David against Goliath

Reddit’s attack on Wall Street and the distorted maneuvers that hedge funds use.

Every so often, the financial system suffers a disruption that rattles its foundations. Over the last week, Wall Street watched the unprecedented move in astonishment. A multitude of small investors, coordinating with each other through a forum on the platform Reddit, have put some of the world’s largest hedge funds up against the ropes. And they succeeded in giving the hedge funds a taste of their own medicine: speculation. Upon simultaneously buying a large number of shares from struggling companies like GameStop and AMC, they caused the stock prices to skyrocket at first, which ruined the strategy of many hedge funds that had bearish positions on those same stocks.

This coup of small-pooled investors reveals several inefficiencies of the markets that should be repaired as soon as possible so that capitalism does not continue to be a source of discontent from which the populist parties drink. The first of those failures is the growing marginalization of minority stock brokers. The concentration of power in the hands of a handful of large fund managers is increasing and their movements condition the future price of any asset. The ordinary investor is relegated to a secondary role in IPOs, takeover bids and shareholder meetings. Furthermore, the forum members’ revolt has been possible thanks to the popularization of the internet, which facilitates objective sharing thanks to digital markets and access to the trading floor with low-cost commission agents.

Nevertheless, the democratization that technology brings implies that many people who aren’t financially educated enough, driven by low interest rates on more conservative investment products, will try their luck in the stormy waters of the stock market without the advice of professionals, with the high risk that this implies.

Another point for reflection is the use of short selling. This type of operation, which is very common in certain hedge funds, consists of borrowing shares from companies in dire straits to sell them on the open market with the idea of buying the stocks back later at a lower price and pocketing the difference. Beyond the debate — albeit almost a moral question — of whether those who only bet against the market or those who invest expecting prices to increase is more speculative, the truth is that bearish strategies increase market volatility. In Spain, for example, the stock market supervisor temporarily banned short selling, both when the financial crisis hit and also after the COVID-19 outbreak. More transparency should be required for short selling because, although they may have positive effects such as giving the market more liquidity, they undoubtedly generate a clear distorting effect under certain circumstances.