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Wednesday, February 3, 2021 Leer en Español

In Defense of Hedge Funds and Short Selling: GameStop, Reddit, and Robinhood

It is not the hedge funds that are ultimately responsible for market volatility and financial crises.

Image credit: FEE composite | Fox News - Gage Skidmore from Peoria

Does Wall Street gain at the expense of the little guy? Yes. Is this gain via hedge funds and short selling? No.

The fallout from the Robinhood/GameStop saga has led to the usual finger pointing at the wrong parties as a result of political tribalism. But it would be helpful to have some truth and reality, and understand who is and isn’t responsible for what.

Let’s start with short selling. Political pundits like Fox’s Tucker Carlson stated the following:

“Short selling has no obvious value to the American economy….short selling hurts companies, obviously, it hurts its investors, its employees, ultimately it hurts our country itself.”

Like most political statements today, this is a mere assertion with no basis in fact.

Short selling involves the borrowing of a stock in order to be able to sell it without owning it, and buying it back later and returning the borrowed shares to the lender of the stock. But it is still just selling a stock. One can buy a stock and sell it later, or sell a stock and buy it later. A change of order in the process does not make it harmful. If selling a stock before buying it is bad, then selling a stock after buying it is bad, too. Both involve selling (and buying!).

There is nothing wrong with betting against a company if one deems it to be an inferior competitor that will not survive. Why not make bets that Sears, Kmart, Blockbuster, Pan Am, Polaroid, or that horse and buggy company from 1910 will not survive?

Short-selling stocks with poor prospects serves to accurately value companies according to their actual economic viability, providing balance to the market place and keeping things stable by preventing companies from being overpriced.

In futures contracts there necessarily must be a seller on the opposite side to the buyer who thinks the price is going lower instead of higher. Is the seller of a cattle contract bad because she thinks the price will go lower? No, she is merely trying to value the commodity appropriately by keeping prices in check with respect to the underlying fundamentals. She might have identified that prices had run too high during a time of a supply crunch given the limited amount of supply reduction that actually exists.

What if you wait until after Labor Day to make that beach trip because you think prices will be lower after school starts? You are implicitly taking a short position on hotel prices. That’s not being evil by trying to put the hotel out of business.

Are people betting against the American economy if they sell their car, home or small business? No, they are just moving on and doing what they think is best for their lives. We all buy and sell for various reasons, and we all have different perspectives on what is undervalued, overvalued or just good for our lives. It’s called a marketplace, an economy.

What about the fact that hedge fund managers talk negatively about companies they have short positions in so that the price will fall? So be it! What about people who talk up bad companies doing poorly? People talk well or badly about all kinds of things in society in an attempt to sway society in a way they think would benefit themselves. “Don’t buy from businesses who support Trump!” for example.

Contrary to popular belief, hedge funds do provide an economic service: they help people keep the savings they have when these would otherwise be eroded by inflation.

Further, shorting takes place in the secondary market, and does not directly influence the actual company in any way.

Now, what about the hedge funds themselves? First, to tie them to the conversation about short selling, remember that the hedge funds involved in this week’s news are just making a bet that the companies in question will go lower in price instead of higher. There is nothing wrong with that. GameStop is a target because it is an old-economy company expected to succumb to online shopping. A reasonable bet, not an evil conspiracy.

But what about Citadel’s possibly having asked Robinhood to shut down GameStop trading to protect its (adopted) short position? If this were true, it indeed is a scandal and the two entities should be duly prosecuted.

However, it is unlikely that this is the case. There is a plethora of evidence pointing to Robinhood’s defense as a valid one: it had to stop trading due to its own exponentially increasing risk as a clearing firm of having to cover non-payments from traders who got burned—a regulatory requirement.

Other brokerage firms took similar action, including Webull, TD Ameritrade, Charles Schwab, and Interactive Brokers. Even the national clearing house Depository Trust & Clearing Corporation (DTCC) had to take action, and it specifically referenced the risk inherent to clearing firms in the particular stocks for which Robinhood ceased trading.

There are actual risk parameters and constraints that brokers face when markets get wild. Not everything is shady.

In fact, hedge funds are actually the rather innocuous part of Wall Street. Unless they do engage in illegal activity—there are bad apples in every corner of society, the hedge fund industry included—they are merely managing money for people.

Contrary to popular belief, they do provide an economic service: they help people keep the savings they have when these would otherwise be eroded by inflation. When prices go higher, our money loses purchasing power, which means we actually lose money in real terms. Hedge funds and other fund and money managers help keep investors purchasing power strong by investing in financial assets that rise at or higher than the pace of inflation, namely stocks, bonds, real estate and the like.

The few hedge fund managers who are very successful, like top basketball players, get rewarded greatly for the value they deliver.

It is not the hedge funds, highly leveraged and highly speculative as they often are, that are ultimately responsible for market volatility and financial crises.

But it is not the hedge funds, highly leveraged and highly speculative as they often are, that are ultimately responsible for market volatility and financial crises. It is the government, its central bank, normal banks, and Wall Street broker-dealers.

These actors are the ones printing money, causing it to slosh around the financial system, pushing prices ever higher, and then crashing lower, causing financial crises and recessions. It is these actors engaging in pyramided unsustainable debt-based money schemes that cause chain reactions across the banking and financial system that can sink the entire economy, putting our individual checking accounts at risk of vanishing.

Yet congresswoman Maxine Waters, without any proof of wrongdoing, blamed hedge funds for everything, even though young individual investors were actually the ones driving up stocks so rapidly:

“We must deal with the hedge funds whose unethical conduct directly led to the recent market volatility and we must examine the market in general and how it has been manipulated by hedge funds and their financial partners to benefit themselves while others pay the price.” 

It is highly unlikely that Waters could offer any proof of hedge funds manipulating market prices. She just asserts that they are.

It is not the hedge funds that create and lend pyramided money and send it roaring through the financial system causing massive volatility. It is Maxine Waters as a member of congress, and the government’s central bank and government-protected/supported banks who do. Without them, market volatility and rising prices couldn’t exist.

Lastly, there should be no fundamental beef with the Reddit crowd either. They are piling into stocks with their money and pushing prices higher just as other groups of investors do every day (though not via open collusion). Buyers often try to short-squeeze short sellers. It’s all part of the money-sloshing markets we live with.