Surf Report: Game stopped.
Issue 18: 01.29.2021 (Special Bonus Edition for Everyone 🎉)
INTRODUCTION
January 29, 2020
Hey everyone—I’m so glad to have you here. What a week. Month. Year.
I planned to write about something else entirely, but given the events of the week we need to talk about GameStop.
I’m devoting more space here to break down this historic short squeeze and its implications for everyone who was having trouble keeping up with the madness. And if you have no idea what I’m talking about right now: even better! Rarely do my interests in finance, human behavior, gaming, and technology sync up into such a concentrated fever pitch. (Bitcoin even made an appearance, because of course)
Here we go. It will be fun I promise.
What happened?
This whole thing started because awhile back a hedge fund called Melvin Capital (and others) decided to massively short sell GameStop, purveyor of new and used video games & accessories (stock ticker: GME). They bet so heavily that GME would go down they actually borrowed extra money to do it. If this strikes you as a very risky and irresponsible thing for a hedge fund to right off the bat—a company whose job it is to manage people’s money—then you would be correct.
Risk gets multiplied the instant you borrow money to take it on.
Wait, what’s short selling?
Here’s how short selling works: You can short anything, it’s just a bet. Let’s say I wanted to short the video game Cyberpunk because I think it’s overrated and gonna be worth less next month, and I want to make money on that bet. Here’s how I’d do it:
The game is selling for $60, but instead of buying it I go borrow the game from someone I know, then sell it to someone online for $60.
Next month it drops in price just like I thought it would, down to $30.
I go and buy the game at $30, then give it back to the person I borrowed it from.
Do you see how I made $30? First I received $60 in exchange for a game I borrowed, then gave someone $30 to get the game back so I could return it to its owner. That’s short selling. The money you borrow to do it is called margin.
But what if this wily scheme of mine doesn’t go according to plan? What if this Cyberpunk video game turns into a hit and next month it actually goes up in price, selling for $90? Well, eventually I’m gonna have to give back the game that I borrowed and sold for $60. To do that, when the person I borrowed it from wants it back, I’m gonna have to buy the game at its current price of $90. I just lost $30. The higher it goes in price before I buy it back, the more I end up losing on my short position.
Ok, keep going…
So that’s what happened to Melvin Capital.
They have a history of betting against companies and borrowing money from investors to go irresponsibly short (like, over 100%), profiting hugely from the demise of businesses on the brink. Usually it works for them, only this time a group of everyday “retail” investors in a Reddit forum called r/WallStreetBets (WSB) decided enough was enough. Many had been burned in the 2008 financial crisis due to irresponsible borrowing and lending, and wanted to give Wall Street—specifically Melvin Capital, and similar hedge funds betting against their favorite video game purveyor—a taste of their own medicine.
They saw that Melvin Capital had an absurdly huge short position open against GameStop, and banded together to sync up efforts to buy GameStop and drive its price up instead. They were willing to buy GameStop at whatever price it was trading at, driving its price higher and higher. The hedge funds who were short GameStop were losing millions by the minute, but figured they could just borrow money from other rich investors longer than these Reddit people could continue buying the stock.
But the buying never stopped.
Regular retail investors like you and me got swept up in the frenzy too, sticking it to the man and making money along the way. (Nothing frenzies a crowd like a good underdog-overcoming-injustice story) One prominent reddit user who initially organized the effort ended up profiting~$46 million on GameStop’s run, driving the price per share up 928% in a matter of days. Melvin Capital was forced to eventually close its short position, buying GameStop at an astronomical price and losing billions of dollars in the process. (-30% of its total portfolio). This type of thing has happened occasionally before, though not to this extent. It’s called a short squeeze.
Did anyone do anything wrong here?
Here’s the thing: all of this is perfectly legal.
Here’s another thing: Not all hedge funds are bad. Some are more ethical than others, or manage risk more diligently. The ones that grab headlines are usually engaging in risky behavior out of greed, taking advantage of massive wealth to get massively outsized returns. Those firms are unsavory at best, but not illegal.
