Global Financial Markets Center | GameStop Explained

ELISABETH DE FONTENAY: Professor Fletcher, I'm going to start with you. Analysts would say that the current stock price, even having fallen so much in the last couple of days, bears essentially no relationship to its fundamentals. And so the company's cash flows do not justify the current valuation. And clearly, the Reddit folks were encouraging buying of the stock.

So a fair question is, are we worried about these people? Do we think that they might end up in jail for violating the securities laws? What can you tell us about that?

GINA-GAIL FLETCHER: Sure. So it's undeniable that GameStop, and AMC, and the other ones that you’ve showed that we've talked about, or that have been spoken about on Wall Street Bets-- that their fundamentals don't match their current share prices. There's nothing controversial in that statement.

But what's really interesting is everyone wants to think of this as some form of market manipulation because of that kind of disconnect between the fundamentals and the share price. But from a legal standpoint, market manipulation requires more than that kind of disconnect between the fundamentals and the share price. And so when we think about what's been going on on the Reddit boards and with GameStop, and we want to think about whether or not this is market manipulation, there are two key points that really we have to contemplate to see whether or not there's some kind of violation of the securities laws.

The first one is, was there any fraud engaged? Was there any fraud as a part of what was going on with this meteoric rise of GameStop's stock price? And I've never, ever been on Reddit-- just to show who I am. And so that would tell you even more so, I have no idea what goes on Wall Street Bets.

But based on what I have seen reported about what's being said on these boards, this doesn't really meet that level of fraud. So what we're normally looking for when we're talking about fraud related to market manipulation is that we're normally looking for some kind of misinformation, misstatements as to what's going on with the company. We're thinking like your classic pump and dump scheme where you spread misinformation about what's going on with the stock or the company. That stock rises.

Somebody then offloads all their shares, and the stock plummets. That's not what's going on here. What's going on with GameStop does not fit the classic pump and dump situation.

So, we're not seeing that kind of fraud, even on the boards, even if with everybody saying GameStop, we should all buy it because it's undervalued. That's not that level of fraud that we're looking for those kind of material misstatements.

The second thing that's really key to manipulation is intent. So there needs to be some kind of manipulative intent. That level of intent, whether it's specific, or recklessness, or something, but there has to be that kind of intent to manipulate the price or that intent to engage in manipulative conduct. And again, based on what has been reported as being said on these Reddit boards or what's happened there, that intent, I believe, is probably missing without more. So I'm not going to say definitively, because I don't know.

And so I think what's going on now is that the SEC is combing through all this data. They're combing through these trades. They're combing through what's been said. They're combing through what's been done in order to kind of see if they're able to find those key elements that they would need in order to hold someone liable for that market manipulation, or for fraud, or something along those lines. And maybe there is something there. But generally, based on what we've heard so far, I think it's going to be a real difficulty for the SEC to make that case.

ELISABETH DE FONTENAY: Thank you. Professor Strauss-- so one group that hasn't been talked about much is the companies themselves, so GameStop, and AMC, and so on. Put us in their shoes for a second from a securities law standpoint and, maybe, just a psychological standpoint.

So what, if anything, do the issuers, themselves, need to worry about when their stock price is so high and so divorced from the fundamentals? Can the executives buy and sell stock during this time? Can they raise a bunch of new capital? What if anything do they need to disclose about what's going on in their stock? Any thoughts on that?

EMILY STRAUSS: Sure. So if you were an issuer, if you are in GameStoper, or if you are AMC, or Nokia, or Bed Bath and Beyond, you are really in kind of an interesting spot right now. You own this company, and your share price is skyrocketing, and people really want to buy your stock.

And you might rationally want to capitalize on this and sell them some stock. And there are mechanisms in place for this very purpose right there at the market offerings, where issuers do self-registration and they take down securities at the market price. And these are designed for exactly this, to enable issuers to take advantage of market windows. And I think it is probably indisputably true that if you are one of these issuers, you would think, oh, my gosh, this is an amazing market window.

There are some problems with this. First, you might miss the window. And so that's a risk that you take any time you do something like this. But more specifically, for these particular issuers, you're in an uncomfortable position because you, along with, as Gina-Gail was saying, presumably, most of the rest of the market, know that your current fantastic stock valuation is not actually based on how good your business is.

And so let's be real. Probably what's going to happen is that eventually there will stop being such frenzy buying of these stocks. This is already starting to happen.

And the price will go back down to something that more realistically reflects the value of the company. And potentially, that means it could go down pretty far. And then the people who bought it from you, as the issuer, when the price was high, will be upset, and they might want to sue you.

And so from a practical legal perspective, if you were an issuer and you do decide to do an offering to take advantage of these share prices, you need to be super, super careful about what you say. There cannot be anything in your offering materials or in the statements that you make that sound remotely anything like, why, yes, this wild enthusiasm for our company is justified by our sound business model. You cannot have anything that sounds remotely like that.

And in fact, if you say anything, it might behoove you to say something more like, you know, there is no material information to account for this delightful share price that we are experiencing. And this, again, is sort of counterintuitive because it's not usually the kind of thing that you say when you are trying to sell something. But you really here as an issue or want to avoid even the appearance of selling securities whose value you know to be inflated under false pretenses.

Similarly, if you are an insider in one of these firms and you want to sell your stock, you would have to do so very, very, very carefully to avoid even the appearance of trading on material non- public information. And based on the information that I was able to find, it looks like a lot of GameStop insiders sold a bunch of shares before the market went crazy. I believe the last sale I saw was on January 15. And it was for something like $30 a share. So people, generally, it seems are not doing this so much.

One of the things that I want to talk about-- and you mentioned that AMC is getting a lot of airtime right now. And one of the reasons for that is because it is one of the meme stocks that actually did capitalize on this crazy evaluation and has done pretty well out of strategically managed issuances during this time. They raised about $500 million in equity and another $400 million in debt. They launched an at the market offering.

They had about $600 million in convertible bonds that the holders actually converted into stock. And if you are AMC, that's fantastic for your balance sheet. And the great thing about this for AMC, in particular, is that before all of this hoopla, it was warning investors that it was on the brink of bankruptcy. And so this has actually gone kind of a ways to pulling it back from the abyss.

