What is happening on Wall Street, and what does it mean for the economy? Dartmouth Week wrote to UMass Dartmouth Finance Professor Duong Nguyen to find out. The following guest column has been edited for length and clarity.

GameStop is a struggling brick-and-mortar retailer of video games and merchandise in the US. Its stock price should be going down. However, it skyrocketed 400% in the past week, closing out January with a whopping 1,625% gain (according to CNBC).

So what has fueled the rally? 

A US hedge fund, Melvin Capital, was heavily short-selling the company’s stock (140% of the shares available for trade), as they thought it was overpriced.

(Short-selling a stock is when an investor borrows a stock to sell because they believe the price will drop — so they sell it at a high price, hoping to buy it back at a cheaper price to return to their lender, and pocketing the difference. If instead the price goes up, they will have to buy it back at a higher price, resulting in a loss.)

A group of investors on the social media website Reddit noticed the short position and started buying the stock.

When the price went up, Melvin had to buy back shares at higher prices to close the trade, which in turn kept taking the stock higher (this is called a short squeeze).

Once the stock was moving up, more and more investors kept coming in and buying.

Melvin lost massively and had to be bailed out by other hedge funds (Citadel LLC and Point72 Asset Management), which have infused close to $3 billion into Melvin to shore up its finances.

By the end of January, Melvin Capital reported a 53% loss, mainly due to its short position in GameStop (according to the Wall Street Journal).

Blame game and Robinhood

The hedge funds say that the Reddit investors are effectively engaged in a crowdsourced pump-and-dump scheme, in which fraudsters buy up shares of a company, spread rumors about its prospects, and then sell at a higher price to other investors tricked by the fake news.

However, the Reddit investors say they are just seizing an opportunity and that the manipulation is clearly on the other side, especially after popular trading app Robinhood barred “buy” orders on their platform.

This move benefitted Citadel and other hedge funds — who are Robinhood’s largest customers. 

Robinhood claimed that it restricted buying because its clearing broker demanded more collateral from brokers as GameStop stock became riskier. (Clearing brokers are large firms that process trades and hold collateral in the two days between when trades are placed and when they are settled.)

Robinhood paused buying and rushed to figure out how to come up with the funds. TD Ameritrade and E-Trade also took similar actions.

However, while buying was shut down for individuals, hedge funds and institutional investors continued to trade GameStop stock as normal — maybe not with Robinhood, but with other trading platforms.

If there was no trouble allowing hedge funds to buy GameStop and helping them cover their shorts, why not allow regular investors to buy the stock too?

Citadel handles a large percentage of Robinhood’s order flow and contributes as much as 40% of Robinhood's revenue.

If there is evidence that Robinhood stopped the buying of those stocks to protect their real customer (Citadel) so that Citadel could cover their shorts at preferential pricing, then what happened is likely criminal, since it is such a blatantly obvious collusion.

Beating Wall Street at its own game

The interesting thing is that the hedge funds got punished by much smaller and less sophisticated investors, who are playing by the big funds’ own rules. 

The hedge funds shorted 140% of GameStop’s total shares outstanding. They are borrowing more shares of GameStop stock to short than the number of shares available in the market. They were arrogant and overdid it.

Melvin Capital assumed no one would notice and did not take any steps to limit its losses.

Had Melvin hedged its position properly, it would not have been drained like this. It was a strategic mistake and some smart people were able to leverage it. 

Investors are just playing by the same rules banks and hedge funds play by, and those hedge fund deserved what happened to them in the process. 

Go directly to jail; do not pass GO.

So far I believe all of this is legal.

Short selling by itself is necessary and healthy to the market. It keeps the market more efficient, and often it is the shorts who call out bad behavior and accounting fraud.

While these hedge funds may have abused their short positions, which could drive companies to bankruptcy, it is still legal.

It is also not illegal for traders to buy up shares for a squeeze. 

So far, it appears that Robinhood and other small brokerages stopped individual investors from buying shares so that they could raise more capital for clearing corporations’ collateral, which is legal.

However, later on, if there is evidence that Robinhood just used this as an excuse and the real purpose was to protect Citadel and other hedge funds, then it is illegal. 

Impacts

The short squeeze on hedge funds resulted in these funds selling their other stocks to get cash to cover the short, and that helped drive the market sharply lower.

If this situation continues, i.e., hedge funds and Reddit investors continue to hold their positions, it will be bad for the market since it will drive the stock market down further, and create huge market volatility and uncertainty.

Therefore it will probably affect people’s 401Ks in the short term.

Since this event is only related to few stocks, I don’t think there will be a crash, and there is no evidence that this is a market bubble. 

If the Federal Reserve intervenes, it would send a dangerous signal that the Fed can bail out anyone and would increase risky behaviors in the market.  

GameStop should not satisfy the short sellers by issuing new shares, since doing so would be detrimental to their existing shareholders.

The Securities and Exchange Commission may investigate if there is any evidence of fraud on either side, and may add restrictions to short selling, e.g. limiting it to 100% of the available shares.

I think the situation should be left to take care of itself. The hedge funds made their bed, and we should let them lie in it.