The GameStop game and financial transactions taxes

The Wall Street crew is furious over the masses at Robinhood and Reddit ruining their games with their mass buying of GameStop, which wiped out the short position of a big hedge fund. The Robinhood/Reddit masses are touting this as a victory over Wall Street. The Wall Street insiders are decrying this effort to turn the market into a casino. It’s worth sorting this one out a bit and answering the question everyone is asking (or should be), would a financial transactions tax fix this problem.

First of all, much has been made of the fact that the hedge fund Melvin Capital was shorting GameStop, as though there is something illicit about shorting a company’s stock. This one requires some closing thinking. In principle, a major purpose of the stock market (we will come back to this) is to assess the true value of a company based on the information that investors collectively bring to the market.

Often this leads people to buy stock with the idea that the price will rise. However, an analysis can also lead investors to conclude that a stock is over-valued. In that case, if they are correct, they will make money by shorting the stock.

A short position carries a large inherent risk in a way that buying the stock doesn’t. If an investor buys a stock, the most they can lose is the money they spent on the stock. By contrast, a short position means that an investor has sold a stock with a commitment to buy back the shares at some future point. If the stock price soars, as happened with GameStop, then they can lose many times their initial investment.

For this reason, most investors taking short positions cover their bet in some way. For example, they could purchase a call option at a price that is substantially higher than the price they shorted. This would allow them to limit their losses by exercising the call option.[1]

Covering their bet however also means that they will make less money from their short, if it pays off, since they had to also spend money on this insurance. As a result, some investors don’t cover their short and take the full risk themselves. This seems to have been the case with Melvin Capital.

Holding an uncovered short position leaves an investor exposed to the sort of risk posed by the Robinhood-Reddit gang. When they started buying GameStop, the price began to rise rapidly. This put Melvin Capital more in the hole.

The hedge fund’s creditors wanted them to limit their losses, which meant that they had to rush out and buy shares, covering their position. This sent the price still higher. The net result was that the price rose by more than 1500 percent, from just under $20 a share earlier this month, to a peak of over $400 on Wednesday. The price has since fallen some, but it is still hugely above its levels from earlier this month.

What Does It Mean?

Let’s assume that Melvin Capital was right in its assessment of the stock. (I have not studied the market prospects for GameStop, but the attraction of a brick and mortar store selling video games does seem limited.) In effect, we saw a group of small investors manipulating the stock price to the detriment of a high-flying hedge fund.

It’s hard to shed any tears for Melvin Capital. They are supposed to be the grownups in the room. They should have understood the risk of an uncovered short position. If for some reason they chose to take the risk, and lost, well them’s the breaks.

What about the idea of people acting collectively to manipulate stock prices? Well, this is bad, but it needs some additional context.

First, the point about it being bad is that there are smaller investors out there who buy and sell stock all the time (e.g. people with 401(k)s), and if they happen to get into the market at a bad time because of this manipulation, this will be bad news for them. To be concrete, suppose some sucker put $10,000 in GameStop when it was at $400 and at this time next month its is back down to $20. They lost 95 percent of their money.

As a practical matter, small investors should never be buying individual stocks, but you can still have a story where the not very sharp manager of a fund held by small investors buys into GameStop at $400. Presumably, that didn’t happen in this case, but it is easy to imagine investors being the victim of smaller manipulations of say 5 or 10 percent.

The GameStop case shows us an example of a large group of small investors acting collectively to manipulate stock prices. We can say this is bad, but what about when a large single investor, who controls billions of dollars of assets, does it themselves?

This is clearly illegal, but it nonetheless happens. In principle an investor can be fined and even imprisoned, but stock manipulation is difficult to detect and prove. The cases that are prosecuted are surely a small subset of the cases that actually occur.

There are also variations of what the Robinhood and Reddit gang pulled. For example, a prominent stock commentator may invest in stocks they tout (or get kickbacks). This was the accusation against Henry Blodget, a prominent stock analyst in the dotcom bubble. It is very hard to distinguish a situation where a commentator is making a pronouncement about a company because it is what they actually believe, from a situation where the comment is due to some carefully concealed financial interest.