Here’s another thing: Not all short sellers are bad. As I’ve written about before, short selling historically serves a valuable purpose as a check-and-balance in the markets so that CEO’s can’t just say whatever they want and publish false figures to drive up their company’s share price. Short sellers will do loads of research in an effort to surface wrongdoing, fraud, or conflicts of interest. Their intention is to expose poor management and liars—of which there is no shortage—and will often publish their research for free even if they don’t put on a short position. (Here’s a great, recent conversation with former short seller and current rocket engineer Jen Ross)
So, no, nobody here did anything illegal. Melvin Capital was effectively punished for being irresponsibly short a company that actually had nothing systemically wrong with it. No ethics violations or evidence of funny business in the books. Sure they’ve fallen on hard times recently, just like many other businesses trying to stay relevant in a world that’s going increasingly digital, but they appointed a new CEO in 2019 in an effort to turn things around and a lot of people hold GME shares because it’s an underdog company and they’re rooting for it. This is the free market in action.
There’s also nothing illegal about telling all your friends to buy a stock you like. In fact, that’s exactly what hedge funds do.
So where did things take a turn for the worse?
Robinhood.
Robinhood is a popular investing app that exploded in popularity last year, especially among Millennials and newer investors, as people were quarantining at home and looking for ways to play around and make some money. You can buy stocks and even trade options (another margin-related activity that requires borrowing money for increased risk) with just a few taps. It has a great user interface and an inspiring motto: Democratizing finance for all.
But when this frenzy of GME (GameStop) buying was happening, buying started extending to other down-and-out companies that hedge funds were shorting like AMC, but also popular Reddit stocks like Nokia (stock ticker: NOK). It even spilled over to “just because” stocks like—get this—the bankrupt company formerly known as Blockbuster Video. It all became a bit unhinged, with people coordinated buying and selling all over the place. Message board millionaires were being minted while so-called professional investors were losing their shirts.
That’s when Robinhood stepped in and prevented its retail investors from buying certain, specific stocks such as GameStop, Nokia, AMC, and BB Liquidating a.k.a. Blockbuster Video. Other brokerages followed suit temporarily.
At first people argued that it wasn’t entirely problematic, and they were right. Sometimes trading is legitimately halted due to huge volumes, since it can become a liquidation issue for a bank (i.e. a brokerage might not be able to have enough money to provide for margin-related options calls and such). It’s not common, but it happens. But while Robinhood didn’t allow people to buy shares of GameStop for reasons it did not fully disclose, it did allow people to sell GameStop shares. They didn’t halt trading, they only halted buying. The whole thing was unprecedented, but a wonderful development for Melvin Capital who wanted the price to go back down.
People were understandably furious, quickly banding together (again) to bring the Robinhood app from a 5-star rating on the app store down to 1-star, forced to look on from the sidelines as Goliath once again got the upper hand on David and eliminated any chance of the have-nots to have any. The U.S. government is now looking into it. AOC is involved. It’s all a mess. And the Robinhood CEO claims he halted buying specific shares “preemptively” and in accordance with the SEC “to protect the firm and protect our customers.” (Protect them from what exactly he didn’t say. Profits? Losses?) Robinhood has since taken on an additional $1 billion in emergency funds from investors just to stay afloat.
His cagey explanation may have something to do with the fact that Robinhood is working on an IPO and wants to have good relations with these hedge funds who will either build up its stock or destroy it when it goes public. And wouldn’t you know: Robinhood’s biggest client Citadel is part owner of Melvin Capital and helped to bail them out of all this. Rumors are swirling that these firms may have intervened and “urged” Robinhood to limit trading to stop people from fleecing them, essentially committing market manipulation.
Which, if true, is a big problem.
While regulatory guidance and responsible banking practices are important, if there are wealthy fingers tipping the scales to favor certain outcomes then any notion of “free markets” goes out the window. It’s the exact type of behavior that people have been angry and frustrated with for decades, and which has led us into the types of national crises that prompted government bailouts.
Some think it’s time for a reset.
So where does this leave us? What now?
