GameStop case puts the focus on market plumbing

There’s an adage in financial markets that in a gold rush one should simply sell pickaxes. The wisdom behind the aphorism — it is more reliable to make money from other people’s optimism than to get swept up in it yourself — was on display this week as market makers enjoyed the effects of a retail trading frenzy prompted by Reddit.

Users of the social media site’s r/WallStreetBets message board had backed their ability to send shares in GameStop, a US video game shop, “to the moon” at the expense of hedge funds who had shorted the stock, contributing to the busiest week in options markets on record.

Companies including Citadel Securities, which executes the orders for Robinhood, a fee-free trading app, appear to have been among the biggest winners from the episode. Higher trading volumes help those that profit from executing the trades: GameStop’s share price has dropped dramatically from its peak; Virtu Securities, the only listed US market maker, is still up substantially. Robinhood and broking apps such as eToro and Trading 212 have seen a surge in interest, registering hundreds of thousands of new users.

The pickaxe sellers have still found themselves mired in controversy. Robinhood and some of its peers restricted users from buying any more shares in GameStop, as clearing houses — which ensure that cash and securities change hands in an orderly fashion — demanded the brokers post more funds as collateral. Reddit users and even lawmakers including Alexandria Ocasio-Cortez and senator Ted Cruz alleged this signalled a basic unfairness in markets: Wall Street insiders were protecting each other by preventing outsiders — retail investors — from taking advantage of a hedge fund.

There is little substance to this allegation: the market makers want to encourage activity. The reality was more mundane. Robinhood’s success meant it needed to play by the same rules as the bigger players. It had to scale up, rapidly, to meet post-financial crisis rules that aim to make the system safer. No would-be prospector, convinced they will soon strike gold, wants to be told they are not allowed a pickaxe. Regulators, though, have frequently learned the hard way that the optimism that propels markets upwards can swiftly turn to fear and a destructive rush for the exits.

Still, there is reason for Congress to take another look at the market’s plumbing. Reforms may have made banks safer but critics allege they have shifted risk elsewhere in the system: higher bank capital requirements have made trading less attractive and so the high frequency outfits, such as Citadel Securities, which make a profit from the tiny gaps between buying and selling prices, now play a bigger role. Clearing houses, too, are more important — for good reason: it was partly the bankrupt Lehman Brothers’ inability to make good on its trades that helped turn the bank’s failure into a full-blown financial crisis in 2008.

When volatility spikes, liquidity can come at a higher cost, as the broker apps found. There is little systemic concern from that episode but these problems were seen most dramatically, and worryingly, during the early stage of the coronavirus pandemic when traders found themselves paying a lot more to buy and sell US government bonds, the world’s most important financial asset. The Federal Reserve resorted then to flooding the system with liquidity itself, as it had during disruptions to the Treasury market and repo market in September 2019. Any congressional inquiry should focus less on conspiracy theories around Robinhood, and more on real concerns over how markets now function.