The GameStop Market Frenzy: Key Drivers, Players, and Lessons

The past two months shocked investors, corporations, and the public alike as an unprecedented series of events sent several stocks on a rollercoaster ride. On January 11th, GameStop (GME), the well-known American video game and consumer electronics retailer, appointed three new directors to its board: Alan Attal, Ryan Cohen, and Jim Grube, all former executives at pet food e-commerce giant Chewy. The board change came as the first step in GameStop’s bid to turn the business around and to increase investor confidence after years of struggling against the industry’s transition to digital retail. The announcement caught the attention of the Reddit forum r/wallstreetbets, a community of individuals posting memes and gambling large sums on high-risk, short-term bets such as derivatives contracts. Just two days later, on January 13th, the stock spiked over 50% as retail traders poured in, the first massive jump in a series of bumps that sent GME’s shares trading from $20 on the 12th to a peak of $483 on January 28th. Moreover, companies like Nokia, BlackBerry, and AMC were also targeted on /r/wallstreetbets and subsequently saw massive price hikes during the same period. While many investors lost billions of dollars, there were a lucky few who rode the wave and generated immense wealth - a turnout that may further encourage high-risk trading through retail brokerages.

Interestingly, the Reddit forum’s interest in GameStop predates the announcement by just over half a year, often linked to a YouTube video uploaded on July 27th, 2020 by Reddit user “DeepF***ingValue,” in which the user discusses his bullish stance on the company’s stock. Just two weeks later, on August 14th, high-performing long/short hedge fund Melvin Capital filed its form 13F, revealing its current positions. Several Redditors noticed that midway through the list, the hedge fund held a significant short position against GameStop - in essence, betting that the company would perform poorly and its share price would decrease. They quickly posted this news to the r/wallstreetbets forum, historically a gathering place for individuals with a strong belief that hedge funds maliciously manipulate the market for the benefit of the wealthy. Subsequently, a plethora of retail investors began piling money into the stock to raise its price and “short squeeze” Melvin Capital out of its position. While Redditors and other retail investors sparking the rise from $20 to $483 is astounding, the stock had already risen 400% in just half a year with Melvin Capital’s short position as the initial catalyst.

This gargantuan hike in valuation begs the question: which players and financial instruments made the rise possible? The main groups involved in the saga are small retail investors through platforms like Robinhood, billionaire “whales” with erratic behaviour such as Chamath Palihapitiya and Elon Musk, traditional and quantitative hedge funds, and banks. These four parties each took steps to encourage further trading and positive investor sentiment, creating a dangerous feedback loop that pumped the stock “to the moon”. The key financial tool that helped orchestrate this event was the call option. Call options are contracts typically sold by large financial institutions, which give the buyer the right - but not the obligation - to buy a stock at a certain price at or before a specified maturity date. They are typically a bullish indicator and are the opposite of puts, which give buyers the chance to sell a stock at a certain price. In essence, options let investors hedge against risks such as exchange rate fluctuation, but at the same time can be a powerful weapon for speculation. The reason behind their importance is the way banks treat options: option sellers have to be able to deliver the promised shares if the option strike price is triggered, causing them to continuously hedge their risk by buying or selling the underlying security as more options are sold, and thus affecting the price. 

Furthermore, the impact of this dynamic was exacerbated by the sheer quantity of calls purchased in such a short timeframe. The month of January set a record for highest volume of options traded at over 843 million contracts, up 62% year-over-year. At the same time, as all of these orders were put through, high-speed traders and market makers generated immense wealth. Firms like Citadel Securities, Two Sigma, and Virtu Financial often pay brokers like Robinhood to route orders to them, profiting on the spread between bid and ask prices. This practice, known as payment for order flow, is a critical source of revenue for many brokers, but is often criticized as an opaque and heavily controversial business practice. As US trading activity spiked and hit a record 24.4 billion shares traded on January 27th, these largely algorithmic hedge funds profited tremendously.

