The Gamestop and Robinhood Scandal
The recent scandal of Gamestop and Robinhood has hit the financial world in a shocking, unprecedented manner. To best understand this news, it is essential to define a few terms that may be unfamiliar to those who are not involved with the stock market.
Understanding the Basics of the Stock Market
When trading in the stock market, investors typically buy shares of stocks at a low price. Investors sell these stocks when they reach a higher price to achieve maximum profit. This method of trading is called making a capital gain—which can happen when a company has opened new stores, launched new products, or improved its performance somehow.
Short selling is another method among investors in the stock market, though it is lesser-known to the public. Essentially, this method is used when the investor believes that a company will lose value in the stock market, so they place bets against that company. Here’s an example to help better visualize this process:
You borrow a stock worth $10 from an investor and promise him that you will return a copy of the stock to him in ten days. The rental price for the borrowing is $1 so you pay this on the spot.
If you sell the stock immediately, you earn $10.
Since the share you borrowed is now gone, you still have to pay your investor back, so you wait for the price to fall to $5 (a prediction you made before borrowing) so that you can return a share.
The investor gets their share back and you still have the $10 you sold it for, minus the $5 you paid back to the investor and the $1 rental fee. Using this method, you earn a total profit of $4.
However, if your predictions are incorrect, the consequences can be drastic. Let’s say you sold the share you borrowed for $10 (like in the previous situation), but this time the value increases to $100, against your predictions. You’ll have to spend $100 to give the share back to the person you borrowed from, which causes you a loss of $90. This is just one basic example. Short selling is used by many investors for prices amounting to millions of dollars.
The GameStop Controversy
The GameStop controversy begins with a series of losses after losses and store closings. At the start of 2020, the company was only worth $253 million. Hedge funds—an investment partnership where fund managers and investors pool their money together into the fund— all assumed that GameStop was undoubtedly heading for bankruptcy. Many opened short positions—created when a trader sells a security first intending to repurchase or cover it later at a lower price— betting on GameStop’s bankruptcy.
Reddit users in a group called WallStreetBets noticed these hedge funds, primarily one named Melvin Capital, taking a large short position in GameStop. These hedge funds continued to sell stocks short, strongly believing in the bankruptcy of GameStop. This proved to be a wasted effort; as the Reddit community continued to grow and with the release of the PS5 and Xbox Series as well, Gamestop’s prospects were beginning to look up. The community of young traders continued to mess with the big Wall Street powers. By investing in Gamestop shares causing the price of the stock to rise, this increased the losses for the short sellers who had bet against it.
Over the past six months, GameStop’s stock has gone from around $5 to almost $500. This trapped hedge funds in a “short squeeze”, a loop that continues to drive the price upwards. The hedge funds have to start buying the shares to limit their potential losses. This contributes to the share price increase even more, which makes the hedge fund investors’ position even worse. Melvin Capital is now losing nearly $3.5 billion. Some trading companies are going as far as to suspend the possibility of buying GameStop shares, such as Robinhood, to prevent any further losses of these billionaire hedge fund investors.
Robinhood is a financial services company founded to allow people to make fee-free investments. Their main product is an app designed to make it easy to buy and sell stocks without a financial broker or commissions. During this recent Gamestop controversy, Robinhood has decided to put trade restrictions on companies like GameStop, Bed, Bath and Beyond, Nokia, and AMC.
Although generally known to be an app for the common man, restricting the trade of stocks like these caused an outcry among the public. The Robinhood app’s rating on the Android store dropped to 1 star, and although the restrictions have now been lifted, the damage is still being cleaned up. Many Robinhood users filed a class-action lawsuit against the app claiming that “the app has deprived its users of potential profits they could make by investing in these stocks” or that “Robinhood's actions were done purposely and knowingly to manipulate the market for the benefit of people and financial institutions who were not Robinhood's customers.” At least 17 federal lawsuits have been filed against Robinhood. Clashing figures like congresswomen Alexandria Ocasio-Cortez, and senator Ted Cruz, even managed to share the same anger over the situation. Alexandria Ocasio-Cortez tweeted calling Robinhood's “decision to block retail investors from purchasing stock while hedge funds are freely able to trade the stock as they see fit” unacceptable. To this, Cruz replied, “Fully agree.”
Senator Elizabeth Warren came out with a statement: “We need an SEC that has clear rules about market manipulation and then has the backbone to get in and enforce those rules”. It is unclear whether the criminals of market manipulation were the Reddit traders or Robinhood and others who restricted trading on Thursday. The House Financial Services Committee announced that they would hold hearings.
There will be hearings and Robinhood will no doubt pay a price. “We know that customers were upset with the temporary restriction,” Robinhood CEO Vladimir Tenev told Yahoo Finance. “We've unrestricted it now and customers can buy these stocks. We stand with the people who are making their voices heard through the markets, and showing the world that investing is for everyone, not just for the wealthy and the institutions,”