The stock market turned into a spectacle to rival Super Bowl LV this week, as retail investors and hedge funds faced off over GameStop stock. Tom Brady and Patrick Mahomes will have a hard time providing as much entertainment to viewers around the world as this latest step in the gamification of financial markets.
Punting on stocks has always had a sporting element: the thrill of placing a bet and watching the game play out. But financial markets now offer a chance for combat as well as entertainment. The element of combat was introduced with the proliferation of hedge funds that actively short stocks to hedge their positions. Widespread shorting—when you borrow a share, sell it, and hope to buy it back at a lower price—ensures that longs (owners of the stock) are set against shorts in a zero-sum game. With the morality tale of good individual investors on Reddit battling the evil hedge funds shorting stocks, the game was complete. In a populist moment, what could be more fun than seeing lethal combat between individuals and institutions, outsiders and insiders?
How did the gamification of financial markets happen? There are many culprits, including a bored and socially distanced workforce staring at screens during a pandemic, and low interest rates that make traditional saving silly and borrowing to buy stocks cheap, but the most important is the resurgence of the retail investor. You can’t fully gamify an industry without finding a technology to allow many new players.
In the last five decades, institutional investors became the dominant force in financial markets. The rise of defined benefit plans and then the switch to defined contribution plans consolidated market power among the mutual funds where workers invest retirement assets and the hedge funds that promise pension plans and endowment managers exorbitant returns. But that changed two years ago.
A fundamental change in the business model of financial brokerages brought the retail investor back: the rise of zero-commission trading. Commissions were already under pressure as new entrants—notably Robinhood—were funded by venture capitalists eager to find another industry to disrupt with bountiful capital. Brokerages realized that their business model was upside down. They didn’t need to charge their customers commissions to make money; there was much more money to be made by not charging their customers. The allure of “free”—demonstrated by Facebook and Google—was far greater than conventional business models.
As we’ve learned from the internet, what appears to be free is far from it. Just as Facebook and Google monetize user information by selling advertising, Robinhood and all the brokerages that have migrated to zero-cost commission capitalize on information. But there’s a twist. The brokerages don’t sell their users’ information; they sell their lack of it. The fundamental problem for market makers in financial markets is the danger of transacting with people with information—no one wants to trade with someone with more information because they know they’ll lose. That 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 transacting with informed traders.
Robinhood and other zero-cost brokerages monetize their hold 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 realize a bid-ask spread without taking the risk of trading with informed traders. Retail investors get to trade for free, the new generation of Wall Street behemoths like Citadel monetize their ignorance, and the old-line investment banks that used to pocket that bid-ask spread have moved on to becoming, like Goldman Sachs, some combination of a commercial bank and a hedge fund. Fun is had by all.
The gamification of financial markets comes with many costs. This will end badly for the retail investors, though 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 it is little acknowledged: reallocate wealth from the uninformed to the informed. Every bubble is associated with redistribution, and much of the alpha that professional investors boast about is nothing more than timing gains that are redistributions from other parties. The current populist moment in financial markets, like many other populist moments, will only serve to amplify that redistribution toward the rich and informed, all the while suggesting that it is doing the opposite.
Even more is at stake for the real economy. Financial markets are meant to provide price signals that help allocate resources and to provide mechanisms for funneling capital from savers to firms that need that capital. Gamification reduces those important functions to a sideshow. As retail investors reckon with their losses, they will lose faith in the valuable functions financial markets provide.
As with Facebook, or any seemingly “free” market, putting the genie back in the bottle will not be straightforward. It isn’t obvious how to regulate a market where participants are willingly trading their attention. Individuals are not being charged anything, and there is no obvious informational edge that is being capitalized on unfairly. Yet losses will arise over time and financial markets will suffer a further loss in credibility. Until that reckoning, your long-run health will be best served by being a fan and not a player—if you can stomach what the game is doing to the players, that is.