The GameStop Episode: What Happened and What Does It Mean?
Authors: Malz Allan M. 
Published: January 2022

The GameStop stock trading episode that began in January 2021 has been unprecedented in some ways, especially in the ability of market participants to organize collective action openly yet anonymously. In other ways, however, it's been an unsurprising repetition of past experience. Contrary to the cliche of an unregulated and predatory financial system, the actions of the participants and the events themselves shine a light on a remarkably dense array of regulations. And one of the author's main messages is that much of today's regulation makes markets function worse, not better, for investors. Much of the uproar has reflected a long‐standing combination of paternalism, bad advice, and confidence in experts that ends up misleading investors.

GameStop's exceptional return volatility has been decried as an instance of market manipulation and triggered a hunt for insider trading. Investors in GameStop expressed particular hostility to short selling. Yet as studies have made clear, when short selling is constrained by regulation, market participation becomes lopsided toward optimism, and mispricing can persist longer.

Regulators decry conflicts of interest to justify their hostility to payment for order flow (PFOF) by zero‐commission brokers such as Robinhood to the wholesale market makers that execute the trades. But the attacks on PFOF ignore the economic reality that the costs to retail investors of adverse selection in trade execution are likely to be more than offset by reducing the commissions and fees they pay. And so “fair” in this case is not the same as “cheap.”

Regulatory margin rules effectively required Robinhood to undertake its most widely condemned actions. It also illustrates how regulations designed to enhance financial stability by promoting clearing systems with near‐zero credit risk to participants are potentially destabilizing. Sharply higher margin may force position liquidations or “fire sales,” increasing volatility and spreading the impact to other markets.

Long and short GameStop positions are financed in large part with borrowed funds. The GameStop episode has thus been just one manifestation among many of financial market buoyancy sustained by low interest rates. Low volatility and low rates make the outright and embedded leverage of option strategies particularly attractive. Option hedging likely contributed to the rush to buy GameStop stock in an effort to contain losses.

The current consumer‐protection regulatory strategy effectively reinforces the worst possible advice for younger investors. It seeks to identify and expunge all conflicts of interest to ensure what is effectively impossible as well as counterproductive—that retail investors will have the same accurate information and engage in stock picking on an equal footing with the pros. The costs to investors of conflicts of interest, real or putative, are trivial compared to the returns they forgo by not avoiding active management altogether, by looking for the “honest” and “superior” manager who can beat the market, and by engaging in market timing. The real solution lies in liquid markets that are cheap to invest in, and people, especially the young, who are better informed about investing, not the targets of political manipulation.