The $treet

My buddy in Japan asked me what was going on. This was my description — and why it matters.

During the pandemic, a hedge fund called Melvin Capital was short-selling stock of video game retailer GameStop. Melvin believed the company was on shaky footing, that more gamers were buying games and consoles online and that GameStop would be caught in the general retail slump. Melvin set out to profit from this distress.

They did this by short-selling GameStop stock. In a short sale, an investor bets on the price of a stock going down rather than up. They borrow shares and give their owners an IOU. If GameStop is selling at $25 a share, and you want to buy, then you give Melvin $25 and they give you a borrowed share which they must later replace. If, at the time they have to return the share, it is trading at $15, then they have made $10 profit. You paid them $25 for a borrowed share that only cost them $15 to replace.

But Melvin didn’t simply short-sell GameStop. They short-sold 120+% of GameStop stock. In other words, they offered more shares of the company than actually existed. By the law of supply and demand, when supply increases, price decreases. But when the price of stock decreases, people tend to sell, which decreases the price even further. Using their vast assets, Melvin over-sold GameStop stock and effectively drove the price from $25 to $3 per share, where it was still falling.

But rather than close their position at $3 and take their profit, Melvin got greedy. I expect their endgame was to drive GameStop out of business. If so, GameStop shares would be worthless and Melvin wouldn’t have to give anyone anything. They could keep all the money people had given them and tear up all the IOUs.

Some “retail traders” took note of this. A “retail trader” is a home investor, someone who uses a retail trading service like Robinhood or TD Ameritrade to invest, as distinct from an “institutional investor” like Melvin. A retail trader is an average Joe, and the average Joes on a Reddit forum called r/WallStreetBets (created in 2012), many of whom were gamers, took note of the GameStop situation and came to a different conclusion than Melvin.

They believed that yes, the company was hurt by the retail slump, but that it wasn’t dead, that it could still service customers in some areas, and so was worth more than $3 a share. They were also angry that a company like Melvin, with over $13 billion in assets under management, was trying to profit from others’ economic distress and that their plan, if successful, would put people out of work. They began to buy GameStop shares and to tell each other about it on r/WallStreetBets.

Over the course of several days, because so many people were buying small numbers of shares — many of the individual investments were in the hundreds rather than thousands of dollars — the price of GameStop stock increased dramatically, and the guys on r/WSB realized they had the chance to do the seemingly impossible: to drive a multi-billion-dollar hedge fund out of business. They set out to do to Melvin what Melvin was doing to GameStop. They urged each other to buy as much stock as possible and drive the price higher.

To temporarily cover the cost of their IOUs, which were now very expensive, Melvin took a $2 billion loan from a pair of investment houses, who expected the storm to pass. (One of them, Citadel, seems to control trading app Robinhood.)

It didn’t. Yesterday morning, after mogul Elon Musk tweeted the stock, the price of GameStop shot up from $146 to $352 per share, forcing Melvin to sell some of their other positions in order to cover the losses they were incurring. There was blood in the water!

Almost immediately, retail trading houses Schwab, Merrill, Robinhood, and TD Ameritrade began suspending GameStock trades (along with AMC and other stock also targeted) and in some cases freezing the accounts of the r/WSB traders, who could no longer access their portfolios. The average Joes could do nothing but sit and watch as the price of GameStock drifted swiftly down–

In other words, the funds and trading houses are now betting that fines and judgments will be orders of magnitude less than losses. They’re using class action as an asset haven.

There’s an old saying: Any law whose violation is punishable by fine is only a law for the poor. For anyone else, it’s just a fee.

To put this into context, this marks the second time this month that the barbarians stormed the castle. (The first was on January 6th.) This time, however, they actually came away with some loot. The damage may be in the billions.

As I’m writing this, the story is not over. A class action was filed against Robinhood in New York this morning, and one or two trading houses seem to be allowing trades again. After dropping like a rock to $126, GameStop is trading at $230, and no one is quite sure what will happen next.