are like the professional trader in that they look for opportunities to game the system, hopefully legally. As we now know, they traffic on Reddit's WallStreetBets investing forum, which at last count had more than 7.5 million members. There is some very smart analysis in this forum, just like on Wall Street. They also have many “follow the crowd” chasers, also just like on Wall Street. They use screen names like “roaringkitty,” “stonksflyingup” and “veryforestgreen.” That's not very Wall Street-like.

As early as October, these and other Redditors were detailing how the “Masters of the Universe” were making an egregious error in GameStop. The number of GameStop shares that were sold short exceeded the amount available for trading, or the “float.” It was the most shorted stock on the New York Stock Exchange. They even singled out hedge fund Melvin Capital, which had shorted most of the shares, as particularly vulnerable.

A massive “squeeze” was possible, but like a good trader they waited for a catalyst. This came in mid-January when a surge in the buying of puts preceded a report from Citron Research recommending going short the shares of GameStop. This meant the short squeeze potential was now at its maximum. The Redditors struck with the execution rivaling any of the greatest traders in Wall Street history, and many lawyers say it all looks legal. The Masters never saw it coming.

Selling more than 100% of the float of a stock is what's known as a “naked short,” or selling stock with no intention of delivering the shares. Such activity is illegal under Securities and Exchange Commission rules and stopping it was a principal reason the SEC was created in 1933. As the investigation into the GameStop saga gets underway, the SEC may want to start with why it failed its own basic mission. The SEC's job is to see these things coming and it failed.

But even more disturbing is Wall Street itself. Plenty of smart people must have known that this big a short position put the Masters in a position of vulnerability. But they didn't believe the situation was dangerous because it was unlikely that any large institution would take advantage of it and attempt a massive short squeeze. Self-regulation keeps the entire financial system honest, but it seems to have gone missing here and in many other corners of Wall Street.

Questions about why these Masters were not called out by other Masters need to be asked. Is this just “the way the game is played” on Wall Street? In other words, collusion? Rushing to bail out Melvin Capital is consistent with this idea.

The Masters did not see the many thousands of retail traders banding together as a large enough force to halt their best-laid plans. As a result, a big new player with lots of money and sophistication has entered the game and is probably not going away. They are outsiders who use the Masters' own practices to change the rules and win.

So many on Wall Street and elsewhere could not, or did not want to, see this coming. They have a vested interest in the status quo that clouds their judgement. Many of those same people are now saying that there is elevated risk in the markets now due to the rising power and participation of retail investors. The truth is that they might be looking at the wrong risks and at the wrong players. 

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Jim Bianco is the President and founder of Bianco Research, a provider of data-driven insights into the global economy and financial markets. He may have a stake in the areas he writes about.

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