Long Take: How the Internet/Reddit/GameStop broke our financial market structure, the social contract, and what comes next
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Hi Fintech futurists --
This week, we look at:
Which Fintech and Crypto companies win or lose from the GameStop adventure
The actual market structure issues that led to the suspension of Robinhood’s trading, and what’s next for the mobile broker
The social meaning of the war against hedge funds by Reddit’s Wallstreetbets
Making sense of Elon Musk’s and Chamath Palihapitiya’s role in the chaos
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Long Take
Despite its best efforts to the contrary, Robinhood did end up stealing from the rich and giving to the poor.
Melvin Capital, the $8 billion hedge fund that didn’t find GameStop funny, lost 53% of its portfolio in January ($7 billion) trying to short against the rallying cries of the Reddit Capitalist Union. Gabe Plotkin also faces the embarrassment of having to get bailed out by your old boss.
Speaking of, New York Mets owner and former name-on-the-door of SAC Capital, known most recently for its insider trading fine of $1.8 billion, Steven A. Cohen, put $2.8 billion of capital into Melvin’s fund.
Ken Griffin, owner of the Citadel hedge fund (an investor in Melvin), and Citadel Securities (a massive market maker and buyer-of-order-flow for Robinhood), is seeing capital losses in the former and Washington cries for scrutiny into market structure in regards to the latter.
Robinhood itself — which for goodness sake is *not Wall Street*, but as *Silicon Valley* as it possibly gets — raised $1 billion immediately to protect itself from class action lawsuits, DTCC capital calls, and a now-rapidly-closing IPO window. That means Yuri Milner of DST Global chipping in yet again.
That’s at least 4 people that have had a very bad, no good day.
The Reddit Wallstreetbets army has 8 million members. Robinhood has 13 million users. These are the opposing force. They are, loosely speaking, having a pretty good day.
But there are other billionaires who are having way more fun with this too. World’s richest man Elon Musk is raising the crypto rallying flag, and ex-Facebook billionaire Chamath Palihapitiya is trading along with Reddit for quick profits. Decentralized hedge fund and all. This isn’t how much money you have. This is about a mindset, and a framing of the world. It’s about who you are, and who you are not. And it’s about what you did and did not do.
Do you side with the Internet’s gamer heroes, wearing Nyan cat shirts and crying out sarcastically for “moar Stonks, money printer go brrrr, number go up”! A post-Gawker-4chan swirl of human vectors, coalescing into one giant middle finger to every Karen and Ken? Dopamine splashing out from our pituitary glands into a vortex tornado of well-earned resentment.
Or, do you like your finance suited, ministerial, administrative, and gated? Do you think that it is storied, respectable, and *important*. That you have to go to HYP, and then do your “two and two” at Goldman and HBS, before hopping to KKR or Tiger or SAC and then into your own cozy fund. All that work, all that sweat for the GMAT and the SAT and the bootlicking, to be undone by someone literally making fun of you in the language of money.
It’s not about some truth about Wall Street, or Silicon Valley, or the Internet, or Bitcoin, or DeFi, and least of all about GameStop. Those are just flags of our armies. And we are at war with ourselves.
Market Structure on Display
GameStop is a mall shop that sold video games. The mall shops that rented videos (Blockbuster) or sold books (Borders) are bankrupt and rightly dead. The Internet, and its children Netflix and Amazon, killed them. And yet, their names are etched into the collective childhood memories of millions. GameStop has no chance against Steam or Epic — both brands that are also deeply loved by nerds all over the world. We say this as self-incrimination. And yet, GameStop is a symbol, a feeling, a reminiscence.
The person building financial models and analyzing this stuff according to economics is “right” to point out bad things about “fundamentals” of the business. Within the game of financial capital markets, the fundamentals are the gears of the economic machines that you evaluate with capital decisions. You buy good fundamentals, says Warren Buffet, and you sell bad ones. Another Warren, Elizabeth Warren, also believes in fundamentals. She believes in them so much she wants government to regulate them into the market to protect consumers from losing a traditional approach to value, and “fair, orderly, and efficient function”.
All that might be right, and we are not doubting the wisdom of Keynes, or the animal spirits. But Warren Buffer is no longer number one. It’s an Elon Musk world now.
Fundamentals are what the financial doctors will tell you that you have. Do you think the Internet cares about their diagnosis? No. The Internet cares about being patronized by people in coats. Musk and Chamath are the mushrooms of the Internet. It is in their DNA.
The GameStop trade itself is worth a pause. While some of the original thinking by DeepF*ckingValue that led to his $30+ million capital gain reflected on the GameStop business, the core insight was market structure. The trade was not about GameStop beating its analyst estimates, or any of that boring-play-by-the-rules stuff. It was about a short squeeze. It was about restricting the supply of the stock in such a way as to blow up a levered short bet that Melvin Capital was putting into play.
