Unless you have been living under a rock, you will have heard whispers of the war raging between Wall Street and Reddit over GameStop stocks. There is an element of hilarity to the situation, with part-time, amateur punters taking on hedge fund goliaths and winning, but it also exposes deep flaws in the system.

So first – what happened with GameStop?

GameStop, the well-known video game retailer, was hit hard by the pandemic. Its stock price fell below $3 in April 2020, with access to its high street shops limited by lockdowns. Reddit investors, most notably on the r/wallstreetbets subreddit saw this as undervalued and so scooped it up on digital trading platforms such as Robinhood, causing a rise in price. On the other hand, the actual Wall Street believed this price rise as unjustified and so acted promptly.

Facade with sign and logo at GameStop video gaming store in Dublin, California, August 23, 2018. (Photo by Smith Collection/Gado/Getty Images)

A number of hedge funds (notably Citron and Melvin Capital) bet against GameStop price going up and looked to profit off this. This practice is called short selling, where investors borrow a stock, sell it on the market, then (hopefully) buy it back at a lower price. The investors (short-sellers) then return the stock and pocket the difference. It is a risky business, as stocks can shoot up in the meantime and leave investors open to huge losses – as happened with the GameStop scenario.

It is worth noting that hedge funds tend to be subject to fewer regulations than other institutions such as banks. They can borrow heavily and take large risks. For this reason, generally only accredited investors can invest in these funds. You can make up your own mind about feeling sorry for them over what happened next.

GameStop was the darling stock of Reddit, from people looking to make a quick buck, to others citing revenge for the 2008 crash, they egged each other on to keep buying the stock and push its price “to the moon”. The legality of these actions is questionable and may be considered market manipulation – a banned practice.

What does it mean for the Stock Market?

In this week’s frenzy, GameStop stock went as high as $483 – but what does it mean? First of all, the above stock price is far removed from reality. No one, not even the most delusional Reddit user, believes that Reddit is worth that much. But it is their will to trade at that price and accept the risks involved.

Furthermore – it is bad news for the hedge funds – they will have to pay this difference to those they borrowed from, declare bankruptcy, or incredibly – ask for a bailout. The Guardian reports $6.12bn in losses of GameStop short sellers up so far this year. They have been forced to sell shares they hold in other companies on the cheap – causing various indices to fall over the past few days.

While this may seem a trivial bit of fun, where a few rich guys lose money and nerds on the internet make a bit of moolah, it has wider implications. As mentioned before, hedge funds borrow to invest. This process, known as leverage, allows them to make more profits than otherwise (like using a lever to lift something). Banks will have lent to these hedge funds to support this practice. It works out well for all when things go well, but there is no quicker way to end up losing everything than on credit.

This online vigilantism, a quasi-cancel culture, may happen again. But what if next time it is a bigger retailer – a Walmart or even Amazon? More losses will be felt, and more bankruptcies seen. The common person does not care about a hedge fund manager’s loss, nor should they. The problem arises when banks become involved. By lending to the funds, they expose themselves and so depositors to the bets of Wall Street suits.

Such bets, although in a vastly different world, brought the world to its knees in 2008. Investors were overexposed to real estate in the 2000s like Citron and Melvin were overexposed to GameStop. The only difference now is that hedge funds are subject to the mood of Redditors. The solution? Truly democratise financial markets. A large chunk of this is down to dissatisfaction with how Wall Street and the not so free market are run.

In an irony of ironies, the hedge funds have asked for regulation. If this comes, it must not be one-sided. It is an opportune time to limit how much they borrow and from whom. Limiting the lay person’s indirect exposure to their bets must be of paramount importance. None of us should have to worry about another bailout because rich guys and Redditors cannot play nice.

Conor Bergin – Business Correspondent