Good luck proving Reddit traders did anything illegal by pumping GameStop

Can’t stop.
Can’t stop.
Image: Reuters/Carlo Allegri
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As traders on Reddit’s WallStreetBets channel extol each other to send GameStop shares into the stratosphere, questions are growing about whether the rampage has crossed a line into stock manipulation.

Big-time bankers and one famous day trader have, after all, been arrested for market distortions in recent years. But when it comes to Reddit and GameStop, proving manipulation would probably be extremely difficult, according to John Coffee, a law professor at Columbia Law School.

What’s going on with GameStop’s stock

To recap: The Grapevine, Texas-based seller of games and electronics is seen as a battleground between retail traders who swap ideas on Reddit and hedge funds that were betting on GameStop’s stock falling in value. Shares in the company, which operates thousands of retail stores, had drifted lower in recent years amid a broader shift from physical stores and malls to online sales. Investors got a glimmer of turnaround hope when Ryan Cohen, founder of online pet-food sensation Chewy, bought a stake in GameStop last year and joined its board this month.

But one reason the company’s shares have gone berserk is because retail traders targeted short-selling hedge funds (who were betting on the stock to drop) with a short squeeze: As legions of smalltime traders pushed the game retailer’s stock higher, the thinking goes, institutional investors were squeezed—ie, they were losing money on their bets that the stock would decline. To limit the damage, they too had to buy GameStock shares, pushing the stock even higher. GameStop shares rocketed to more than 20 times the price they started the year at.

WallStreetBets users regularly urge each other to buy a stock and help boost its price. As a member of the channel told Quartz‘s Samanth Subramanian, users began pushing each other in mid-January to hold GameStock until “it hits $1,000 a share.’” Or as a member wrote today on a post: “KEEP BUYING AND HOLDING 🚀🚀”

Illegal market manipulation in GameStop trading will be hard to prove

Does that sound like a coordinated effort to manipulate stock prices? Coffee at Columbia Law School doesn’t necessarily think it’s as sophisticated as that—he likens what is happening to a “mob of uninformed, unsophisticated  retail traders” unleashed by trading apps. But even if there is a cynical manipulator pumping up a stock while knowing it will come crashing down later, which could violate Section 9 of the Securities Exchange Act of 1934, he says it would be extremely difficult to make it hold up in court.

“There is no theory of liability under the federal securities laws that is harder to prove than manipulation,” he wrote in an email. “You are looking for the evil needle in the huge haystack of uninformed, deluded fools. As for ‘squeezing the shorts’ (which is also manipulative), that too is possible, but it is easier to make money by just riding the roller coaster up and seeking to sell at the top.”

Joshua White, assistant professor of finance at Vanderbilt University who has authored market analysis for the Securities and Exchange Commission, said the situation resembles a “classic pump-and-dump scheme” that you would find in the penny stock market. A key difference is that penny stocks aren’t inflated by derivatives like call options. Retail investors have poured into options, which give them a cheap way to bet on rising stock prices. As a hedge, institutions that sell options typically purchase the stock that’s linked to the option, which provides another source of demand that pushes prices higher.

White said short selling alone wouldn’t cause the volatility that’s happened in GameStop stock and that derivatives are a key component of the price swings. “It’s an incredible feedback loop,” he said.

A brief history of market manipulation

It’s worth remembering that top-tier banks have been hit with major fines for market manipulation, and a handful of bankers were sentenced to jail for it. Tom Hayes, a former trader for Citigroup and UBS, went to prison for more than five years after he was convicted of rigging Libor—a key borrowing benchmark that determines interest rates of trillions of dollars worth of securities. Banks were fined billion of dollars by authorities in the US, UK, and EU for manipulating the benchmark.

In 2015, day trader Navinder Sarao was arrested at his home in a London suburb and later extradited to the US on charges of fraud and market manipulation. US authorities alleged the “Hound of Hounslow,” as the newspapers called him, had helped spark a panic in 2010 known as the flash crash, when markets briefly lost $1 trillion before bouncing back again. At a time when high-frequency trading companies were making mince meat of day traders like Sarao, he was accused of creating reams of fake trade orders to trick the market, including HFTs, about supply and demand. Last year he was sentenced to detention at home instead of prison after cooperating with the government on other cases.

To be clear, while the Securities and Exchange Commission says it’s monitoring the stock market volatility, it doesn’t appear that anyone has charged or alleged Reddit members with wrongdoing. An anonymous user of the WallStreetBets forum told Quartz that members try to prevent attempts at manipulation by banning companies with a market capitalization of less than $1 billion. The person said the forum is inspired by a distrust of the financial system in the aftermath of the 2008 crisis. “The banks and other institutional investors who leveraged the economy to the moon and back—they suffered no consequences,” the person said.

The GameStop trade vs. the 2008 financial crisis

The GameStop story, like the financial crisis itself, isn’t as simple as it’s sometimes portrayed. While media articles describe the GameStop sensation as retail traders versus hedge funds, it’s a reasonable guess that algorithmic traders and other sophisticated institutional investors are taking advantage of the share mayhem as well. How much of the price action was truly driven by armchair traders deserves more forensic analysis.

There are other narratives that don’t hold up so well. Some WallStreetBets members say they have a right to disdain hedge funds because of the bank bailouts in the aftermath of the credit crisis in 2008. Or as Vanderbilt’s White put it: “We all endured a financial crisis that was driven by a lot of greed.” Of course, in those years, everyday people were also in on the action, flipping houses during the bubble and contributing to the economic carnage that came later. When it crashed down, Wall Street banks did indeed accept loans from the government to stabilize the financial system. The US Treasury got its money back, with interest, from the banking sector.

Whether or not the Reddit crowd’s trading of GameStop shares will meet a legal definition of market manipulation, it’s clear that some hedge funds have suffered serious damage. One of those is Melvin Capital, which got burned on its short position in GameStop. But here, too, it’s worth asking who exactly is being punished: Melvin generally manages money for “charitable organizations like endowments and foundations,” according to Bloomberg’s Katherine Burton and Hema Parmar. It’s common for hedge funds to manage money for the pensions that regular people rely on for retirement, showing that wealthy hedge fund managers aren’t the only ones hurt by market distortions.

“We need capital markets to function, and we need them to reflect the value of stocks,” White said. “Even if you’re of the view that Wall Street is greedy and Wall Street is bad, capital markets are incredibly important. These types of activities that push us away from capital markets functioning in a healthy way are problematic.”