ELISABETH DE FONTENAY: Perfect, thank you. So Jim, let's step back a little bit and quite apart from the issue of whether there were any legal problems with what the Reddit crowd did. Let's think a little bit about the policy issues and, in particular, the regulator who is very much in the spotlight right now, the SEC. What sort of regulatory problems do you think this uncovered, if any? And what would you recommend the SEC do as next steps, both in the short-term and maybe the longer-term

JIM COX: Well, the first regulatory problem was just solved the other day. That finally, the Democrats and the Republicans in the Senate have agreed to operating rules so we can get the committees up and running. And the relevance of this conversation is the Banking Committee can now start holding hearings on the appointment of a new chairman. Until a new Chairman at the SEC happens, it's very hard to believe-- and who needs to make certain appointments in divisions. There's nobody heading up trading in markets.

So the issue we're looking at is in the bailiwick-- the expertise of the trading and markets division, where we have lots of students, by the way. And we don't have a head there. And we don't have a head of the SEC. So once that gets into place, they can start doing the rational thing and start thinking about, well, what went on here.

So Gina, and to a lesser extent Emily, we're talking about for more of an enforcement's perspective. I would say, let's think about the SEC's mission really as more regulatory. Enforcement's kind of a byproduct. And that is that the SEC have lots of power to prescribe conduct, regardless of whether that conduct is intentional or not, quite frankly. And whether that would make a case for intentional manipulation.

So to be able to move forward here and think about what the problems are, SEC needs to be calling on all of its economists, et cetera, to essentially reconstruct the market. I think that's going to be pretty easy here. Because so much-- I'm speculating here, but reconstructing the market is-- here are the questions we want to know. We want to know how many of the purchases that were occurring during this run up were the result of having to close out short positions by the hedge funds who had been selling, for example, GameStop short. So we need to know that. How much momentum did that provide?

But we also need to know how much of the momentum-- upward price momentum-- was a result of individuals buying options and then executing those options. And that created a demand for the stock to be able to cover the options. And then we can trace-- options are really great because it's pretty damned easy to reconstruct the market when you're dealing with options than when you're dealing with shares.

So we can reconstruct the market to figure out how of momentum was provided by them covering the shorts versus they exercise the option. Then how much of the trading was provided by other kinds of purchases, and more particularly, from these discount brokers? Remember, the model of the discount brokers is they don't charge anything. So they're not a utility. They make money by payment for order flow.

So it's pretty easy to go into the data and reconstruct the market for how many of these orders came from Robinhood, E-Trade Ameritrade, whatever it is like that-- the discount brokers to figure that out. And then you can figure out who the hell those accounts are. Once we have an idea about--

The other thing we need to find out information about is whether Robinhood is telling the truth. I mean, was it just trying to cover the cash demands of the clearinghouses? Or was it also experiencing the following:

So if you're an individual and you have an option to buy 1,000 shares and you exercise that option, and then all of a sudden the stock price goes down, you're not going to feel very good about paying money to buy a stock that's declined in value from the price you had to pay for it. So how many broken trades did we find, for example, Robinhood, E-Trade, et cetera, experiencing so that they had to then front that money themselves? And so that is a very good question.

But nonetheless, we need to give a lot of thought about how much of Robinhood's cash problems were a result of just the clearing process. And that's going to be very reassuring. Because this is the closest we came to the phenomena that we saw in 2008 and 2009 that jacked up all the requirements for clearing, particularly for derivative securities. And it'll be good to really see how well that system works and whether it needs to be tweaked, independent of GameStop, or AMC, or anything else like that. So there's a lot of great empirical questions there.

Now, the question is-- do you want to get into the question now, Elisabeth, about the path forward? Or you want me to just shut up?

ELISABETH DE FONTENAY: No, let's talk path forward. Lee is going to talk about the clearing and settlement, so we've got that covered.

JIM COX: So that's good. I'm not going to go into that. But the path forward may look something like this-- I've been talking to a lot of traders about this. And that is, we need to re- examine this whole process about who can get leverage.

There's leverage you can get by margin, but also leverage you can get by buying options, rather than just trading in the stock itself. And maybe we ought to have some callers on that, in terms of qualifying, in terms of what your capital is. And all of these are things that are clearly within the SEC's path to prescribe.

And my guess is that we've never been at a point where we've had an incoming chairman of the SEC who was more qualified to take on these questions. The snarking about Gary Gensler is that-- pinching your nose and saying, well, you know, he's not really a securities lawyer. He doesn't look at these disclosure issues about what has to happen if you have a merger, an acquisition, or a private equity transaction. And he doesn't really know about regulation SK and stuff like that.

But he does know about trading in markets because that's where he spent 20 years as the youngest partner ever at Goldman Sachs. So you've never had somebody who is better. And in fact, he was the guiding spirit for so many of the changes we saw in the clearing process that we saw in 2008. So we're at a good crossroads, we just got to confirm this person and get some data. And then we'll figure out what the problems were and figure out how to correct it.

ELISABETH DE FONTENAY: Great. To summarize, one of your practical recommendations would at least be for the SEC to consider whether to limit retail investors use of leverage in purchasing stock or derivatives.

JIM COX: Yep. ELISABETH DE FONTENAY: Thank you. Great, so I am going to play the role of the bad guy here. I'm going to get to some hate mail myself. So what I would like to do is defend, somewhat, the hedge funds here.

So one of the interesting things here is the very differing driving forces behind the Reddit crowd. I think there were lots of different motivations for what was going on. But it's pretty clear that at least some of the motivation was to get back at the hedge funds that were shorting GameStop stock. And so the starting point that we could have here is a discussion of whether hedge funds shorting GameStop stock actually hurts GameStop.

And I'd like to give you the short answer, which is really no. So one thing that's confusing for people for whom this is not their bread and butter is that all of this buying and selling of stock, and buying and selling of derivatives relating to the company's stock is happening on the so- called secondary markets. That is to say, we're buying and selling from each other. None of that money is going to the company.