Anyhow, long and short, the Robinhood/Reddit gang basically got into the game of stock manipulation. This is not especially to be applauded. They did catch a big hedge fund with its pants down, but many of the people involved are likely to end up losers – the people who bought GameStop at a grossly inflated price.

How Do We Fix It and Do We Need To?

It would be good if we could crack down on efforts to manipulate stock prices, whether they come from big actors like hedge funds, corporate CEOs timing their options, or the collective action of small investors. This will always be a difficult task, but unfortunately it is easiest when it is on open display, as appears to have been the case with the Robinhood/Reddit deal.

To be clear, if a group of people debate a company’s value and decide that a stock is grossly under-valued, there is no issue. But, if a group of people collectively say “hey, let’s try to drive up the price of GameStop,” you have a clear case of manipulation.

I’m not advocating a massive crackdown on the Robinhood/Reddit crew, but there should be consequences for this action. And, it would be reasonable to make the companies involved, Robinhood and Reddit, pay the costs. They should not allow their platforms to be used for stock manipulation.

A Financial Transactions Tax to the Rescue?

As a huge fan of financial transactions taxes (FTT), I would love to be able to say that a FTT would stop this sort of game-playing. Unfortunately, this isn’t true. FTTs of the size being discussed would barely place a dent in what we saw with GameStop.

The FTT just introduced by Representative Peter DeFazio is a tax of 0.1 percent. This means that an investor playing with $10,000 would pay $10 in taxes.[2] That isn’t likely to discourage a person determined to get rich while sinking a hedge fund. FTTs are great at limiting high frequency trading, which operates on very low margins, and will reduce the volume of trading more generally, eliminating waste in the financial sector, but they will not have much impact on those looking to make big bets.

One thing that they will do is ensure that the government gets a cut. In this sense, we should think of it as a tax on gambling. Other forms of gambling, like casinos or state lotteries, are subject to very high taxes. It shouldn’t be a big deal to impose a tax of 0.1 percent on Wall Street gambles.

If the Robinhood/Reddit deal ends up leading to an extra $50 billion in trades (a very crude guess), that would net the government $50 million in revenue with the DeFazio FTT in place. That is not big bucks compared to a $5 trillion federal budget (it comes to 0.001 percent), but it is substantial compared to some of the items that are occasionally subject to big political debates.

For example, it’s more than 10 percent of the $450 million that the Federal government is currently spending on the Corporation for Public Broadcasting. It’s roughly 30 percent of the National Endowment for the Arts $170 billion annual budget. In short, the money raised by a FTT from this deal would at least allow us to pay for some nice things.

The Message of the GameStop Affair for Financial Transactions Taxes

One argument that opponents of FTTs like to make is that they will inhibit the process of “price discovery,” so that the market price of stocks and other assets will be further removed from their true price. In this story, the distortions will cause capital to be more poorly allocated and therefore lead to a less productive economy.

This argument suffers from the fact that relatively little money for investment is raised through the stock market. Usually, initial public offerings are done to allow the original investors to cash out. Established companies raise only small a portion of their investment funds through issuing shares.

However, this episode shows us all the craziness that can have a huge impact on stock prices. Should GameStop be worth $20 a share or $400 a share? That is a huge difference. Let’s imagine that the DeFazio tax could result in GameStop’s price being 5 percent too high or too low for limited period of time. (That would be a huge effect for a tax of 0.1 percent.) We would be talking about a range between $19 and $21. Does anyone still want to tell us that that a FTT will undermine the process of price discovery?

In short, this episode should help us to see the stock market with open eyes. Much of what takes place there is clearly gambling. We let people gamble in other contexts, but we tax it. There is no reason we shouldn’t tax it on Wall Street.

And the idea that it will distort market prices; do you want to tell me how Donald Trump really won the election?

[1] A call option gives an investor the right to buy a stock at a specified price on a specific date. For example, if a stock is currently priced at $20, I can buy a call option that gives me the right to buy the stock at $25 a share on March 31. This means that, if I am shorting the stock, the most I can lose is $5 a share, plus the cost of the call option.

[2] Senator Bernie Sanders has proposed a tax of 0.5 percent, but that still would likely not have been a major hindrance to the Robinhood/Reddit folks.