It should come as no surprise to know that many people, even (especially) those who profited greatly from this fiasco, want out of a system that appears to be as rigged as suspected. The whole Robinhood intervention was also executed with the “it’s for your own good” tone aimed at smaller “less sophisticated” retail investors who, it should be noted, managed to understand the nuances of market mechanics well enough to legally take down a multi-billion dollar hedge fund and become independently wealthy in the same day.
It’s a shame, because what I’ve always loved about the stock market is that it forces you to have some skin in the game and put your money where your mouth is. There’s some integrity to be had in taking risks under your own name and owning up to the consequences, good or bad.
I make bets all the time just like the bigwigs at Melvin Capital. The difference (besides the dollar amount in play) is if I’m wrong I take the loss and don’t call my friends to help bail me out, or ask to have the rules changed entirely. I’m wrong all the time, it’s part of being a human person. But being wrong doesn’t require ruin. I just cut a loss quickly and move that capital into a better investment before things get worse. I also keep responsible position sizes from the start so that no single trade can bring me to my knees. I maintain a solid sleeping point. I also don’t borrow money to trade on margin. This is how I make money. This is called being a responsible investor. You don’t need a fancy credential to know better.
I let my winners run and gradually scale out profits that I can gradually scale into new trades. It’s not sexy, but it works. And all of this is a small proportion of my main activity of: sitting on broad market index funds and doing nothing. My level of patience is matched only by my ability to have most of my wants satisfied by books, coffee, and the occasional used video game from GameStop.
However.
I do all of this based on two assumptions:
The market isn’t being manipulated
There is sound, hard money undergirding the whole thing
And it’s becoming painfully apparent that the first may not be true, and the second is definitely not true.
People will write entire books about this past week, and if there’s a central theme to the story I think it’s this: Trust.
If you can’t trust the market or the currency you’re exchanging on it, then nothing much else matters.
So what’s the problem with our currency? Well, to make a very long story very short:
With the Bretton Woods Agreement in 1944, currencies from around the world became pegged to the US dollar’s value, which was in turn backed by gold. It was followed quickly by a U.S.-Saudi agreement in 1945 which created the petrodollar, forcing all oil transactions specifically to be tied to the U.S. dollar as well. So all trade was denominated in USD from that point on, in part because the United States was the most stable world power following the devastation of WWII. John Maynard Keynes was a big proponent of this solution, though it did require the creation of some centralized organizations to help manage the thing and keep it in check: the IMF and the World Bank.
That was all fine and good (not really, but bear with me) until 1971 when Richard Nixon took the U.S. off of the gold standard. It was known as the ‘Nixon shock,’ done in response to increasing inflation. So since 1971, the entire world has been trading with US dollars that are actually backed by nothing. Of course, a professor or government worker might say something like, “That’s nonsense, it’s backed by The Fed [U.S. Federal Reserve].” But that’s just another way of saying “It’s backed by because-we-said-so, but also mostly armies and guns so tread carefully here bucko.”
This was all fine and good (not really, but bear with me) until a novel coronavirus hopped a plane and scared everyone into selling everything they had and closing up shop entirely, bringing trade and commerce and business to a screeching halt. Which was fine and good (not really) until the U.S. Federal Reserve went and printed more money in one month than they had in two centuries and then gave it away to everyone. When you flood a money supply like that you accelerate inflation because dollars become worth much less. It’s not so much that prices go up, but that cash buys you less and less. Your “purchasing power” goes down. It’s like an invisible tax on people’s savings, which is part of why people run to things like the stock market in order to have some kind of hope of not falling behind, let alone get ahead.
(If you think inflation isn’t so bad and is only at about ~2% because that’s what the Consumer Price Index (CPI) says, you’ll be sad to hear that the CPI only measures the cost of consumer goods like bread and video game consoles but it doesn’t include the cost of assets—things like healthcare, real estate, education, stocks, or treasury returns. Real inflation is more like 15% or more if you include assets. So you now need your money to be growing at a rate of at least 15% per year if you just want to keep pace. Yes, I’m mad too.)
