Our thinking Quick reads Crisis…which one?
 
Sharpe Thoughts
February 2021
7 min read

Crisis…which one?

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Well, it’s hard to tell these days. There are many nominees for the most overused word of the pandemic, but “crisis” must be up there. Today’s crisis du jour is the one facing equity markets. No, no, not the one caused by hedge funds, this time: the one caused by seemingly ordinary people. Ordinary people who want a piece of the action.

A lot has been said (mostly by hedge fund managers) about the damage being done to the industry, the market mechanic and pension funds (yes, there are good points to be made on all those fronts), but can we really take that narrative seriously when it’s based on such a convenient loss of memory? Are we really going to admonish ordinary investors for activist investing and speculation, when causing crisis is exactly what hedge fund managers have been doing for decades?

The pontificating by hedge fund managers who were on the wrong side of the trades, misses something fundamentally more fascinating here. Since when did fund managers have a monopoly on what investment strategies were fair game, or what speculation is supposed to look like? To the ordinary investor this may sound somewhat ironic if you look at the economic history of hedge funds themselves.

You don’t have to go back too far to find hedge fund managers facing the same criticism themselves.

I recall reading research papers years ago which all argued that the proliferation of hedge funds manipulating (and increasing the volatility of) the market was to the disadvantage of the ordinary investor. Hedge fund managers vociferously denied this, arguing, on the contrary, that they created liquidity and that disruption and dislocation were inherent features of a properly functioning, efficient market. Today’s ordinary investor is armed with better technology, better market access, more (query whether any better) information and is certainly better organised than was the case, many decades ago. Financial literacy, overall, has steadily increased in developed economies, since the dotcom bubble burst. Social media is accelerating that exponentially. Rightly or wrongly, ordinary investors are no longer the passive victims, they are the new market disruptors. The inconvenient and often unpalatable truth for some managers is that hedge funds are no longer the market disruptors they once were. They no longer cause any crisis.

Are we to believe that ordinary investors are making equity markets any less stable or more volatile than they have been historically? Equity markets have resembled a casino floor for some time. One only has to look at the short positions on broad based equity indexes, like the Russell 3000, in January. Hedge fund managers may have thought they were the only ones with the right (or the might) to play the tables, but that is no longer the case. Talking down ordinary investors trading through social media forums is a little like moaning when the little guy at your table wins. The irony is that, just like casinos, efficient equity markets depend on not just the high rollers, but also lots of low rollers (it’s these actors who often provide the majority of the turnover). The casino ecosystem accommodates a vast array of players: billionaires, problem gamblers, adrenalin junkies and those who are convinced they have the system to break the dealer or beat the house. So do (and should) efficient equity markets if we truly believe in free and unfettered markets.

Which brings us to some reflections on this recent episode.

It’s not so much a question of whether ordinary investors should have access to financial markets, they already do. Trading has become increasingly decentralised over the last couple of decades. The growth in online trading platforms and, more recently, commission free trading apps (and the underlying payment for order flow pricing model) means so called “amateur” access to the markets is at an all-time high and the barriers to entry are falling faster, year on year.

We are at a fascinating intersection in the history of financial markets, where technology is bringing gaming, social media and youth culture together, in a new environment.

Ordinary investors now have the same (or very similar) tools to the pros, and when you add high speed Internet, instant market data, courtesy of social media and search engines, and an organised peer group forum, in which to explore ideas, you have something which looks very much like a trading floor, albeit an unlimited, virtual one.

These virtual trading floors challenge the legal and regulatory orthodoxy, long accepted by their institutional counterparts. Ordinary investors need not concern themselves with MiFID, EMIR or a host of other financial regulations, nor are they subject to the legal duties and obligations that corporate frameworks often impose on their institutional peers. They are fluid, dynamic and, as the SEC recently discovered, increasingly hard to regulate. There are many noble arguments to be made about the socio-economic value of broader access to financial markets, but I am not sure untrammelled access with few real checks and balances will be the best way to achieve it. Just like the politics of recent times, financial markets, too, are becoming even more segmented by sentiment and ideology.

Why does any of this matter? Isn’t it just a load of rich old guys getting richer? Well, maybe, but it does shine a light on some trends in broader society, which are reflected in financial markets. It’s not simply about bubbles, crisis, dangerous speculation or trying to stick it to the man (or woman). At its core, the Reddit Revolt is, itself, a social commentary on wealth, power, inclusion and generational change in attitudes. These will undoubtedly continue to be key themes of the coming decade, and how regulators and governments adapt, adjust and accommodate them will define whether we achieve true democratisation of financial markets.

Central to all of this is the role played by social media. Ordinary investors may see the abundance of information at their fingertips as power, but who owns, controls, qualifies, disseminates (and/or censors!) that information are all equally important considerations when we look at how that power is being used. If social media can be used to influence social, political, even consumer behaviour, then why not financial? The dangers of financial gaslighting on social media forums are real for both markets and ordinary investors. That which we would call bad faith, crisis, fraud or misrepresentation should smell just as foul whether repeated on social media, or in a buy/sell recommendation from an analyst. Financial regulators have their work cut out. In the years ahead, expect them to be wrestling, through the legislature and the courts, with the question of whether ordinary investors trading through virtual trading floors, social media forums and/or influencers are manipulating or facilitating financial markets.

There is a fine balance to be struck if we are to support the virtues of broader market access, whilst also ensuring the integrity of the market framework. Generational and demographic changes in attitude to financial markets will continue to push the boundaries of our current legal and regulatory framework, and financial markets will continue to evolve in response to the changing political, social and economic behaviours those changes in attitude bring. The outcome of this period of transition will have a lasting impact on all our financial futures. As the website of a well-known trading app favoured by the Reddit traders says, “we are all investors”.

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