The stock market turned out to be a spectacle to rival the Super Bowl LV this week, when retail investors and hedge funds clashed over GameStop’s shares. Tom Brady and Patrick Mahomes will have a hard time providing both entertainment to viewers around the world and this last step in the gamification of financial markets.
Stock punting has always had a sporting element: the thrill of placing a bet and watching the game. But financial markets now offer a chance for combat as well as entertainment. The combat element was introduced with the proliferation of hedge funds that actively sell shares to protect their positions. Widespread short selling – when you borrow a stock, sell it and hope to buy it back for a lower price – ensures that long positions (owners of shares) are compared to short positions in a zero-sum game. With the morality tale of good individual investors on Reddit battling the evil hedge funds that sold stocks, the game was complete. In a populist moment, what could be more fun than seeing a lethal fight between individuals and institutions, strangers and interns?
How did the gamification of financial markets happen? There are many culprits, including a bored and socially distant workforce looking at the screens during a pandemic, and the low interest rates that make traditional savings foolish and the loan to buy cheap stocks, but more importantly, the resurgence of the investor retail. You cannot fully gamify an industry without finding a technology that allows many new players.
In the past five decades, institutional investors have become the dominant force in financial markets. The rise of defined benefit plans and the shift to defined contribution plans have consolidated market power between mutual funds where workers invest retirement assets and hedge funds that promise exorbitant pension plans and fund managers. But that changed two years ago.
A fundamental change in the financial brokers’ business model has brought back the retail investor: the rise of zero-commission negotiations. Commissions were already under pressure, as new entrants – notably Robinhood – were financed by venture capitalists eager to find another sector to disrupt with abundant capital. Brokers realized that their business model was upside down. They did not need to collect commissions from their customers to make money; there was a lot more money to be made by no charging their customers. The fascination of “free” – demonstrated by Facebook and Google – was much greater than conventional business models.
As we learned on the internet, what seems to be free is far from it. Just as Facebook and Google monetize user information with the sale of advertising, Robinhood and all the brokers that migrated to the zero-cost commission capitalize on the information. But there is a twist. Brokers do not sell their users’ information; they sell your lack of it. The fundamental problem for market makers in the 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 will 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), since these spreads reward market makers for the risk of trading with informed traders.
Robinhood and other zero-cost brokers monetize their control over active traders who are decidedly uninformed. They sell these trades to a new generation of market makers, such as Citadel Securities, who pay for the ability to perform a bid-ask spread without running the risk of trading with informed traders. Retail investors can trade for free, the new generation of Wall Street giants like Citadel monetizes their ignorance, and the old-fashioned investment banks that used to pocket this buy and sell spread have become, like Goldman Sachs, a combination of a commercial bank and a hedge fund. Everyone has fun.
The gamification of financial markets has many costs. This will end badly for retail investors, although it is unclear exactly when and how, and some will make money along the way. In the process, financial markets will do what they have been doing for centuries, although it is little known: reallocating wealth from the uninformed to the informed. Each bubble is associated with redistribution, and much of the alpha that professional investors brag about is nothing more than time savings that are redistributions from other parties. The current populist moment in the financial markets, like many other populist moments, will only serve to amplify this redistribution to the wealthy and informed, while suggesting that it is doing the opposite.
Even more is at stake for the real economy. Financial markets must provide price signals that help allocate resources and provide mechanisms to channel capital from savers to companies that need that capital. Gamification reduces these important functions to a secondary spectacle. As retail investors calculate their losses, they will lose faith in the valuable functions that financial markets offer.
Like on Facebook, or any seemingly “free” market, putting the genie back in the bottle will not be easy. It is not obvious how to regulate a market where participants are willingly negotiating their attention. Individuals are not being charged and there is no obvious informative advantage being unfairly capitalized on. However, losses will arise over time and the financial markets will suffer an additional loss of credibility. Until that reckoning, your long-term health will be better served by being a fan and not a player – that is, if you can take what the game is doing to players.