So when the company goes through, for example, an IPO, that's when they raise a bunch of capital. Or if they sell bonds, they raise a bunch of capital. But when people are trading in their stock or people are trading in derivatives in their stock, that actually does not directly affect the company's cash flows at all. The company doesn't get any money when people buy its stock. The company doesn't lose any money when people short it's stock.

So, in fact, the hedge funds that are shorting GameStop stock don't affect the company's cash flows directly in any way. And the folks buying GameStop stock don't affect the company's cash flows directly in any way. So one point here is that if these folks really want to help GameStop, their best bet is, by far, is to just write the company a check or to go out and buy some of the products, as opposed to purchasing the stock and trying to get back at the hedge funds.

So let me just show a quick slide here. This is GameStop's profits leading up to the-- this is pre- pandemic. You can see that there's already signs of big trouble for GameStop. The company was not doing well.

And so the mantra that I'd like to repeat here is that shorting doesn't cause companies to fail. It's the other way around. If you are a hedge fund and you notice that a company is doing poorly, you think the company is in financial distress and that things are going to get worse, and if that's not fully reflected in the current market price, then you have an incentive to short the stock. To make money if the stock price falls even further.

But it's not the shorting that caused these problems for GameStop. It's exactly the reverse. That the company was in trouble and that caused funds to come in and short the stock.

So a classic example of this is that before the financial crisis of 2008-2009, the banks got in very big trouble-- the big Wall Street banks. And after the fact, the CEOs of those firms like to tell the story that, oh, the financial crisis was just caused by people shorting our stocks. That's complete nonsense. That makes absolutely no sense. It's the exact backwards of what happened. The banks took on very risky bets, were in big trouble. And then people came in and shorted the stock.

So if shorting doesn't actually cause companies to fail, where does the widespread hatred of shorting come from? I would say there are a few sources. One is just confusion about the fact that-- of whether shorting actually causes companies to fail.

The second is management. So corporate management hates people who short their stock. Elon Musk is a classic example of this. He despises short sellers. Why? Because it's painful for their egos.

It's essentially viewed as a criticism of their performance. It can be bad for management when, if the shorts come in, the market recognizes more than it had up to that point, that the company is in trouble and the stock price falls because the executive stock options aren't going to be worth as much, and so on. So it really is a notion that is actually pushed by the establishment, by corporate management, that has caused people to question short selling quite a bit.

The other reason is that there is absolutely some fraud by short sellers. So you can imagine someone spreading a rumor, a false rumor, that the company is engaged in fraud or its product is going to fail. And then the stock price falls, and the short sellers have made money.

The answer to that is most of that fraud, today, does not happen by the hedge funds. They have compliance officers and things like that. It happens, actually, by the small bit short sellers, including on the Reddit crowd. And that fraud happens in the other direction as well. People boosting stock artificially, as the pump and dump schemes that Professor Fletcher described. And so attributing that as the reason for why we should dislike short selling is a little bit misguided.

So shorting can, in fact, perform a really beneficial role in the financial markets. I am not here to defend hedge fund managers. I think most of them qualify functionally as sociopaths. But the function that they serve can be quite useful. Which is to say, they can bring out useful information to the markets.

So those who shorted Enron stock brought out useful information that the market was completely blind to. That there was, in fact, quite a bit of fraud going on within the company. So getting more information out, ensuring-- if the market believes what the short sellers are saying or trying to signal, then the market price of the stock will adjust, and things will be priced correctly. So that's the role of short sellers. And I will stop there on that point and move on now to Professor Reiners.

So one thing that gets buried in all of this discussion is the real underlying plumbing of the financial market. So people don't realize how, in some sense, clunky financial transactions actually are. We can do things instantaneously. Stock is traded in nanoseconds. But there's a lot of plumbing behind there, some of which is really not moving at the same speed. And that has played a big role in what we've seen. So in particular, the fact that when GameStop's stock price was surging, Robinhood, this discount broker through which almost everyone-- the retail investors are trading-- shut down trading in GameStop stock. And so, Lee, do you have any wisdom to share about why that happened? And what that means about the plumbing of the financial markets?

LEE REINERS: Yeah, so the devil is always in the details. And so after Robinhood and a few other retail brokers limited their customers trading in GameStop and a few other meme stocks to only sell orders, has naturally put downward pressure on the share price. When you can only sell a stock, it's natural that it's going to decline in price.

And so when Robinhood did this, it infuriated the Wall Street Bets crowd and a few other prominent social media personalities, like Barstool Sports, Dave Portnoy. And so this led to all sorts of conspiracy theories that Robinhood had caved to pressure from hedge funds that have been losing their shirts in the short squeeze. And of course, the truth is far less sinister and probably pretty boring to most people, if I'm being frank.

So when two people agree to trade a stock, they're exchanging cash for shares. And that contract is just the start of a complicated set of transactions. So the most critical part is what's called Final Settlement, where the actual securities and the cash are exchanged, and that occurs two days later. So this is called T plus 2 Settlement.

And in normal market conditions, a two-day delay for final settlement has little consequence. But in periods of market volatility, like we saw last week, two days can be a very long time, as Robinhood found out. So to see why, consider that the seller faces credit risk in the interval before settlement if the buyer goes bankrupt before the transaction is complete.

So to limit such counterparty risk, a very large entity, called a clearinghouse, processes these transactions. And we can think of a clearinghouse as a buyer to every seller and seller to every buyer in the market. In the case of US equities trading, the clearinghouses the National Securities Clearing Corporation. And they are a subsidiary of a more well known company called Depository Trust and Clearing Corporation or DTCC. So they're the ones that settle equity trades.

Now, to guard against failure, DTCC requires that brokers guarantee transactions by posting collateral. That is to make sure that in two days the promised cash will be there to complete the purchase. The broker for the buyer must have sufficient funds in an account at DTCC. So that clearinghouse determines the overall amount of collateral required, depending on a combination of the broker's transaction volume, the volatility of prices, and a few other factors, such as lopsided buy or sell activity.

