GLOBALISATION ISN’T SUCH A DIRTY WORD AFTER ALL
In the aftermath of the global race to develop vaccines against Covid-19, the US too is making a welcome return to realising its worth
Twenty years ago, Michael Lewis, the Boswell of Wall Street, profiled a 15-year-old from New Jersey, Jonathan Lebed, who had been sanctioned by the Securities and Exchange Commission for using what was then new technology — Internet bulletin boards and online trading platforms — to manipulate the market in penny stocks.
The pump-and-dump schemes had earned at least $800,000 for Lebed, his friends and some very grateful teachers at his high school. It was a hilarious tale with a serious point: that in publicly touting stocks owned by his friends and clients, Lebed was doing nothing different from what legions of Wall Street analysts did every day. I was immediately reminded of the piece this week as a similar drama played out on Wall Street, with a group of amateur day traders banding together on social media to execute a short squeeze on some of Wall Street’s most successful hedge fund managers.
The reactions have been as comical as they are predictable: Wall Street grandees bemoaning the sophomoric heathens who’ve turned finance into a video game. Dire warnings from analysts and brokers of painful losses for retail investors. Finance professors bemoaning how the extreme volatility is interfering with the market’s “price discovery” process. Angry politicians threatening to hold hearings and clueless regulators promising to investigate.
All week, threats and denunciations lit up social media while readers of mainstream media cannot get enough of the David and Goliath, Silicon Valley vs. Wall Street, and angry-insurrectionists-storming-theramparts-of-capitalism narratives. I’d be surprised if Michael Lewis hasn’t already inked a seven-digit deal for the book and movie rights.
Outdated regulation
What you need to know about this unfolding morality play is that it is the inevitable outcome of decades of lax regulation, cheap money and misguided notions about the efficiency of financial markets. The result is an oversize and overcompensated financial market that has long since abandoned its role to channel savings to the highest and best use, becoming nothing more than a high-tech casino.
Those unschooled in the nuances of modern finance might be forgiven for thinking that a bunch of investors openly conspiring to drive up the price of stocks with the aim to profit from it is a case of market manipulation that ought to be illegal.
But of course, what the Reddit cabal did to inflate the stock of bygone-era companies like GameStop, AMC Entertainment and Bed Bath & Beyond simply mirrored what the hedge fund sharpies had done in conspiring to “short” those same stocks and drive down the prices.
When the day traders won and prices rose rather than fell, the hedge funds had to scramble to buy the shares they did not own but had promised to sell, at a cost of not only billions of dollars but their reputation as the smartest guys in the room.
But in terms of manipulating the market, either both groups engaged in market manipulation or neither did. And the ridiculous thing is that, in the eyes of market regulators — the SEC and its cousin, the Commodity Futures Trading Commission — it’s all perfectly legal.
Multiple bets
The amateurs are like the pros in two other respects. In conspiring to drive up the price of stocks, the insurgents made aggressive use of call options — contracts that give them the right to buy the stock over a certain period of time at a higher price from a broker who may not actually own the stock.
The advantage of buying the call option rather than the stock itself is that it allows investors to place the same bets at a fraction of the upfront cost, substantially increasing winnings if the price rises. Call options do for investors who think the price of a stock will rise what short sales do for those who think the price will fall.
Note what is happening here. By offering puts and calls and all manner of other fancy derivative contracts, Wall Street makes it possible for investors to wager much more money on each company than the company is actually worth. In effect, multiple bets can be placed on every share. And that, in turn, makes it easier for people to manipulate a stock price.
The other thing the amateurs and pros have in common is that they placed many of their bets with borrowed money. Margin debt is at record levels for both small and large investors. That is due, in part, to a lax regulatory environment. But even more significantly, it is due to the loose money policy of the Federal Reserve, which over the past decade has injected $8 trillion into the financial system.
The ostensible reason for all this money printing has been to keep the economy out of recession. But much of that cheap money has been used to fuel an orgy of speculation in stocks, bonds, real estate and crypto currency, driving prices to levels that bear less and less relationship to underlying economic value.