Background
At the end of January 2021, the stock market was met with a polarising incident. GameStop, an American video game store whose stock price was decreasing due to a combination of the pandemic’s adverse impact on in-store sales as well as competition from digital distribution competitors, was a favorite among short-sellers. Simply put, short-sellers are investors who make a profit from betting that the price of a stock will drop. The investor does this by borrowing shares in a stock and then selling it in the market, betting on the prospect that the stock is fundamentally overvalued and therefore its price will decline. In order for short-sellers to realise their profit, they must at some point purchase the stock and return it to the party from whom it was borrowed. This makes shorting inherently more risky than long-term investing, as the short-seller’s losses are theoretically unlimited. Moreover, in the event of a dramatic rise in the price of the stock, the short investor can be forced to “cover”, or buy back, the shares due to the ever-increasing margin required to maintain the short position. But when a stock is consistently in decline short-selling can appear to be a quick and easy way to make money.
The risks of short selling were on display at the end of January 2021 when retail investors started buying GameStop stock in order to “attack” short-sellers and make a profit. The explosive buying of GameStop stock started with a Reddit group called WallStreetBets. The group consisted of retail traders who realised that GameStop was a heavily shorted stock and, if purchased by a significantly large group of people, the ensuing rise in the price of the stock would force the short-sellers to cover. Thus, those who caused the initial rise could make a profit by selling to the short-sellers who would be forced to buy in order to “cover” their short. Those who shorted the stock would obviously lose significant sums of money. By the end of 27 January 2021, the price of GameStop stock had risen from under US$ 20 (approximately GBP 14.60) a share at the beginning of 2021 to US$ 350 per share (around GBP 255) - a gain of 1650 percent.
The majority of retail investors who were a part of the Reddit forum used Robinhood - which allows investors to trade stocks with zero commission fees, as a trading platform. The stock then dropped because Robinhood restricted the buying of GameStop stock for its users. Due to Robinhood’s restrictive action, investors could no longer continue to buy shares in GameStop, which was the primary source of demand causing the share price to rise. They were therefore left with the choice to either sell the stock or do nothing.
The activity from both WallStreetBets and Robinhood has been a polarising topic because many personal and professional investors debate and question whether the actions from both parties are legal. In fact, up until the GameStop incident, it was hard to envisage such a ban on just buy orders. Circuit breakers exist on organised exchanges and halt all trading activity in certain stocks and on exchanges as a whole at certain volatility parameters, but not on only the buy or sell side of the market. Naturally, such a unique incident raises many questions as to the legality of the actions of both WallStreetBets and Robinhood. Are individuals allowed to “target” a shorted stock in order to make a profit and cause larger investment funds, hedge funds, and others to lose money? Can Robinhood just prevent its users from buying or selling stock whenever it deems suitable? This article will analyse the laws and regulations of the United States Securities and Exchange Commission (SEC) to further consider whether any of stock market events in January 2021 were illegal and if market manipulation occurred.
Laws and Regulations: Were they violated?
The US Securities and Exchange Commission (SEC) was created as a result of the stock market crash in the 1920s. The SEC is a US independent agency whose purpose is to prevent the manipulation of the stock market and misrepresentation of material information associated with publicly and some privately traded instruments. In the United States, market manipulation is illegal under the Antitrust Laws and Securities Laws. In short, under these laws, it is illegal to coerce investors to buy or sell stocks by the means of spreading misleading or false information.
There are three major federal antitrust laws that aid in protecting consumers:
The two key sets of federal securities laws are as follows:
Since the GameStop stock incident, authorities are analysing whether or not market manipulation occurred from either WallStreetBets or Robinhood as defined under the Securities Acts. There was no time wasted in filing a federal class-action lawsuit against Robinhood under the accusation that Robinhood knowingly manipulated the market in order to stop the rise in the GameStop stock price. As of now, the instigator, Keith Gill of WallStreetBets, has not had a lawsuit filed against him but he will most likely be facing legal action in the near future for market manipulation.
First, let's discuss the actions of Robinhood. As the number of retail investors buying GameStop skyrocketed, Robinhood was concerned they would not be able to guarantee the trades that their users were attempting - this process of guarantee is known as “clearing". Robinhood did not have the capital to guarantee these trades. Moreover, in general, it is costly to meet clearing and margin obligations for such a volatile stock. Therefore, in order to maintain their platform, Robinhood froze not only the ability to buy GameStop stock but the ability to short it as well. This action had Robinhood users in rage. They interpreted Robinhood’s actions as a means of protecting large Wall Street hedge funds and spiting the smaller retail investors. On this basis, Robinhood has been accused of market manipulation and served a class-action lawsuit. This is despite the fact that suspending GameStop stock was a way of avoiding legal action because Robinhood knew they would not be able to meet clearing obligations on the stock.
Now onto the actions of WallStreetBets. WallStreetBets was instigated by Reddit user Keith Gill who informed the members of the Reddit chat room of the highly shorted GameStop stock. According to the antitrust and securities laws, there is nothing illegal about telling others to buy stock via online message boards. Although obvious that WallStreetBets was targeting the GameStop stock in order to commence a short squeeze, under the Securities Exchange Act of 1934 this is not illegal. However, there is the possibility that Keith Gill could be accused of market manipulation due to the large number of retail investors that bought GameStop stock solely based on his word. This is because Gill’s profit fromthe GameStop stock would only continue to increase as the number of people you bought the stock increased. This involvement and personal motive could result in him being accused of market manipulation in the near future.
Future concerns
All in all, it appears that nothing illegal occurred during the GameStop incident. Robinhood did not want to be in a position where they did not have enough capital to fulfill clearing obligations and the users of WallStreetBets saw an opportunity in the US stock market to make a nice profit. Due to this incident, however, regulations of the market could possibly change. The excessive volatility that we saw in the GameStop stock might lead to stricter regulations of stocks and the act of shorting stocks. There may also be new regulations for electronic exchanges in terms of “trading halts” and “circuit breakers” designed to maintain orderly and efficient price discovery on exchanges, rather than inducing fifty percent price gaps in a matter of minutes in the value of an underlying company. Should the same regulations that require a company to halt the release of material information regarding a takeover bid apply equally to other events that cause significant material?
In addition to questions regarding the potential need for increased regulations, this event has undoubtedly sparked many individuals’ interest in the US stock market. It is imperative to the capital formation process of the US economy that its citizens have faith that capital markets allow for the efficient and fluid transfer of savings and investment of capital from one investment to another. Therefore, any event that calls into question this confidence requires action to be taken, regardless of whether it is seen as an isolated event or not, to ensure all investors, large and small, that the market is not a place where manipulation can occur with impunity. Overall, this incident has ignited a good number of varying perspectives of the stock market, and it will be interesting to follow the future actions of not only the SEC but also the influence of online messaging boards and their impact on individual retail traders.