In other words, we are talking about the metagame, not the grunt Excel spreadsheet game. SAC, Tiger, Point72, Melvin Capital and every other hedge fund worth its salt plays the metagame. That’s the whole point. You get a PhD in financial instruments by doing the work and testing the levers, rather than believing in them blindly. And Wallstreetbets dared to play the metagame as well. Retail investors aren’t supposed to self-organize into a hivemind of levered derivatives strategy driven by spite. And here we are.
To go short, Melvin has to borrow. To borrow, you have to pay an interest rate. To cover your short, you have to buy back the stock. You’re paying an interest rate and have to buy back the stock. Nobody is selling you the stock, because they hate you. Everyone is buying, to troll you specifically. They are levering up with options. And you keep raising your bids until you cover your position.
Robinhood is a broker/dealer. They came into being in Silicon Valley, a place where consumer services are free, because they are actually not services, but honeypots that aggregate user demand, package it at large scale, and re-sell attention to advertisers. Such is Facebook and Google. Our lives are better because of these services, but also compromised and profoundly insane.
Robinhood uses this playbook to aggregate consumer demand with the honeypot of free trading, and then sends it to market makers like Citadel Securities and gets paid $600 million for the orders. TD and eTrade and other discount brokers do this too! But Robinhood does it most, and does it best. Check out our prior explanation with Paul Rowady here.
There is nothing unusually nefarious going on — it is just American capital markets structure and a clever lead-generation arbitrage. That is if customers are still getting best-execution with Citadel. But the structure is ancient by modern technology standards, and far from real-time. It takes 2 days for a trade to settle, and this among other reasons leads to a requirement of capital to be placed with a “clearing house”, in this case the DTCC. Given the volatility in GameSpot caused by the Internet trying to break a hedge fund the way Soros broke the Bank of England, capital requirements skyrocketed ten-fold.
Robinhood, as well as TD Ameritrade, ended up restricting trading in the instrument as a result of this capital call. If you are burning and raising a USD billion per year, you probably don’t have a “tenfold” of cash lying around to give to the DTCC to make them feel comfy. So, you know, they just removed the “Buy” button for a whole bunch of crusaders on a mission, with their capital on the line. They didn’t remove the “Sell” button, and threw fire on the Internet conspiracy meme machine.
Was this done on instruction from Citadel billionaires? Was this the banksters colluding against the common person? Was “Wall Street” trying to take away our constitutional freedom to trade on a mobile app? Even Ted Cruz and Alexandria Ocasio-Cortez found common ground in finding someone to blame!
Alexandria Ocasio-Cortez @AOC
This is unacceptable. We now need to know more about @RobinhoodApp’s decision to block retail investors from purchasing stock while hedge funds are freely able to trade the stock as they see fit. As a member of the Financial Services Cmte, I’d support a hearing if necessary. https://t.co/4QyrolgzytIf it caused losses in reliance, then damages will come. They will follow the class action lawsuits and the rioters.
The New Social Contract
It’s not a lot of rioters yet.
But remember, Fintech — including Robinhood, Revolut, SoFi and the rest — is supposed to democratize access to financial services. That meant very little a decade ago, and "dumb money” was disorganized and uninformed. Now, information is free and available to all. Equities trading is largely costless and frictionless. And the scariest part, for the suited part of finance anyway, is that strength lies in numbers and can now self-organize.
In addition to this, we have the crypto currency ecosystem. Unlike Fintech, which went after distribution, blockchain goes after manufacturing. If you are a trader or market-maker on Ethereum, there is no clearing house. There is no broker/dealer. There is only you, and the distributed machine with its smart contracts, automated rule sets, and software-enforced property rights. All data is real time. The blocks click into being one after another without a single lawyerly piece of paper in sight. Hundreds of millions of people in the world have touched this asset class, and it renders financial intermediaries unnecessary in their imagination.
Now don’t get us wrong. A trade on Ethereum is going to cost you $10 to $100 today, and another 1% in slippage. It is going to cost you some immeasurable but ever-present probability of cyber risk and regulatory overhang. But you nobody can take away your “Buy” or “Sell” button, and the speed and scale issues are mere technical problems to be solved by the entrepreneurial gods.
Here’s the rub. Post-fintech-crypto-democratization and all.
Humans are social animals. It is on our bones. The concept of fairness has been selected through the evolutionary filter, and fueled a cooperation-based multi-billion person civilization. We’ve shared the below video before, but check out again what it means for our monkey relatives to experience unfairness. After a minute of injustice, you can see the monkey occupying Wall Street.
Redditors are monkeys in the same way that we at the Fintech Blueprint are monkeys.
Democracy is not oligarchy. Democracy means that each person has one vote. If you were to vote according to assets under management, which is how finance has done it to date, you get very different outcomes than when you vote person-by-person. James Madison is deeply eloquent around these points in the Federalist Papers, talking of the dangers a democratic majority will impose on its minorities. Unintentionally funny is the mention of an unchecked power to sacrifice the obnoxious individual, i.e., Melvin Capital.
