The stock market turned into a spectacle this week to rival Super Bowl LV as private investors and hedge funds faced GameStop stocks. Tom Brady and Patrick Mahomes will struggle to bring entertainment to viewers around the world as much as this latest step in the gamification of financial markets.
Punting on stocks has always had a sporting element: the thrill of placing a bet and seeing the game. But financial markets now offer both an opportunity for battle and entertainment. The element of the struggle was introduced with the rapid proliferation of hedge funds actively shorting stocks to hedge their positions. Widespread shorting – when you borrow, sell, and hope to buy back a stock at a lower price – causes longs (owners of the stock) to be pitted against shorts in a zero-sum game. With the morality story of good individual investors on Reddit battling the evil hedge funds shorting stocks, the game was complete. What could be more fun in a populist moment than seeing a deadly battle between individuals and institutions, outsiders and insiders?
How did the gamification of financial markets come about? There are many culprits, including the bored and socially distributed workforce staring at screens during a pandemic, and low interest rates that traditionally save and borrow to buy stocks cheaply, but most importantly, the resurgence of the retail investor. You cannot gamify an industry completely without finding a technology that allows many new players.
Over the past five decades, institutional investors have become the dominant force in the financial markets. The emergence of defined benefit plans and subsequent switch to defined contribution plans consolidated market power among the mutual funds where employees invest pension assets and the hedge funds that promise retirement plans and capital managers exorbitant returns. But that changed two years ago.
A fundamental change in the business model of financial brokerage brought back the private investor: the rise of commission-free trading. Commissions were already under pressure when newcomers – Robinhood in particular – were funded by venture capitalists eager to find another industry to disrupt with abundant capital. Real estate agents realized their business model was turned upside down. They didn’t have to charge their customers a commission to make money; there was much more money to be made not charge their customers. The appeal of ‘free’ – demonstrated by Facebook and Google – was far greater than conventional business models.
As we learned from the internet, what seems free is far from it. Just as Facebook and Google monetize user information by selling ads, Robinhood and all brokers who have migrated to free commission benefit from information. But there is a twist. The brokers don’t sell their users’ information; they sell their lack of it. The fundamental problem for market makers in the financial markets is the danger of dealing with people with information – no one wants to trade with someone with more information because they know they will lose. That problem gives rise to so-called bid-ask spreads (the difference between the price at which you can buy and sell an asset), as these spreads reward market makers for the risk of trading with informed traders.
Robinhood and other free brokers make money from their hold on active traders who are definitely uninformed. They are selling these trades to a new generation of market makers, such as Citadel Securities, who are paying for the opportunity to make a bid-ask spread without risking trading with knowledgeable traders. Retail investors can trade for free, the new generation of Wall Street giants like Citadel make money from their ignorance, and the old investment banks that used to have that bid-ask spread in their pocket are, like Goldman Sachs, a combination of a commercial bank and a hedge fund. Everyone is having fun.
The gamification of financial markets entails a lot of costs. This will end badly for retail investors, although it is not clear exactly when and how, and some will make money along the way. In the process, financial markets will do what they have been doing for centuries, though it is little recognized: reassigning wealth from the uninformed to the informed. Every bubble is associated with redistribution, and much of the alpha professional investors brag about is nothing more than timing gains that are redistributions from other parties. The current populist moment in the financial markets, like many other populist moments, will only serve to amplify that redistribution to the rich and the informed, while suggesting that it does the opposite.
There is even more at stake for the real economy. Financial markets are designed to provide price signals that aid in the allocation of resources and provide mechanisms for directing capital from savers to companies that need that capital. Gamification reduces those important functions to an afterthought. When private investors take their losses into account, they lose confidence in the valuable functions that the financial markets provide.
As with Facebook, or any seemingly “free” market, putting the genie back in the bottle won’t be easy. It is not clear how to regulate a market in which participants willingly trade their attention. Individuals are not charged and there is no obvious informational advantage that is unfairly exploited. Nevertheless, losses will occur over time and financial markets will suffer a further loss of credibility. Until that settlement, your long-term health will be best served by being a fan and not a player – if you can tolerate what the game is doing to the players.