So the bigger each of these factors are, the more risk that a transaction will not go through after two days, and so the more collateral is required. And that's what happened. On Thursday, January 28, DTCC announced that trading in stocks like GameStop, quote "generated substantial risk exposures at firms that clear these trades." So they raised collateral requirements by 30%. So the collateral height compelled a number of brokers to restrict trading until they raise the funds. And Robinhood was able to cover this additional collateral requirement by drawing down on a loan from JP Morgan and raising new capital from existing investors, but only after they restricted trading.

So the irony here is that despite the outrage from retail traders, the system actually worked exactly as it should have. Clearinghouses are arguably the most critical, most interconnected component of our financial system. And if one were to fail, the consequences would be catastrophic for the broader economy. So when this volatility materialized out of thin air, it was good that DTCC asked for additional collateral.

ELISABETH DE FONTENAY: Great. And one other question I have for you is since you have been out there in the real world dealing with the markets for some time, is this really new-- all of the Reddit crowd trying to band together to boost stocks and stuff like that? Are there other corners of the financial markets where we see this kind of activity?

LEE REINERS: So I teach fintech here at Duke Law, and so I cover cryptocurrency. And a lot of what we've seen this past week with Reddit, and GameStop, and AMC has been a feature of the cryptocurrency market, essentially from the very beginning. So fundamentally, an asset is worth whatever people are willing to pay for it. And what they are willing to pay for it is derived from a number of different things.

So in the case of a stock, it can be based on discounted cash flow analysis. It can be based on some multiple to earnings, or to comparison to a similar firm. But none of these methodologies apply to cryptocurrency.

So why is Bitcoin worth $34,000 and not $100 or $10,000? And the reality is that a community of true believers in cryptocurrency has formed primarily online and created a shared narrative. And that narrative is that Bitcoin and other cryptocurrencies are effectively digital gold. And they're a hedge against inflation.

And this narrative is enforced by memes, on Twitter, by chat groups on Telegram, celebrities like Elon Musk. And that same dynamic is essentially what happened the past couple of weeks with GameStop-- was that a community narrative was created online. And this would never have been possible without the internet, without message boards like Reddit, and other chat boards. And it just drew a phenomenal number of people in who bought this narrative. And here we are.

ELISABETH DE FONTENAY: Thank you. So Professor Baxter, we want to get your thoughts on several different things. So one question I have is this really an SEC problem or a Fed problem? Which is to say, is this just indicative of the fact that interest rates have been so low for so long, and threw the pandemic have gotten, basically, down to zero. And so we're in the middle of seeing what we always see when that happens, which is a big asset bubble. So are there macro implications to this beyond just looking at GameStop and AMC?

The second is-- I know you and I have differing views on this, so I'd like you to take the opposite position-- the defending the Reddit crowd against the Wall Street fat cats. Share your views on that. And lastly, given your expertise, can you say anything about the derivatives piece of this? How does that play in here? Because most of the trading that was done here was through derivatives, not necessarily directly through the stock of GameStop.

LAWRENCE BAXTER: Sure. Thanks, Elisabeth. On all three of those items, in almost every respect, I agree with what everybody said before including, your own views on short selling. But let me explain where I would differ in detail.

So first of all, the question of the Fed or the SEC. I think Jim is exactly right. This is going to be- - to the extent that it is a problem at all, it's going to be an SEC problem. And the reason I say that is that the Fed only really becomes relevant if there's some kind of systemic risk issue evolving. And is being caused by its easy monetary policy.

Now, as most of you are aware, there is a meeting today with Janet Yellen. And she has staffers from the SEC and other agencies who are meeting to discuss whether there's any kind of common issue they need to be worrying about. But these spikes and frenzied trading episodes are still, as far as I can tell, so far and few between.

Lee talked about the cryptocurrency. I couldn't agree more. It's the QAnon of trading. The silver market went nuts recently, but that's happened before all the way back to the Hunt brothers. But they are relatively insignificant.

And even the GameStop and the AMC trading, in the bigger scheme of things, are relatively insignificant unless this starts to emerge a clear link between the easy money chasing the prices up. That's when the Fed would become involved. And I venture to predict that after their meeting today they will simply say they are watching it and monitoring it. I can't imagine any Fed level action at this stage.

In terms of options, of course, the SEC and, depending on the combinations, the CFTC may have an interest in it. Options have seemed to have driven some of the price increases because it's so inexpensive to buy options and walk away from them. But I would agree with Jim that Gensler is the perfect guy for this. He was head of the CFTC as well. And then he had that experience before.

Nobody knows markets as well or better than him. So I think it'll be fairly well adjusted to the extent that there should be adjustment by the regulators.

As far as the short selling is concerned, this is where I might differ slightly. And we may actually even agree on this. I'm generally a big supporter of short selling. I think it is the right way in the secondary market to determine what real value is there.

And I'm sure that CEO egos, which many of us have had to deal with in the past, are the real source of anger. And sometimes it's countries when they're short selling of their currencies and so on—countries’ international pride and so on. The part that I thinks left a very bad taste in the mouth of the interested public is that short selling is justified because it leads to price discovery. Meaning, that you will find-- the price of a stock that is sustained by its real value. Usually, the reference is fundamentals. I'd caution you to be very careful about so-called fundamentals analysis.

I read all the fundamentals analysis about GameStop. And what stunned me was not one word about COVID. I have a personal interest in that because as a direct result of COVID, I've become a huge fan of simulated racing. And I needed to find a GameStop store to buy the hardware.

Now, if GameStop had any strategic foresight, they would also be downloading software as well. So the distinction that Jerome made between software and physical stores doesn't have to be that way. So the fundamentals don't take any of that into account.

And like Peloton, it could be that they were about to experience a huge boom if properly managed. I don't know. I don't have any of their stock. And I haven't really followed them before this, other than that I tried to get some hardware from them a few months ago.

But having said all that, what I think left a bad taste in the mouth of many people is that this price discovery was all well and good when many traders and hedge funds-- they didn't quite collaborate together, but they went into short selling including even naked short selling, which means you're selling the stock without even borrowing it, and to drive the price down. Now, it may be that's because they didn't believe there was anything there and the price needed to go to zero.

But I rather suspect the motivation was just to make a buck out of the short sale process. And you make a buck if the price keeps dropping, of course, because you buy the stock back at a much lower price than you sold it for, and deliver it back to who you borrowed it from. That was well and good. And it must have been absolutely nerve racking for GameStop and shareholders in GameStop.

