In the mainstream media, the tale of small-time investors banding together to boost garbage stocks that hedge funds were short selling played like David defeating Goliath, the “democratization of investing” and other similarly hyperbolic glorifications.
In the compliance world, we know better. While it’s fun to cheer on the little guy sticking it to the stuffed shirts on Wall Street, in the end this story is really going to be about managing risk—and the disastrous consequences that will come if you fail to do so.
Unless you’ve been living under a rock the past few days, you’ve likely heard the story: A large number of amateur investors flocked to a Reddit forum and social media channels and decided to go all-in on specific stocks, not because they saw a bright future for the companies but because Wall Street was down on them. We’re talking about flagging companies like GameStop (a video game big-box store that’s seen revenue steadily decline the past decade) and AMC Entertainment (a movie theater chain that told the Securities and Exchange Commission last year it would likely run out of money by early 2021), among others.
You don’t need to be a financial analyst to see these were companies circling the drain. But as a result of these investors’ concerted efforts, the price per share of GameStop, for example, increased by about 2,700 percent from early January until mid-day Thursday.
Many of the investors behind the rally are newbies, a number of whom are likely underemployed due to the coronavirus pandemic and have free time on their hands. Simultaneously, trading apps like Robinhood have made the entry point for retail investors much lower and the process less intimidating than more traditional platforms. When you combine those two factors, you get a formula for market disruption with potentially devastating consequences for all involved.
Here’s where we get to the lesson on risk management.
Recognizing what’s been happening on their platforms and hedging their own risks, trading apps Robinhood and TD Ameritrade on Thursday restricted purchases of certain stocks—GameStop and AMC Entertainment among them. The ability to halt or restrict trading is traditionally a regulatory power, but brokerages can also put the brakes on certain stocks or traders for several reasons:
- To manage their reputational risk. No rational broker-dealer wants their platform to be used in a way that’s risky to them and that might also threaten the markets. Never mind potentially being accused of aiding and abetting market manipulation, would you want to be known as one of the main drivers of the next stock market crash?
- To manage their operational risk. Due to the unexpectedly high volume of trading Thursday, Robinhood found itself in a precarious cash position due to the demand from investors and the behind-the-scenes requirements to have enough money on hand to maintain deposit accounts at clearing firms that help finalize trades. It was reported by the Wall Street Journal on Friday morning that Robinhood raised $1 billion to meet the rising demands.
- To manage the risks of vulnerable customers. Responsible broker-dealers can restrict trades from clients they see as overleveraged or in way over their heads. Robinhood in particular is likely sensitive to this after a 20-year-old user of the platform apparently committed suicide last June. Just before his death, according to his family, the young man saw what he perceived to be a negative balance of $730,000 in his account that was later found to be an inaccurate interpretation.
- To stay off the radar of regulators. The SEC said late Wednesday it was looking into the strange phenomenon occurring with the markets. Robinhood, for one, is certainly not looking to call attention to itself, particularly after being fined $65 million by the agency in December for allegedly misleading investors about how it makes money. The Massachusetts Secretary of State’s office also filed a complaint against the company for aggressively marketing to inexperienced investors and failing to put controls in place to protect them.
Robinhood on Thursday posted an update on its Website announcing its decision to limit trading of certain stocks, stating it was a “risk-management decision.” As part of that message, it pointed users to resources they could read to learn more about market volatility. While certainly helpful, the fact it posted a message that used terminology aimed at those new to the market and directed them to a page with “Investing 101” as its header demonstrates it understands the risks it likely has already incurred.
The company is clearly trying to manage its risk in this situation. But who’s watching out for the retail investors? Sure, some will walk away with riches, but many more will be caught in the net when the prices for these stocks—artificially inflated by new-age boiler room tactics—inevitably plummet.
People who treat the market like a casino are playing a dangerous game, one in which risk calculations are ignored amid the adrenaline rush of potential riches. And like a lot of gamblers, these amateur investors won’t truly understand the risks until it’s too late.