So we now have a set of promises and representation from companies like Robinhood that suggest a democratic empowerment of individuals to access the storied products of finance. Most people don’t know, or want to know, how the actual machine works. When the promises have a gap to reality, because of whatever reason, this creates kinetic energy for Twitter and Reddit.
It creates energy for people in position of leverage who understand the machine, and want it to change. Elon Musk hates short-sellers for their dampening, and perhaps manipulating, effect on his promises of Tesla greatness. Certainly Chamath, having launched endless SPACs to take Silicon Valley Fintech distributors like SoFi public, understands the machine as well. For them, this tear in the fabric of reality is a power. It is a rallying cry.
If we really want to put this into dystopian, let’s at least reference the theory of overcrowding elites from Peter Turchin. The historian eerily predicted the 2020 rioting and disaffection back in 2010, suggesting that too societies fall apart when they over-produce members of the ruling class. Education has minted PhDs, MBAs, and entrepreneurs who have no seat to inherit from a retiring predecessor. As a result, they take on the populist mantle, and position themselves as outsiders to attack the insiders, while of course being fabulously gifted. Thus Donald Trump and all the rest.
If you are holding power today, you probably don’t want everything to fall apart just because Redditors hate a caricatured notion of hedge funds. So you tweak things at the edges. Edit out the glitches in the current Matrix. It is through this lens that we see Google deleting 100,000 negative Robinhood reviews for being “inauthentic”.
Of course they were coordinated. But they were very authentic to the people that wrote them. They were, however, “inauthentic” to the current rule-set of the game. Based on fundamentals, market structure, and a variety of other “this is how things work” explanations, Robinhood did nothing wrong. Nor did Melvin, really, as far as we can tell from the media coverage. They just played a game that has become a cartoon that millions of people despise. Google’s app store is also an incumbent, a rule-set as well of what constitutes good behavior and what you should do according to its Terms, and so on. Protecting Robinhood’s reputation because it did not fundamentally err is what you do when you believe the current system works.
What’s also notable is that TD and other brokers that couldn’t support trading didn’t get such a backlash. The answer as to Why? is obvious — the brand promise of Robinhood is to bring in a new world, which it simply can’t do using old world tools.
Who wins and who loses?
This is a rich vein, but we’ve got to wrap up. How does this all shake out?
In the short term, it’s a bit of a mess. Robinhood is getting amazing publicity, and like Facebook, will flourish in growth despite repeated calls to “cancel it”. It will IPO a year late, but with 10 million more pragmatic users who don’t care about Internet culture. Its Fintech competitors, Public and WeBull, will pick up disenchanted users who still want to trade stocks.
Crypto/Fintech bridges like FTX or Synthetix will get some of that spill over as well, by creating trading pairs in Reddit darling stocks with derivatives. Coinbase will win, as more people start to believe in the underlying philosophy of crypto assets. They will win so much that their websites will break under new volume.
Regulators have an urgency here, and scapegoating will be important. It’s possible that order-flow payments are restricted as a result, like they are in Europe, even though that has little to do with collateral calls from the DTCC. Or perhaps, they finally see the benefits of blockchain-based capital markets infrastructure, and open up the gate to stronger innovation in clearing and settlement, however improbable that sounds. We don’t see how the traditional finance world benefits from this at all — as increased scrutiny usually lead to more regulation and downward fee pressure.
Longer term, the people will win.
We are in an age of anarchic, capitalist collectivism. This philosophical word soup is important to understand. The populism that seeped out of Donald Trump’s presidency, with roots in the right-wing Internet, and the anarchic trolling pleasures of Anonymous, 4chan, and Crypto Twitter, will continue to put focus on and find leverage in the needs of the “people”. This is at the expense of “those in power”, despite such words holding little meaning but lots of emotion.
This reactive population is increasingly cohering into decentralized communities with pointed power. We see this as the rise of a type of unionism or collectivism in the Internet age. Unlike unions of the past, which protected against participation in an unfair employment arrangement, our new unions are collectivist digital farms. For example, Google is seeing the organization of its workers according to ethical issues. Or, blockchain-based decentralized autonomous organizations are running financial ecosystems with broad-based governance. And do we have to mention Reddit partnering with the Ethereum foundation?
Even longer term, however, is where there is a thick fog. As we move more of our economic activity onto decentralized software and participate in DAOs, as decentralized finance eats traditional finance, there is a redistribution of value. Early adopters of the crypto paradigm earn asymmetric returns for the risk they take — the risk of being entirely wrong, and being perceived as anti-social psychopaths.
This all evens out once the new machine and its digital property rights enforcement mechanisms are up and running. But collectivization is no cakewalk. It can become a tragedy. Taking the crown from Silicon Valley and Wall Street is not a friendly game, as we can already see with something as silly as GameSpot. Also, collectivization often fails; it loses to free market capitalism in the annals of history.
A good answer eludes us. For now, we hold dearly the question.
Great article. One of the best I've read on the "macro" issue.