But when it turned the other way, all of a sudden there were howls for intervention by the SEC. And hedge funds, in particular, were starting to squawk-- bloody murder is the phrase that I was raised with. The irony is that the retail actions in Reddit are relatively minor. The real big buying didn't come from retail traders. It came from after-hours buying by hedge funds in huge volumes.

So it turns out that the ones who reveled in short selling for price discovery, now didn't like where the price was going. And I worry that we will have misguided efforts to regulate this when the market was working, as Lee says, perfectly well. That we may intervene to prop up companies like Robinhood because they're unable to meet their collateral requirements.

When in fact, if the markets work properly, you just let them go down. That's their problem. They profit when it's good. And if they don't plan properly, they go down the tubes. But there was far more than Robinhood, and Reddit, et cetera, involved there-- and Wall Street Bets. There were very big hedge funds involved. Now, they sometimes try to get a pass by arguing that they are the professionals on Wall Street. I've taught a lot of traders-- glorified frat boys-- they don't know anything more than a lot of the Redditors who trade through Robinhood. Some of them are very knowledgeable people. So we shouldn't be misled by that either.

They're a big advantage with the hedge funds and that is that they have vast swaths of capital that they can use to muscle the market around. I'm not saying intentionally. I'm just saying that they have that advantage.

So I think this is a bit of a storm in a teacup, to use an ill-fated term that Jamie Dimon used over the London whale, and then came to regret. I don't think the markets malfunctioned until there were calls for our regulators to get involved. So that's my contrary view. But it's based, I think, on the same outlook that all of you have just described.

ELISABETH DE FONTENAY: Great. Thank you so much, Lawrence. So I actually want to switch now to taking questions. I would love to hear from, especially, students who have been on Wall Street Bets and have views on what's going on, and the motivations for the various trading and so on.

So if you can use the question function in Zoom or if you prefer, you can send things through to the chat, either way. Otherwise, the rest of us will just keep talking, which we are very good at doing. Ben--

BEN: Hello. So I guess my question is, like a lot of the stuff in the sub-Reddit was motivated by this-- there is this one poster who I'll abbreviate to DFV, who bought GameStop in 2019. And it's been an ongoing running joke that he just owns an absurd amount of GameStop stock for no good reason. And everybody would just go in the comments and call him an idiot.

And it came out that he also has a YouTube channel with a decent following. And he made this whole video about why he bought GameStop, and why he was just holding. So before, and then out of nowhere-- not out of nowhere-- but then he started doing very well, I guess, because of these very large short positions.

And then it just became a joke to buy GameStop and just hold no matter what happens because GameStop will never fail this guy because he's had it for x amount of years. And now they're calling him in to testify. So my question is, you can't really accuse him of manipulating a market when he's been doing the same thing for two years?

ELISABETH DE FONTENAY: Right. So that is a really important question. First of all, just as a practical matter, is the SEC going to try to go after the ring leaders? And it seems like he is being hauled before Congress in a couple of weeks, including with the CEO of Robinhood.

Professor Fletcher, do you want to comment on that? If this person really has been holding stock for a long time, does that weigh in favor of not finding any market manipulation, even though he was hyping the stock throughout? GINA-GAIL FLETCHER: I mean-- here's the thing. So even if he's been providing his opinion on the stock and this opinion is not some kind of misstatement or fraud, that kind of hyping that we're really concerned about, I'm not sure. I've never been to his YouTube channel, so I can't speak to what he actually says there.

But having an opinion is not the basis for market manipulation, really. And if he's been holding this stock-- I mean, him holding it versus him selling it-- you can hold a stock and make money on it. So whether he held it or sold it really isn't the telling part for whether or not this could be manipulative or he could have been manipulating the market.

I think it's much more telling what his comments and conversations were-- he's being called before Congress, and I'm sure his trades are being looked at very closely, and his words, and his actions to see whether that rises to the level of manipulative conduct. So just that he's held it for such a long time isn't necessarily indicative of anything per say. It just shows that he's held it.

And actually, the other side of the argument could be this gives him a good reason to hype the stock and make it have the price go up very high. But if what he's saying is just providing his opinion on these things, then without more, I'm not sure that would rise to the level of manipulation in that regard.

ELISABETH DE FONTENAY: Great. So, Sam, I want to get to your question next. But first, I just wanted to mention a great question that I got in the chat. Which is, this is not actually about GameStop. This is not actually about making money. This is really a social movement.

People are still mad about the financial crisis. They're still mad at Wall Street, that all the gains are going to the 1% and, in particular, the financial sector has done extraordinarily well. Whereas, the real economy in lots of sectors has not done as well. What is there to that?

So Jim, I think you have a bit of an interesting perspective on this given that you've gotten a bunch of hate mail from the Reddit crowd, following your recent appearances on TV. Do you want to say something about that?

JIM COX: I presume I'm unmuted-- that's great. Yeah, I don't disagree with that. I mean, that was my answer two days ago. And then when I started getting this hate mail after yesterday's exposure on CNN and my inbox was filled with this stuff, I'm now leaning substantially to that idea, that this is bigger than a market manipulation area.

Now, that said, means a couple of things. Just like the divisions we're seeing in society are not going to go away right away, and this is a part of those divisions, this is not going to go away right away. So it means that this problem is not isolated. It's going to recur. It runs a serious risk of recurring.

And we need to think about the following. Do we care about that? I think we should for reasons I said earlier. But also, how are we going to do it? So that's the issue there. And it also goes with the remedy. The remedy is likely to be prophylactic. That is that when you're dealing with questions of social movement, that frequently the best way is to start dealing with things prophylactically.

And we've had lots of evidence of that in society moving along. We deal with racism. And we think one of the best ways of addressing that is putting people close together so you understand that we're all creatures of God-- and regardless of what our color, or political orientation, et cetera, like that. And so we have integration moments. And we've done this a lot.

For example, 20 years ago, we had a big problem in securities markets, which are called penny stock frauds. And what did we do? We dealt with that prophylactically. We thought the problem with penny stock frauds is that high pressure brokerage techniques stepped in and forced widows, and widowers, and orphans to buy stocks that it would not normally buy.

