The meteoric rise in videogame-retailer GameStop’s stock price from a few dollars to more than $300 in a couple of weeks, swelling its market value to about $25 billion, has made the company and mania surrounding it a household name.
Trading in shares of the beleaguered retailer has gone through the roof. Short interest — bets against the company — exceeds the total shares outstanding, and call and put option volume has been in the tens of millions. Those statistics are an order of magnitude greater than for similar stocks.
Investors, including those on Reddit’s WallStreetBets forum and other social media, have been buying GameStop
shares, causing a short squeeze for those betting against the company, in turn forcing the short sellers to cover their positions. As a result, that’s driving the shares higher. While the saga is still unfolding, we wouldn’t be surprised that when the music stops, GameStop’s share price would return to terrestrial levels.
The dramatic turn of events has led many to speculate the underlying causes and proffer regulatory remedies. Some draw a parallel to pump-and-dump schemes that seek to manipulate share prices. However, pump-and-dump schemes are already illegal, which might shift attention toward other regulatory avenues.
Three come to mind: payment for order flow, a transaction tax and enhanced financial literacy education.
Payment for order flow
Payment for order flow (here’s an SEC study) transfers “some of the trading profits from market making to the brokers that route customer orders to specialists for execution.”
This practice has experienced renewed scrutiny as a central source of revenue for retail brokerage platforms such as Robinhood, Charles Schwab
and E*Trade. The brokers’ business model offers zero-cost trades to attract business from individual and institutional clients in exchange for the order flow payments they receive from market makers such as Citadel.
Detractors argue that zero-cost trades induce excessive trading. While that might be true, it’s naïve to believe that it remotely explains the price movement witnessed in GameStop. Moreover, the lower cost of trading in all stocks and better execution have democratized investors’ access to securities markets without adverse effects on securities market. In fact, greater investor participation and trading enhance price transparency and liquidity — both desirable tenets of securities markets. Making order flow payments verboten will deprive markets of these benefits.
Clearly, trading volume in GameStop shares is many times its historical average. This anecdotal evidence of high trading volume and high volatility might revive the financial transaction tax proposal.
A financial transaction tax is typically premised on notions that trading fuels volatility, and trading, especially high-frequency trading, does not serve a useful social purpose. An alternative explanation is that economic news and uncertainty contribute to trading and price volatility.
As the COVID-19 pandemic hit the U.S. in March 2020, the adverse news and high degree of uncertainty about U.S. economic prospects manifested in a sharp fall in asset prices and the VIX rising almost instantaneously to a historic high. Simultaneously, trading volume doubled. From April 2020, asset prices rose and VIX dropped rapidly with federal stimulus, accommodative monetary policies and Treasury fiscal support to businesses.
However, trading volume has remained elevated, which contradicts the notion that trading fuels market volatility. A financial transaction tax would discourage trading, for sure, but it is unlikely to attenuate volatility. More importantly, price discovery might be sacrificed as a result of less trading, which would adversely affect efficient capital allocation.
Finally, financial transaction taxes are also unlikely to be effective in curbing episodes such as the sudden rise of GameStop.
A baseline level of education is a prerequisite for an individual investor to trade in options. Enhanced financial literacy education might be a promising approach to discipline investor exuberance. Still, more information is needed to determine its efficacy. This may come in the form of research on the links between education and investor behavior.
Rather than regulation directly designed to curb trading, experimentation in financial markets might hold greater promise in calibrating the form of effective financial literacy education.
The limits of arbitrage capital
The sudden, sharp rise in GameStop highlights the clout of individual investors acting in concert. Their collective buying power has propelled the stock to loftier levels, which virtually everyone believes to be unhinged from underlying economic fundamentals.
Typically, active investors, including short sellers, correct the price by selling the stock. However, the GameStop episode has exposed the limits of arbitrage capital that might otherwise counter the tsunami of buying pressure as a result of coordinated buying by a huge number of investors. A few hundred million to a few billion dollars of capital from short sellers has been too little so far.
Moreover, they could not marshal additional capital to meet margin calls as the stock price rose. Worse yet, buying to close out their loss positions only resulted in additional buying pressure or the short-squeeze effect.
The bottom line is, the efficient functioning of the stock market requires substantial arbitrage capital to correct mispricing that might result from coordinated buying motivated to exact a revenge of what individual investors perceive as a market rigged by short sellers. Unfortunately, in this environment of demonization of short sellers, it’s hard to imagine additional capital will flow to stem what seems like an irrational stock price rise in GameStop.
Of course, only time will tell whether the price rise is rational or that it exposes the lack of adequate arbitrage capital. In the meantime, it behooves to resist being trigger-happy with regulation.
SP Kothari is a professor at MIT Sloan School of Management and former chief economist at the Securities and Exchange Commission from 2019-2021. Eric So is a professor at MIT Sloan School of Management.