Here’s what we should learn from GameStop trading mania

I’m not usually one to favor more regulation, to start with a massive understatement.

However, the GameStop stock market tumult suggests some new rules are in order to protect investment markets from manipulation of various sorts.

GameStop sells video game hardware and software at brick-and-mortar stores. Its fortunes have declined as more of that business is conducted through e-commerce. It has recently attracted a new investor pushing it toward e-commerce. But that’s already a crowded space.

GameStop’s stock was subject to heavy short-selling. Short-sellers make various arrangements through which they can gain financially if the stock price goes down.

They aren’t really investing. They are making a bet about the direction of the stock.

Day traders coordinated frenzied buying of GameStop stock through social media, successfully driving up the stock price astronomically. The repercussions are still reverberating.

The short-sellers have lost billions. Clearinghouses substantially increased capital requirements for brokerage firms the day traders were using. Those firms, in turn, temporarily limited GameStop trades.

The same game is playing out in other stocks in bad odor on Wall Street, particularly among short-sellers.

Let’s begin with the short-sellers. Most free-market advocates believe that short-sellers play a useful role in investment markets. By claiming that a particular stock is overvalued, and putting their money behind the claim, they assist the market in discovering what the right price of the stock should be. At least, so goes the argument.

Although that is usually my team, I’ve never been persuaded that shortsellers are a productive, as opposed to destructive, force.

The problem is that, having bet against the stock, short-sellers have an overwhelming incentive to make their claim of overvaluation a self-fulfilling prophecy.

They conduct campaigns to drive the stock price down. With skin in the game, that’s an attempt to manipulate the market. And it’s unfair to real investors, who actually own the stock.

If a stock is overvalued, the market will ultimately figure that out on its own, without being artificially prodded by short-sellers.

Short-selling isn’t investing. It’s placing a bet, often followed by a campaign to manipulate the market. It should be forbidden.

Since I think short-sellers are just manipulative gamblers and don’t play any useful role in price discovery, that they lost billions in the GameStop mania doesn’t concern me a bit. In fact, it’s hard not to share some of the glee of the day traders that they out-manipulated the manipulators.

And I don’t think there is a problem per se with day traders coordinating their trades through social media.

However, this too can be a form of market manipulation. The social-media gang is trying to run up the stock prices of disfavored companies, in part to stick it to short-sellers, in part to make a buck.

This artificially inflates the stock price of the companies chosen for gang purchases. But only temporarily. Something is only worth what someone else is willing to pay for it. When gang members have to convert their stock to cash by selling it to non-gang members, the price will deflate to its true value.

Paper gains can’t be used to buy the groceries.

The problem is the amplitude of the market distortion social-media driven, frenzied buying can create. The dizzying heights that GameStop’s valuation reached benefits only those who get off the ride before it stops. For everyone else, it makes the stock toxic until reality sets in.

That actually hurts GameStop’s ability to raise new capital to make the pivot to e-commerce, though important to its future prospects.

This amplitude is increased by permitting margin purchases, or purchases using borrowed money, and buying options rather than actual stock.

I’ve never understood why margin buying is permitted. A bank would never lend money to someone to play the stock market. It makes even less sense, and poses greater risk, for more lightly capitalized and regulated brokerage firms to be doing it.

Buying stocks should involve actually buying stock. And doing so cash on the barrelhead. Allow brokerage clients to buy as much stock as money they have on deposit can cover, but no more.

That would dramatically reduce the potential amplitude of market manipulation through buying campaigns coordinated through social media without directly regulating them, which would be tricky and run into First Amendment problems.

Investment markets, and value investors, should be protected against artificial manipulation — whether by rich dudes trying to drive a stock price down, or a social-media mob seeking to increase the price, as they put, to the moon.