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The stock market turned into a spectacle to rival Super Bowl LV this week, as retail investors and hedge funds clashed over the GameStop stock. Tom Brady and Patrick Mahomes will struggle to provide as much entertainment to viewers around the world as this latest step in the gamification of financial markets.
Stock punting has always had a sporting element – the fun of placing a bet and watching the game unfold. But the financial markets now offer a chance for fighting and entertainment. The combat element was introduced with the proliferation of hedge funds that actively sell stocks to hedge their positions. A widespread short sale – when you borrow a stock, sell it, and hope to buy it back at a lower price – ensures that buyers (owners of the stock) face shorts in a zero-sum game. With the moral story of good individual investors on Reddit battling evil, stock-strapped hedge funds, the game was over. In a populist moment, what could be more fun than seeing deadly fights between individuals and institutions, outsiders and insiders?
How did the gamification of financial markets go? There are many culprits, including a bored and socially remote workforce staring at screens during a pandemic, and low interest rates that make traditional saving silly and borrowing to buy good stocks. market, but most important is the resurgence of the retail investor. You cannot fully gamify an industry without finding a technology to allow many new players.
Over the past five decades, institutional investors have become the dominant force in financial markets. The rise of defined benefit plans and then the move to defined contribution plans consolidated market power among mutual funds where workers invest retirement assets and hedge funds that promise retirement plans and managers endowments with exorbitant returns. But that changed two years ago.
A fundamental change in the business model of financial brokerage houses has brought the retail investor back: the rise of commission-free trading. Commissions were already under pressure as new entrants – notably Robinhood – were funded by venture capitalists eager to find another industry to disrupt with plentiful capital. Brokerages realized that their business model was upside down. They didn’t need to charge their clients commissions to make money; there was a lot more money to be made do not bill their customers. The appeal of “free” – demonstrated by Facebook and Google – was far greater than conventional business models.
As we have learned on the Internet, what appears to be free is far from it. Just like Facebook and Google monetize user information by selling advertising, Robinhood and all the brokerages that have migrated to a no-fee commission are capitalizing on the information. But there is a twist. Brokerages do not sell their users’ information; they sell their lack. The fundamental problem for market makers in 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 are going to lose. This problem is what 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 dealing with traders. informed.
Robinhood and other zero-cost brokerage firms are monetizing their grip on active traders who are decidedly uninformed. They sell these trades to a new generation of market makers, like Citadel Securities, who pay for the ability to achieve a bid-ask spread without taking the risk of trading with knowledgeable traders. Retail investors can trade for free, the new generation of Wall Street behemoths like Citadel are monetizing their ignorance, and the old investment banks that used to pocket that bid-ask gap have become, like Goldman Sachs, a combination of a commercial bank and a hedge fund. Everyone is having fun.
The gamification of financial markets entails many costs. It 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 done for centuries, though little is recognized: reallocate wealth from the uninformed to the informed. Every bubble is associated with redistribution, and much of the alpha that professional investors brag about is nothing but timing gains that are redistributions from other parties. The current populist moment in financial markets, like many other populist moments, will only amplify this redistribution to the wealthy and informed, while suggesting that it is doing the opposite.
The stakes are even greater for the real economy. Financial markets are believed to provide price signals that help allocate resources and provide mechanisms for channeling capital from savers to firms in need. Gamification reduces these important functions to a side spectacle. As retail investors take their losses into account, they will lose faith in the valuable functions that financial markets offer.
As with Facebook, or any other seemingly “free” market, putting genius back in the bottle won’t be easy. It is not easy to regulate a market where participants willingly exchange their attention. Individuals are not charged for anything, and there is no obvious informational advantage that is unfairly capitalized on. Yet losses will occur over time and financial markets will suffer a further loss of credibility. Until that calculation, your long-term health will be best served by being a fan, not a gamer – if you can figure out what the game does to gamers, that is.
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