Tuesday, May 11, 2021
January's GameStop frenzy, where amateur online retail traders took what they hoped would be a rollicking joyride through the world of high finance, has left regulators scratching their heads about what to do next and the retail buccaneers themselves with quite a hangover. The newly minted SEC Chair, Gary Gensler, told the Senate Banking Committee in testimony last week that the Commission is still trying to figure out what the GameStop drama meant and what, if anything, the market regulator should do about it. However, some of the online buccaneers have made their next move clear and filed a class-action lawsuit against seemingly everyone who's anyone in the world of retail and wholesale securities trading. The GameStop episode demonstrates that the online buccaneers failed to appreciate the workings of the markets they opted into, and may even hold some lessons for the more experienced participants, particularly when it comes to the complicated dynamics of leverage.
The heart of the suit is an allegation that the Wall Street Goliaths conspired to protect themselves and shut out the little guy. But were the markets' reactions truly the product of some vast conspiracy between thirty-some-odd brokers, hedge funds, and clearinghouses? Or had the online investors just relied on incomplete models and failed to comprehend a complex and dynamic securities market with checks and balances that are well-understood by the major players?
Retail and wholesale securities markets, though heavily regulated, have developed risk mitigation and management systems through the natural evolution of commerce. These structural and economic guard rails and circuit breakers act as a sort of a market immune system triggered to respond to disruptive or chaotic market conditions. One might say that the habitués of the retail and wholesale securities markets have the complete picture of the markets in which they operate every day. Their understanding of their exposures and models is complete.
On the other hand, the online investors overlooked or were not fully aware of these critical circuit breakers. Margin and collateral requirements and the clearing and settlement processes evolved over decades of retail and wholesale trading activities in good markets and bad. Based on years of accumulated lessons learned, these self-correcting mechanisms kick in during periods of stress, as they did for the GameStop frenzy.
Fair or Foul?
Overconfidence may also have played a factor for the online investors. Judging from their class action complaint, the illusion of understanding or superior market foresight may have made them overestimate their market insight and caused them to overlook some critical restrictions on their trading activities. For example, the online investors did not factor into their trading strategies that institutional investors had access to after-hours trading while the online investors did not.
Whether the online investors were treated unfairly vis-à-vis institutional investors, as the class action complaint alleges, is a question of "what duty, if any, did the brokerages owe their online platform clients versus their institutional investor clients?" Brokers generally owe a duty of best execution (i.e., timely execution at the market price). But does this extend to policing the activity on their own ostensibly free platforms? What do the contracts between brokerages and online investors say? The online investor plaintiffs allege that "RobinHood does not warn users of any situation where it could prevent users from buying stock out of its own volition."  But is this true? It seems unlikely that the terms of service omitted restricting client trading opportunities during volatile market conditions or in response to abusive or disruptive trading. Ultimately, with the help of industry experts, the courts will decide if the treatment of the online investors departed from standard industry practices.
The lesson to take away from the GameStop frenzy may be that structures, securities finance markets, and participants reacted to the online investors' disruptive and provocative activity as they should have. Collusion or conspiracy was not necessary to prompt the built-in guardrails and circuit-breakers to engage. They could not have been expected to react otherwise. The online buccaneers have perhaps learned that what you don't know can, indeed, hurt you. And when you live by the sword, you die by the sword.
In part 2, we'll discuss how market forces served to counteract the pressures from the options-leveraged online GameStop investors and eventually shut down the system.
 The illusion of understanding or superior market foresight may have made them overconfident.
"Retail Investors correctly deduced that GameStop was undervalued because large financial institutions had taken large short positions" [Class-action Complaint p. 14]
"The Fund Defendants, Clearinghouse Defendants, and unnamed co-conspirators predicted incorrectly." [Class-action Complaint p. 14]
"Institutional investors, holding large short positions in GameStop's stock and other Relevant Securities began to push back and attempted to message on media and elsewhere that the Relevant Securities were not as valuables the Retail Investors thought." [Class-action Complaint p. 17]
The online investors believed the Fund Defendants' short positions were "highly speculative bets"rather than soundly researched investment decisions made as part of an investment strategy.
"Rather than use their financial acumen to compete and invest in good opportunities in the market to recoup the loss in their short positions the growth in the Relevant Securities' prices represented, or paying the price for their highly speculative bad bets, Defendants instead hatched an anti-competitive scheme to limit trading in the Relevant Securities." [Class-action Complaint p. 25]
 Clapp v. Ally Financial et al. Case 3:21-cv-00896, U.S. District Court for the Northern District of California, Class-action Complaint p. 27