Outside of the players directly involved in trading, there are two more key perspectives needed to understand the big picture: trading platforms and regulators. The former consists of retail brokerages like Robinhood and Interactive Brokers, which give retail investors the ability to easily trade various securities. As the trading frenzy sent several stocks skyrocketing, many brokerages restricted trading particular stocks - particularly GameStop - by raising margin requirements or by allowing traders to sell their positions, but not to purchase more shares. This action prompted further anger and discussion among retail investors, pushing many to file lawsuits arguing that the restrictions were unlawful. Shortly thereafter, on February 5th, the limitations were lifted.

Although they were later removed, the trading restraints led many to develop theories questioning retail brokerages’ sincerity, often pointing to their controversial business practice of payment for order flow as their primary motivator, and accusing them of supporting hedge funds. This particular theory was further strengthened by the revelation that Robinhood directs more than half of its customer orders to Citadel, rather than to traditional exchanges - a strategy whose controversial nature recently cost Robinhood $65 million in a settlement with the SEC. The trading platform and its peers countered by pointing to their vision of democratizing the investment industry and of giving regular consumers the ability to trade with no commissions, a feat that can only be accomplished by pushing traffic to these market makers. Theories aside, there is a fundamental operational reason why these firms had to restrict trading. The brokerages operate through margin accounts, in which clients do not actually own the securities but rather a promise from the broker. Accordingly, Robinhood owns the stock and passes the rights of ownership to the customer. Next, Robinhood lends the share to hedge funds or other institutions to short for daily fees, and is thus left with a debt/credit relationship and generates money from the fees. In the US, equities have a “T+2” process, so settlement of these trades takes two business days, yet the change in value is denoted in trading accounts instantly. This is because Robinhood clears these transactions daily through a third party depository trust and clearing corporation (DTCC), and to do so needs to have enough funding on its balance sheet - something it did not possess to support the exorbitant trading volume in late January and hence had to pause trading and raise $3.4 billion in emergency funding to cover the growing credit risk. Put simply, when a user places a trade on the platform, their account shows the transaction instantly but it does not go through on the back-end for two business days, forcing Robinhood and other brokers to maintain strong balance sheets to outweigh the risk of price volatility in the securities during these interim periods. When the volatility spiked astronomically, the firms were forced to halt trading and seek emergency funding to compensate for the elevated levels of risk.

The final key perspective in understanding the GameStop mania is that of regulators. The issue is highly complex and involves many players, so it is unlikely that the SEC will be able to pinpoint the hysteria on anyone in particular. On January 29th, the SEC released an official announcement regarding the market volatility, saying that it would closely monitor the situation. Several days later, Treasury Secretary Janet Yellen met with the SEC to discuss market volatility and the “integrity of markets.” Two weeks after, Congress held a hearing on February 18th in which executives from Citadel, Melvin Capital, and Reddit testified alongside the now legendary Redditor “Roaring Kitty,” each party discussing its involvement (or lack thereof). The quick-fire series of moves - and lack of concrete results from actions taken by regulatory bodies - highlights the difficulty of finding a “culprit” behind the frenzy.

Now that we have discussed all the main players, we are left with two critical questions: who were the real winners, and what impact will the markets see going forward? Given the rapid rise and fall of these stocks’ valuations as well as the relative lack of transparency in the industry, it is difficult to clearly identify victors outside of market makers who benefited from high order flow volume payments. That being said, there are several investors known to have generated vast wealth by capitalizing on market volatility, with funds like Senvest Management making $700 million and raising its assets under management from $1.6 to $2.4 billion, as well as retail investors turning $500 bets into hundreds of thousands or more. Weeks after the initial chaos, after reaching a stable level at $46, GameStop's share price skyrocketed again, reaching a high of $265. 

As this volatility continues into the foreseeable future, there are several key takeaways: public opinion of hedge funds is highly negative and will make short positions more risky with Redditors monitoring every move, the DTCC is very important as the number of retail brokerages and investors rises, the payment for order flow system may need to be regulated more closely, and - ultimately - investing is not a game and should not be taken lightly.