Reddit revolution puts Wall Street in check and sets off regulator and investor alarms

Maximum tension in the dispute between Reddit and vulture funds over GameStop shares

Maximum tension in the dispute between Reddit and vulture funds over GameStop shares

The combined action of a legion of internet foreros, grouped together on the Reddit page WallStreetbets, has punished some of the most famous names in the powerful, and seemingly untouchable, collective investment industry. Many hedge funds have been caught up in the vertical rise of Gamestop and other stocks where they had placed their bearish bets, and the impact on the market as a whole remains to be seen, which has awakened to a new reality.

The White House press officer had, in fact, to answer questions from the press yesterday about the situation of the video game store chain, which has risen 1,400% in the year. “We are monitoring the situation,” said Jen Psaki. Other securities such as AMC, Evotec, Nokia, or Varta have been targeted by foreros in their attempt to twist the arms of the big bearish managers.

The mechanics are simple; In stocks heavily punished by bearish bets, coordinated purchases by small investors drive up the price, causing such bearish bets to lose. To limit the scope of these losses, the funds have to hedge their position, that is, offset the risk of further increases. Something that can only be done with bullish bets … which in turn accelerate the increases in a snowball effect.

It is a striking but relatively common phenomenon in the market, both in some companies and in the market as a whole. But for the first time, it has been purposely unleashed by the action of a battalion of small investors, coordinated via Reddit and operating thanks to free or low-cost trading applications, such as Robinhood. Taking advantage of the lockdown, these platforms have skyrocketed retail sales on US exchanges in the past year.

It is still unclear if the vertical rise of Gamestop is due only to the massive intervention of individuals (Wallstreetbets users have shot up to three million, which forced a temporary closure yesterday) or if market mechanisms such as high-frequency trading, that launch purchases in hundredths of a second to take advantage of capital inflows and outflows, have played their role.

In any case, in this dystopian version of the class struggle, the bill has been paid by the aristocracy of the markets, the big hedge funds. The Point72 fund of Steve Cohen (a renowned figure and owner of the New York Mets baseball) has lost between 15% of its value due to its investment in Melvin Capital, a manager that has suffered losses of 30% for its bets against Gamestop . Dan Sundheim’s D1 Capital, 20%. Maplelane Capital, a $ 3.5 billion fund, has lost 33% of its value.

The fear of a domino effect has led rival funds to inject 2.5 billion euros into Melvin Capital yesterday, in an attempt to prevent the contagion of problems. The secondary effect of this storm on the market as a whole is twofold: first, closing of short positions in assets on which the industry was betting on the downside, given the risk that the legion of foreros continue their crusade.

Second, there is a more general impact, such as large-scale stock sales. Unsuccessful bets in derivatives markets force investors to deposit additional guarantees, for which they require liquidity obtained by selling assets. And likewise, these failed bets raise the risk parameters of the funds, so they have to reduce their exposure in other market segments to compensate. The effect has been felt in yesterday’s fall in Wall Street, the largest since October, also accelerated by the Fed and some corporate results.

In any case, several professional managers consulted by Bloomberg agree that the impact of the coordinated action of small investors via Reddit will force a rethink of the calculations of the hedge fund industry. It has been living an excellent 2020 thanks to the high volatility of the market during the financial storm derived from the pandemic, but is now trying its own medicine.

Nasdaq chief Adena Friedman said exchanges and regulators should be on the lookout for anonymous social media could be pushing pump and dump schemes . “If we see a significant increase in social media conversations and we compare it to unusual business activity, we can potentially stop that action to allow us to investigate the situation.”

The market supervisor, the SEC, said it is aware of the situation and is working with other regulators to “review the activities of regulated entities, financial intermediaries and other market participants.” Senator Elizabeth Warren, highly critical of Wall Street for decades, called on regulators to take action.

“For years, the same hedge funds, venture capitalists and large investors today dismayed by GameStop’s operations have treated the stock market as their own personal casino while others pay the price,” Warren said. “It is time for the SEC and other financial regulators to wake up and do their job.”

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