So the prophylactic response were a series of rules which stretched out the process. So you cannot close a deal on a penny stock, in any way, until several days passed and several steps have to be gone through. And the result, the fear about penny stocks, literally, has gone away. So I think that's what we're going to be doing here, like that.

It's a social movement. We've got to think about-- we may not be able to correct the feelings about the social movement, but we can certainly think about steps and procedures that's going to ameliorate, if not eliminate, the bad effects on price discovery and liquidity in our markets caused by what we witnessed in the last week.

ELISABETH DE FONTENAY: Yeah, I guess in terms of the social movement, I feel the same way that I do about populism, generally, which is people are absolutely right to be angry. There is some fundamental reason why they are angry. And they're 100% about right. They're just 100% wrong about what they're asking for and how they want to go about fixing it.

So is finance rigged? Absolutely, and in 1,000 ways that these folks don't even know about. But by trading individually on Robinhood, that is not going to fix their problems. It's only going to exacerbate them. I would say, you can be in the position of the Wall Street fat cat by investing in an index fund. You're going to get all the benefit of the market appreciation at essentially zero cost.

What they should be asking is why are the financiers paying half what they are in taxes, and things like that. So it's a really hard problem of educating people, not just about how the markets work, but also about the true injustices that underlie all of this. Sam, go ahead.

SAM: I'm a novice to markets. I don't know if I'm going to use these terms correctly. But I think something I kept seeing thrown around online was this idea of naked shorts. I kept reading about that this number of 140% that-- I guess there was an excess of 100% of the shares of GME that were actually shorted. Can you speak to maybe the legality of that or even what that means? Because I'm not quite sure what it means. ELISABETH DE FONTENAY: Sure. So Lawrence, do you want to take that? So naked shorting means that you're making a bet that the stock price is going to go down. But usually the most common way of doing that is you borrow the stock from somebody else, and then you sell it on the markets, and you agree that after whatever period of time you're going to buy back that stock, and then give it back to the person from whom you're borrowing it.

So a naked short is when you're basically making a bet that the stock price is going to fall, but you don't actually have the stock. There's no stock backing this up. And so that is actually the way in which the Redditors were able to make the hedge funds lose so much money. Which is that there wasn't enough stock to back up all these bets.

So as the price went up, they were getting collateral calls, so they had to come up with the stock. And so they had to buy stock. And that just pushed the stock price even higher. Lawrence, do you want to say anything about the legality of naked shorting or anything else?

LAWRENCE BAXTER: I don't know the broader legality, but I do know that many exchanges will penalize naked short selling. For example, Citadel, one of the huge hedge funds, was fined recently by the Chicago Board of Exchange for engaging in naked short selling. Obviously, there's a big risk and big companies can afford to take that risk.

But if something goes wrong and, for example, they can't buy the stock to deliver, then they have neither borrowed it nor are able to buy it at a price they can afford. So it's like naked credit default swaps. It's at the riskiest end and, of course, most profitable end of short selling. But I think you described exactly what it is. Jim may know about what penalties there are for naked short selling on the securities exchanges.

JIM COX: Well, certainly, the naked short selling as done by broker dealers is prohibited. So we have rules about that and they are very clear. People, unfortunately, go right through many red lights, that's the problem. They get caught, and they get disciplined. And get disciplined mainly from FINRA, not by the SEC.

ELISABETH DE FONTENAY: We have another question, Carre Yang?

CARRE YANG: Hi, this question is for Professor Fletcher. When you were talking about market manipulation-- I wanted to ask, in this case, what would manipulative intent actually look like when they're looking for it? I'm thinking that-- the situations that I'm thinking about are that you have a lot of players doing some very detailed due diligence analysis that they post online.

And a lot of these analyses are quite detailed. And they took advantage of the short position and explained it to everyone, including how to take advantage of it, including things like calling your broker to not lend out your shares after you purchase them. And so at what point is this sharing information OK? And at what point would it point to manipulative intent, especially if there is no fraudulent element, like if it was not misinformation?

GINA-GAIL FLETCHER: Sure. So honestly, just sharing information that's not incorrect is OK. So the things that you're describing-- that they're sharing information about how they've conducted their trades. That's OK, so we we're not going to penalize folks for that. We're not going to call that market manipulation.

So what you're describing, though, is this concept that I've talked about in one of my writings or in some of my writings, actually, is this concept of open market manipulation. So we're trying to manipulate the market, but we're being completely legitimate-- or facially legitimate transactions are what we're using to create this artificial price.

And one, it's a type of misconduct that both commissions have gone after folks for. They've gone after folks for using these facially legitimate transactions-- in different ways. So maybe they're doing-- I've never seen a case that has the facts that you're describing there.

But they'll go after folks who are-- probably aggressive short selling is one of the things that they'll go after folks for. Or for marking the close, meaning heavy selling at the end of the trading day that might cause the price to jump up. Neither of these types of activities are per-se illegal, but they might have some kind of disparate impact on stock price. And the commissions have gone after folks for that.

The courts, however, in adjudicating these types of cases, have been pretty much skeptical of these cases a lot. So the courts, a lot of times when these open market manipulation cases have been brought, have said unless you can show me that the only reason that the traders engaged in this type of trade-- that the only reason that they did it was to manipulate the price of the underlying stock or commodity, we're not going to hold them liable.

And so the burden of proof is quite high when it comes to these things. And that level of intent that needs to be demonstrated-- it's not impossible to demonstrate, but it's going to be quite a heavy burden on the regulators to show that without more.

Now, we're going to have a lot of words on different boards that can be used against folks. And so possibly there will be things there like, I want to manipulate the market. I don't know if that will actually be there. And it doesn't necessarily have to be that extreme in order for it to be a basis for liability. But we're going to be looking for something fairly blatant and fairly obvious, especially if what we're dealing with are facially legitimate transactions that we're alleging manipulated the market.

ELISABETH DE FONTENAY: Great, thank you. Christophe-- and then we'll take some questions from the chat.

