Democratise finance by decentralising, not mobbing

IT HAS been two weeks since the GameStop saga started attracting a great deal of attention and occupied the headlines of almost all financial media. When Citron Research called on its Twitter livestream on Jan 22 for a sell of the shares of this once-dormant brick-and-mortar video-game retailer, it probably never occurred to the firm that it would backlash in such a dramatic way. Retail investors were antagonised and, marshalling forces via online chat rooms such as the sub-Reddit WallStreetBets, decided to buy up GameStop shares and call options to squeeze out the short-sellers.

The GameStop price skyrocketed and caused massive losses for a number of hedge funds that held short positions in GameStop.

Melvin Capital, one of the high-profile hedge funds that shorted GameStop, saw its portfolio value plunge by US$3 billion because of the short position. Melvin Capital called up its investors and managed to get a capital infusion of US$2.75 billion, which only infuriated the retail investors even more, leading to more frenzied buying of GameStop shares and call options.

GameStop's share price surged 244 per cent between Jan 22 and 26, increasing by 135 per cent on Jan 27 alone.

The story was still comprehensible up till then. Most investors with some trading experience would understand how short-selling works: an investor who does not own a certain stock, but believes its price will go lower, short-sells by borrowing the shares and selling them in the market, with the intention to buy back later - hopefully at a much lower price - and return the shares to the owners.

Such a practice would enable investors to express their negative views on certain stocks, and empirical evidence suggests that in general, short-selling helps expedite the price discovery process, mitigate stock overvaluation, and, to some extent, prevent the formation of severe financial asset bubbles.

GET BT IN YOUR INBOX DAILY

Start and end each day with the latest news stories and analyses delivered straight to your inbox.

Sign UpVIEW ALL

Short-selling comes with its own risks though, among which the risk of a short squeeze should not be ignored. It is widely known and has been repeatedly proven by historical events that overzealous stock prices can persist for extended periods of time. Hedge funds and short-sellers, of all people, should know best.

Melvin Capital probably made more than one wrong decision along the way and ended up losing money and pilloried at the same time, but it was still within the scope of market risk and the fund's operational risk; it was not that unusual in a functioning financial market.

What was shocking, however, was the development that followed. On Jan 28, a number of big US brokers - including Robinhood, an online brokerage app used mostly by retail investors - halted the trading of GameStop and a few other securities. While the retail investors could not buy shares anymore (they were allowed to hold or sell), Wall Street institutional investors could still buy and sell as they have many privileged channels.

GameStop's stock price nosedived from US$483 to US$112 on the day, and then bounced back to over US$300. Imagine the retail investors scrambling to sell their shares amid the frenzy, while institutional investors were able to buy back shares to close their short positions at a much more comfortable level, and some could even take profit from a newly-opened short position established near US$483.

We do not agree with the way the retail mob planned and carried out the short squeeze. It is always the most disadvantaged small-time investors who get hurt - in this case, latecomers were lured into buying GameStop by the hype created on social media, only to find later that they were unable to execute trades on Robinhood. And small-time investors were disadvantaged against established institutional investors with various trading channels at their disposal.

As we closed the second week of the GameStop episode and with retail investors' buying frenzy suppressed for days, the retailer's stock price fell under heavy selling pressure and closed on Friday at US$63.77. But the saga is far from over; the retail mob is moving on to other assets.

Aside from the socio-political implications, the tumult has left a long to-do list for financial regulators. It might take weeks or months for the regulators to understand what had happened and investigate, among other things, the role of social media and online brokers in this episode. It will also take time to change or tighten regulations on short-selling, leveraged trading, risk disclosure of institutional investors, online brokerages, and circuit-breaker rules in order to protect the integrity of financial markets and the interests of retail investors.

MAIN STREET VS WALL STREET

Some commentators likened the GameStop saga to a battle mounted by retail traders from Main Street against the hedge funds at Wall Street. This has prompted some philosophical debates on questions such as: Is it possible for Main Street to consistently outsmart Wall Street with the power of social media? Can we really improve or reform the existing capitalist financial markets by mustering the force of retail investors to mount GameStop-esque attacks on the hedge funds and the like?

To reform financial markets and democratise finance, should we fix the traditional centralised marketplace? Or is it better to fundamentally reform the market structure by promoting Satoshi Nakamoto's ideal decentralised market of distributed trust, such as decentralised finance (DeFi)?

We feel that in this episode, retail investors may have won a battle, but they are far from winning the war. It is rather difficult for retail investors to consistently defeat the hedge funds and other Wall Street capitalists on their own turf, where victory usually favours those with information advantage and deep pockets.

Also, the power of social media often feeds on emotion, fervour and hype, rather than hard data, valuation analysis and rational investing.

In our view, a more effective strategy is to improve or fix existing financial markets and institutions by leveraging on new information and mobile technologies, and enhancing the support from polices and regulations. At the same time, technological advancements should be used to innovate and create new inventions in financial services to democratise finance, and to make inclusive finance more accessible to the larger population. But it will be more of an evolution and a process that will take time.

A case in point is the licensing of digital banks in Singapore. Referring to newly licensed digital banks, managing director of the Monetary Authority of Singapore Ravi Menon said: "We expect them to thrive alongside the incumbent banks and raise the industry's bar in delivering quality financial services, particularly for currently under-served businesses and individuals. They will further strengthen Singapore's financial sector for the digital economy of the future."

It is worth noting that DeFi projects are now attracting more capital. By October 2020, over US$11 billion was deposited in various DeFi protocols. This number has since increased to US$20.5 billion in January 2021, and US$30 billion in early February.

DeFi is a form of finance that does not rely on central financial intermediaries such as brokerages, exchanges, or banks. Instead, it utilises smart contracts on blockchain. DeFi can promote financial inclusion because DeFi transactions are typically open-source, fully transparent, and "permissionless" - that is, anyone with an Internet connection can access them, with no need to rely on any centralised entity to provide credit intermediaries or endorsements.

So, DeFi helps democratise finance and promote inclusive finance. For instance, Uniswap allows anyone with an Ethereum wallet to trade tokens, while Cook Protocol aims to build an

Ethereum-based asset-management platform where investors can access professional asset managers with fund security and information transparency guaranteed by smart contracts.

• Pei Sai Fan teaches at the Singapore University of Social Sciences (SUSS) and other universities; he is also co-founder of Libai Academy. Yu Yinghui is head, Master of Finance programme at SUSS.