Takahide Kiuchi's View - Insight into World Economic Trends :
Individual Investors Shake Up the US Stock Market
#Market Analysis
#Takahide Kiuchi
Feb. 10, 2021
The moves made by individual investors in the US stock market after the turn of the year have attracted considerable attention. These investors, having colluded on the SNS platform Reddit, drove the share price of major video game retailer GameStop up by more than 18 times in less than a month since the beginning of the new year. This action caused the share price of specified stocks to soar, leading hedge funds which had shorted those shares to suffer massive losses.
Rampage by individual investors or democratization of the stock market?
With the hedge funds that took these huge losses now asking other hedge funds for help, we see that the effects of this turn of events are broadening. Individual investors have themselves characterized these actions as a victory for private investors against institutional investors who have reaped tremendous profits, and have touted it as the “democratization of the stock market”. Meanwhile, some have also expressed the fear that these acts could severely destabilize the stock market.
Cases where investors intentionally spread false information to manipulate stock prices, or where they secretly conspire to commit such manipulation, are ripe targets for crackdowns by the authorities. Yet in this current case, the SNS posters did not use false information to deceive other investors, and they colluded on an SNS platform, a public forum. Thus, it would seem that under the current legal system it would be difficult to clamp down on those involved.
What is at issue here is not merely the actions taken by individual investors. The brunt of the criticism has been directed at the online brokerage Robinhood, which is used by numerous individual investors. Named after the legendary chivalrous thief Robin Hood who famously robbed from the rich and gave to the poor, this online brokerage has facilitated investments by individuals without any commissions, and has advertised itself as an ally of the common person. The individual investors who make up Robinhood’s client base are known as “Robinhooders”.
However, given the heightened volatility in stock prices, Robinhood temporarily restricted trading of GameStop shares and other specified stocks, and invited a harsh rebuke from individual investors. Behind these criticisms lies the observation that the brokerage has prevented freedom of trading, and that it has allied itself with the hedge funds that took losses from the rising share prices. There are even growing calls in Congress to look into this trading restriction.
Robinhood’s business model now attracting attention
Having been forced to stay at home because of the Covid-19 situation, these young novice investors became Robinhooders and devoted their free time to invest in equities, engaging in trades as in a game-like fashion. Given how they engaged in options trading and other high-risk investments with ease, and how this led to heavy losses, views critical of Robinhood’s business model from the standpoint of investment education and investor protection have been growing more intense since last year.
The aspect of Robinhood’s business model that is attracting newfound attention is PFOF (payment for order flow). PFOF is the process by which a brokerage firm receives compensation (rebates) in exchange for routing orders from clients to institutional investors such as HFT (high-frequency trading) firms or other market makers. Robinhood then uses those rebates to provide commission-free services to individual investors.
One conceivable reason that HFT firms want information on the orders of individual investors—even if they have to pay these rebates—is that by analyzing the big data involved with AI, they can enhance the precision of their own algorithmic trading.
However, the observation has been made for some time now that in using the order information of these individual investors, HFT firms are obtaining unjust profits through transactions that anticipate the moves of individual investors. The issue at hand now has created an opportunity to put a new focus on these practices by brokerage firms.
Revealing anew the structural problems of the financial markets
The recent actions taken by individual investors have thus brought to light once again many of the structural problems that have long plagued the US financial markets. These events, it may be hoped, will perhaps lead to a deeper discussion about those various problems, and to measures being taken to improve them.
Nevertheless, I believe where measures need to be taken immediately is in preventing individual investors from manipulating stock prices. If that investment activity were purely a matter of making money, stock prices surely would not have been driven up this high. This is because a certain number of investors would emerge who—believing that when a share price rises to some extent, it will likely fall at some point¬—would begin selling their shares to secure their profits. One could even argue that it is precisely this kind of investment activity, rooted in a profit motive, that supports the liquidity, efficiency, and stability of the stock market.
That said, this instance of boosting share prices through the use of SNS also involves another motive, namely beating the institutional investors who have reaped massive profits. Thus, there seems to be an element involved here that caused the share prices to surge abnormally.
If this kind of investment activity by individual investors were to persist going forward, stock market volatility will likely only intensify further, leading the market’s efficiency, fairness, and credibility to take major hits. Before this ends in some tragic finale, where a stock price freefall leads individual investors to suffer huge losses and then becomes a serious societal problem, something must be done to put the brakes on such collusion by individual investors using SNS platforms. Doing so will likely require not only the efforts of the financial authorities themselves, but also cooperation from SNS operators.
However, now that a Democratic administration and a Democratic-controlled Congress are in place, which will be more sympathetic to individual investors in the interest of solving social inequalities, one might worry that such efforts will not proceed very quickly.