CHRISTOPHE: I have question with regard to corporate law. I mean, since it's all happening on the secondary market, is there a duty of the board or for courts, in the situation, as it was for GameStop to take certain actions? We talked about the possibility of erasing capital, but are there other duties they have to do to undertake some actions?

ELISABETH DE FONTENAY: So Professor Strauss had to drop off. Jim, do you want to take this one? JIM COX: I'm not sure I understood the question.

ELISABETH DE FONTENAY: So what are the obligations of the boards of say, GameStop, under this circumstance? Do they have to put something special in their [INAUDIBLE]

JIM COX: No, I think their lawyer-- my guess is their lawyer says, hey, keep your mouth shut. It's like you see a domestic dispute going on, probably better to call the police-- but stand aside-- I mean, I think a lawyer is going to tell them they don't have any obligation. And the minute you enter into it, then it's like you get attached to whatever misimpressions may exist in the market, and they become yours.

ELISABETH DE FONTENAY: Great. So I've gotten a lot of DM's from everybody. There's a bit of a theme in the questions, which is, the SEC might do all this stuff, and the result of that is going to be limiting retail investor's ability to trade. Maybe we go back to forcing brokers to charge an explicit transaction fee every time somebody does a trade, things like that.

All of this is going to end up curbing retail investor trade. Isn't that unfair? Is that why people are now switching over to Bitcoin, and so on?

What I would say to that is, again, the concern here is a little bit odd. It's like saying-- knocking at the door of the Casino and saying, you have to let me in because I want a right to lose a lot of money. The notion that we're restricting retail investors and we're preventing them from making money, that everybody else out there is making money and they're being prevented from doing that, is frankly, I think, a very unfortunate narrative.

So we know the performance of retail investors when they invest their own money versus when they put it, say, in an index fund. It's night and day. They do much worse. They do much worse. And so the notion that they're being kept from these great profits, I think, is wildly mistaken and really unfortunate.

It is not, actually-- we have lots of data on this. It does not work out on average for people to do their own trading. But it's a powerful force.

Since it's Thursday afternoon and we're among friends, I will say something controversial, which is I constantly forget how much men, in particular, like to gamble. And I think that's part of what's going on here. And I wish they went back to betting on sports or something because I worry these people are really going to lose a lot of money thinking that they're actually doing something that's going to make them a lot of money.

LAWRENCE BAXTER: But Elisabeth--

[INTERPOSING VOICES]

JIM COX: Can I add a point here?

ELISABETH DE FONTENAY: Lawrence, why don't you go ahead first. LAWRENCE BAXTER: Well, I have to push back on you because your last sentence actually justified why they should be allowed access. If you start taking the position that they should be prevented from trading for their own good, in terms of monetary returns, I think that is extremely dangerous. There are some traders who make a lot of money. Now, we on average, as you've rightly pointed out, that they generally lose.

But, hey, we go to the casinos, and we regard that as a net plus. And as much as we deny that the markets are casinos, there are 10% of the population, apparently from the studies, who actually get a thrill out of that. Sometimes they get a financial reward. But they still keep doing it, simply because they really think, ultimately, they can beat the market. And I don't know how you regulate against that without becoming patronizing.

ELISABETH DE FONTENAY: To be clear, I'm not at all advocating making it illegal for people to trade their own money. But I think it's perfectly reasonable to say, Robinhood, instead of pretending that you're not charging anything for your services by not having any trading fees, and instead, getting paid for order flow, which is people are paying Robinhood to send all their orders because they know it is the dumb money and they're going to make money off of them trading on the other side.

They know these are uninformed traders. That is a cost that these people are bearing, but they have no idea they're bearing it. They think they're getting a free service and they are absolutely not. So my view is, let's make the cost explicit. Instead of all this massive payment for order flow, make them charge an explicit trading fees.

Don, a question--

JIM COX: So Elisabeth, I was going to add the following on the political context. It's interesting to me that the issue about whether we want to wall off markets from the people is now being advanced by the Democrats-- the more inclusive people. And it's ringing true. That all my friends, are like myself, are saying that what we've seen, not just the last four years, but actually the last 12 years through the Obama administration and the Trump administration, is opening up lots of different risky investors to the populous, which is not a good idea. But it's only a good idea because it makes the people who operate these funds very wealthy.

On the other side, the Republicans are the ones pushing for the idea that we don't want to increase the meaning of [INAUDIBLE] credit investor. We want to make sure that people can invest in private equity funds-- yada, yada, yada. We want to have leveraged exchanged traded funds-- all these risky instruments. So that's what's going on.

And so the biggest puzzle for me is where Lawrence is on this whole thing? Because quite frankly, my own thinking is that gambling-- maybe it's because I grew up in Kansas, the home of Carrie A. Nation and puritanical beliefs. But I think gambling is just like lotteries. Lotteries, to me, are the stupid people's tax. And we should get rid of..

ELISABETH DE FONTENAY: It's very regressive. Very regressive. JIM COX: And markets-- my point to Lawrence, there's huge externalities to allowing gambling in markets.

ELISABETH DE FONTENAY: Ultimately, we bear the cost of all these people's losses. When they retire with no money, it will be our problem. I agree. Don, you have a question?

DON: Yeah, it seems to me like there's another component where if we're going to start stepping in and regulating retail investors, kind of spurned by them investing in a market that we think is overpriced, isn't there a sense there where we're trying to enshrine a very small select group of these hedge fund managers and their research?

We're just collectively deciding that we're going to elevate them to this level where-- if somebody like this DFE guy comes along and has countered research, and even if it seems to be somewhat correct, and something that the hedge fund guys overlooked, we're just going to step in and allow Robinhood and things like that to just make the prophecies of these hedge fund managers come true. It seems like we're moving away from a-- it's a less free market in a sense because we're giving these people this elevated position.

ELISABETH DE FONTENAY: Great. It's a very nice point. This is kind of the First Amendment view. One view of the First Amendment is you should have as many ideas out there as possible. And that's going to lead to the best ones rising to the top. And if that's a view, as long as it's not fraud, you should let everybody weigh in on what is the correct value of the security and stuff like that. Lee, do you want to say anything about that?

