Cora Leeuwenburg

Associate Editor

Loyola University of Chicago School of Law, JD 2022

 

The regulation of hedge funds has largely been unchecked allowing big Wall Street players to manipulate the market for the benefit and at the detriment of other investors. But forced by an unprecedented movement of retail investors, Wall Street is being forced to reckon with the hypocrisy of their practices.

What is the situation with Gamestop?

Wallstreet hedge funds like Melvin Capital suffered a fifty-three percent loss in the last week of January as retail investors drove the value of multiple stocks that the hedge funds had shorted. These stocks include Gamestop, AMC Theaters, Nokia, and Blackberry. This strategy of driving up the price of these stocks hurt the numerous Wall Street players who had bet massively against these companies. Accordingly, accusations of market manipulation are being leveled against both sides of this movement; the hedge funds and the retail investors.

A quick look at the Reddit page that started it all shows that investors are committed to holding these stocks and show no signs of selling until short sellers are forced to buy back at hugely inflated prices in order to execute their options. If you overlook the crude language of the page, the rationale behind this Reddit driven movement is based on plausible financial projections. These stocks have been massively shorted by hedge funds and they will have to buy back the stock at some point leading to an increase in buying which will only further drive up this price resulting in greater losses for short-sellers and increased gains for retail investors.

Is this market manipulation and is it legal?

There have been calls for the SEC to investigate investors for market manipulation but the retail investors holding Gamestop stock are pushing back, arguing that this kind of market manipulation has been used by hedge funds and big Wall Street players for a long time without any interference or regulation.

Legal and financial analysis of this situation is wholly speculative as this sort of collective action from retail investors in all but unprecedented. One question of legality centers around the choice of financial service firms like Robinhood who halted their customers’ ability to buy these volatile stocks. Republicans and Democrats alike have called for investigations into these firms’ actions and their role in market manipulations. One of the legal questions surrounding this event is what is protected speech and what is illegal market manipulation? Furthermore, what should the SEC do about it?

Can this be regulated, and should it be?

In a statement, Senator Sherrod Brown, D-Ohio and the incoming chair of the Banking Committee summarized the hypocrisy of the hedge funds calling for more stringent regulation of retail investors. “People on Wall Street only care about the rules when they’re the ones getting hurt,” Brown said. This sentiment is one echoed by the investors who were blocked from buying stock as well as those active in the Reddit community. Brown also stated that “it’s time form the SEC and Congress to make the economy work for everyone not just Wall Street.”

 

While this unique event has provided the opportunity for many retail investors to make massive gains, it has also shed light on the bigger issue of regulating the market. Another outspoken politician is Senator Elizabeth Warren, D-Mass., who called for the SEC and other financial regulators to “wake up and do their jobs”. She also noted that while hedge funds, private equity firms, and wealthy investors have long used the market as “their own personal casino while everyone else pays the price” they are now the same group now calling for more stringent market regulations.

The SEC faces a challenge in regulating this complex situation as their main goal is to protect investors and ensuring they are provided sufficient information to make informed decisions. “The SEC has for years worried about hedge funds coordinating their positions and coordinating bear raids and otherwise engaging in activities to move around a stock,” said Tyler Gellasch, a former SEC lawyer. But in this case, retail investors have leveraged their buying power en masse with full knowledge of the potential risks. The problem the SEC now faces is that “the SEC rules haven’t thought about what happens when it’s 100,000 people coordinating via Reddit versus three people coordinating via email,” Gellasch states.

This argument over legality and regulation is likely to be ongoing and has yet to be settled but various congressional committees as well as the SEC have stated that it is an issue that must be addressed.