And this is where our story finally draws to a close… and another story may begin.
What does Bitcoin have to do with it?
There’s a reason public companies and institutions are increasingly moving their cash reserves into Bitcoin instead of holding it as cash. There’s a reason Harvard, Yale, and Brown endowments have been buying Bitcoin for over a year. There’s a reason more pro athletes are asking to be paid in Bitcoin. There’s a reason traditional banks like Fidelity and legendary investors like Ray Dalio, Bill Miller, and Stan Druckenmiller are changing their tune and recommending at least some exposure to Bitcoin in portfolios.
The reason: a fiat standard is inherently inflationary, but a Bitcoin standard is inherently deflationary. And smart people don’t want the value of their cash to continue melting away.
This is where a lot of people got Bitcoin wrong. I know I did at first, and maybe you did too: the endgame isn’t for everyone in the world to be using bitcoin for all their transactions, but for currencies around the world to be backed not by the US dollar or gold but by Bitcoin. The idea is that Bitcoin can be the underlying settlement layer to the money supply. You wouldn’t use it to buy your coffee—you could still use US dollars or Japanese yen for that—but those currencies would be pegged to the price of Bitcoin, and backed by the incorruptibility of the decentralized Bitcoin protocol.
Did you catch the most important word in that last sentence given recent events? Decentralized.
The technical ins and outs of Bitcoin are outside the scope of this essay, but the key is that Bitcoin is simply distributed trust. It’s a cryptographically secure and completely decentralized blockchain—a database for maintaining a fixed supply of value, against which you can settle up and log transactions. Crucially, it solved a well-known problem in computer science called the Byzantine Generals problem, and in doing so prevents values in the database from being tampered with. There will only be 21 million bitcoins ever created so its supply is capped, with production halving every 4 years. Each bitcoin is divisible into 100,000,000 subunits originally called ‘bits’ but now referred to as ‘satoshis’ or ‘sats,’ so you don’t need to own one entire bitcoin to use it. The network nodes are run by normal people with normal computers all over the world, each with a full copy of the entire ledger of pseudonymously masked transactions. Bitcoin miners use powerful computers to perform “proof of work” calculations (much like gold miners perform work and expend energy to dig up gold from the earth using heavy industrial equipment), and many do so economically using cheap, excess power from natural gas flare-offs or energy from wind-/hydro-electric plants in remote locations that would otherwise have gone unused.
There’s no single entity who runs Bitcoin—it’s an open source protocol. You can hack Bitcoin exchanges but you can’t hack the Bitcoin protocol, unless we quickly advance quantum computing progress by ~100 years. To take it down you’d have to take down the entire internet. Governments could ban the use of it (just like the U.S. banned its citizens from owning gold back in the day), though they would just be shooting themselves in the foot and opening up dire game theoretical consequences putting other nations at a major advantage. Early signs point to Bitcoin-friendly regulation in the near term: the U.S. already allows banks to use public blockchains as a settlement layer.
Other, more centralized “alt coins” have come and gone, but only Bitcoin has been able to compound trust for over 12 years now.
Again: this whole thing is about trust. Betting on Bitcoin is simply a way to short the dollar.
Could Bitcoin fail? Could this whole thing meet more resistance than even the biggest naysayers predict? Could we see war and devastation play out before anything like a Bitcoin standard getting peacefully adopted? Could this whole narrative take an unforeseen turn and lead to an altogether different solution to this problem of manipulated markets and a continually debased money supply? Absolutely.
I could be wrong. So could all the other people who trust in Bitcoin right now. And there’s nothing wrong with being wrong. As I mentioned earlier, there’s integrity in taking risks under your own name and owning up to consequences, good or bad. Bitcoin is an experiment just like America. And to paraphrase John Maynard Keynes himself: experiments have a way of surviving longer than alternatives can remain solvent.
At the end of the day, GameStop may end up changing the entire stock market, and Bitcoin may end up changing the global currency reserve system. But if instead nothing changes and we all go back to the way things were, well…
the Game was fun while it lasted.
—Mark