LEE REINERS: Well, I'm going to kind of agree. I'm not in favor of this paternalistic attitude that says, well, listen, the average investor is going to be worse off by actively trading stocks, so therefore we should try to prevent them from doing so or nudge them away from doing so. So that is where your suggestion, Elisabeth, is that if you bring back the standard broker commission, that they'd be forced to internalize the cost of their trading, and therefore, do less of it.

But if you actually want to trade, there's no doubt that the free commission model makes you better off. I mean, so payment for order flow-- I mean, I do see problems with it. But at the end of the day, for a retail trader, you're losing fractions of a penny as opposed to having to pay $5, $7, $10, whatever it used to be on trading commissions.

And so I guess I'm disinclined to say, well, let's bring that back because people are dumb and they're going to lose money. So therefore, commissions-- and don't do it. So, yeah, I guess I'm generally in agreement with the student. I mean, people should be allowed to do dumb things, provided it doesn't have externalities that affect the rest of us.

And I think that's kind of where we're at with this is does this pose a systemic risk? Does what happened last week threaten the broader market in the broader economy?

And I've gone back and forth on this, and I just don't see it. I honestly think when we look back a year from now at Robinhood, we'll just kind of have a chuckle. And there really won't have been any sort of lasting either regulatory changes or consequences to the market. Because at the end of the day, it's an interesting story, but I'm not very concerned about it.

ELISABETH DE FONTENAY: So you think the meme stock trading is not here to stay or at least it will pop up every once in a while and make a splash, but not fundamentally change the course of the markets?

LEE REINERS: No, because people are going to lose money. And you learn from your mistakes. I mean, at the end of the day--

ELISABETH DE FONTENAY: Do we?

LEE REINERS: Huh?

ELISABETH DE FONTENAY: I said, do we?

LEE REINERS: Well, maybe not collectively, but certainly--

ELISABETH DE FONTENAY: Yeah, not collectively.

LEE REINERS: Not collectively, but certainly an individual who jumped in when GameStop was going up last week is doing very poorly now. And I would imagine they feel pretty chastened by the experience.

ELISABETH DE FONTENAY: So Ryan Clements, I'm sorry to call you out, but you had some very interesting comments in the chat. And I was wondering if I could encourage you to ask them out loud?

RYAN: Yeah, absolutely. I tried to turn on my camera, but it's not working. I just wonder about the price of volatility and the impact of distributive profits. Because it's easy to say that this is a social movement, but when we really look at the social movement, I'm curious of what the result of this social movement is.

Because it appears to me that the benefactor, at least financially, is actually the 1%, in form of distributive profits. So Robinhood benefits when more people trade untethered from fundamental information. Citadel profits through the bid-to-ask spread. And all the market-makers profit. The hedge funds seem to be profiting.

Matt Levine had an interesting piece on that this morning. Who I don't think is profiting, likely, other than a few idiosyncratic traders, like Roaring Kittie, are everyone else who's interfacing with the market.

And I know this paternalism dynamic is controversial. But it seems like this is a mechanism for a distributive profit away from Main Street to Wall Street. And so what is the actual effect of this social movement? It doesn't seem to be working very well, other than distributing Main Street's money to Wall Street. ELISABETH DE FONTENAY: And the hedge funds are busy scraping Reddit right now and doing momentum trades based on the sentiment that they see there.

LEE REINERS: And let me just, Elisabeth, jump in on Ryan's point. I mean, this whole notion-- this David versus Goliath frame-- as Ryan pointed out is absolutely wrong. I mean, one thing is for certain, that we're just scratching the surface in terms of what we know about what happened in terms of trading behavior last week.

Whenever there's big market movements, whether it be the flash crash in 2010 or even when oil went negative last spring, the initial narrative is normally almost always wrong. So I'm sure we're going to hear more stories as Matt Levine and the Wall Street Journal had a front page story today about how some hedge fund rode the wave up and made $700 million on the GameStop trade.

Ryan's right, the social movement is not working for the Reddit crowd. I mean, if you really want to stick it to Wall Street, call your representative and argue for a financial transactions tax or a return of Glass-Steagall. I mean, it's good old-fashioned Democratic politics is what's going to bring about real change, not trying to beat Wall Street at their own game, which everyone is destined to fail at.

ELISABETH DE FONTENAY: We are well over our time. But if we have a final student question, does anyone want to jump in and ask? So somebody asked-- several people actually have asked whether Robinhood is in trouble. So whether they, in fact, can be sued either by class action by the Robinhood traders or by enforcement by the SEC for stopping the trading?

What is the threshold there? Do they get to make discretionary decisions about when to halt trading? Or do they actually have objective triggers for that they disclose and have to abide by? Jim, do you want to say something about that?

JIM COX: I just want to speculate something else. I think the answer is that-- Lee would have a better idea about what the triggers are for clearing. But let me ask a question here-- we're talking about the social costs are the same.

What would our conversation have been if Robinhood hadn't been able to raise $3 billion to cover the position that was being closed out? What would we be talking about then? Would it be the same conversation? I don't think so.

So I think that more than just saying, boys will be boys, and thinking that this is just going to be episodic and it'll pass, there's a big problem here. We may have dodged a bullet. I don't know. So I think there's a big question here about our markets.

And it may be that we want to have a Tobin's tax and charge commissions. But we may also want to add to that and find something that's needed. Is that we may want to have a Tobin tax that's also on the hedge funds who are algorithmic traders. That's a bigger question. LAWRENCE BAXTER: I'll never forget the size of the volumes that vastly outweigh the retail traders, including with GameStop. The dark trading and after hours trading, which retail traders have no access, they dwarf all of those. So that's where I think you're right. That's where you've got to start looking at things like taxes.

JIM COX: This isn't a huge question. And I think we're going to make some progress on that.

ELISABETH DE FONTENAY: We definitely should stop now. There is far too much to talk about. And we would love to keep the conversation going with everybody, either formally or informally. So thank you to the Global Financial Market Center and the Interactive Entertainment Law Society. I, too, get nostalgic about video games, but for me it's the consoles from the 1980s. I'm thinking Atari. So, goodbye everyone. Thank you so much for joining us. This was a lot of fun.