Market participants, structural dysfunctions and the GameStop event

At least eight dimensions can be used qualify the way financial participants trade:

1. Transaction speed from slow to quasi-instantaneous.
2. Transaction rate from rare/infrequent to quasi-continuous.
3. Selection of transactions from disorganized to very organized (e.g. backed by mathematics and research).
4. Transaction's future obligations from no future obligations to with future obligations (e.g. backed by personal wealth).
5. Time scope of transaction's obligation from immediate (e.g. transfer cash) to long term (e.g. payout bond coupon after 30y).
6. Number of participants on "same side of transaction" from small to large
7. Size of single transaction from small to large.
8. Influence of fundamental/"real world" properties of traded contract from none to very important.

In the context of the GameStop event we note the following: 

Traditionally,  retail investors execute transactions:

1. Slowly
2. Infrequently
3. In a disorganized way
4. With no future obligation
5. With only immediate obligation
6. As part of a very large group of similar participants
7. On transactions of small size
8. With more care about the image/brand of the traded products than the fundamentals

To differentiate, one type of hedge fund's transactions might be qualified as:

1. Quasi-instantaneous
2. Quasi-continuous
3. Organized with algorithms and machine learning
4. Including much future obligation
5. With future obligations up to ~1Y
6. As part of a small group of similar hedge funds
7. On transactions of small size and of complementary transactions of larger size.
8. With a combination of caring only about short term machined learned properties to some caring about longer term fundamentals

And to differentiate with at least thirty other market participant profiles going from broker to settlement bank, or insurer. This last point being important: it is not "just" about the retail investors and certain types of hedge funds, there is a whole "ecosystem" out there of financial interdependence. Also coming back the hedge fund example: important are the strong future obligations, the hedge funds "have promised" something. In this case to give back the GameStop shares they have borrowed, or pay out options that depend on the high value of the stock.

Now then, the key changes in the GameStop event are the retail investors GameStop transactions becoming:

1. Slow
2. More frequent
3. Very organized: buy only, "buy for ever"
4. With no future obligation
5. With only immediate obligation
6. As part of a very large group of similar participants
7. On transactions of small size, (probably bigger average)
8. Caring about "beating hedge funds", making a killing with the rising share price, the charismatic"gaming product" brand, with absolutely no caring about fundamentals.

The "very organized on one side" is the killer ingredient here. All trading strategies are a form of balancing act, and all participants assume some amount of future market behavior will support their trading strategy. The traditional retail investors assume that someone will be there to buy back what they have purchased. Hedge funds assume they will be able to take advantage of the different needs and random nature of the different market participants, and more importantly, they assume that they can rebalance their risk "on the fly" within their trading strategy.  One can visualize a hedge fund as a bicycle that is pulled to the left or the right as trades are made, and that actively needs to rebalance from time to time by making selected trades, to avoid "falling over". However, if all the trades are "one sided", and worse, they are all counter the initial assumptions of the hedge fund, things go bad quickly, as the hedge fund is mostly only able to make trades that imbalance it further, leading to it hitting its financial limits, and either being acquired by a bigger fish, or going bust. 

The flash crash, was another example of "structural dysfunction" to the market, when the prices plunged because most quotes were pulled. With the GameStop event, the prices exploded because a large enough group of participants suddenly decided only to buy and hold. 

There are many markets with an imbalance of buyers and sellers. What is new here is: in a market with future obligations a disproportionate amount of participants suddenly decided to actively participate only on one side of the transaction (here buying). A learning that hedges funds will integrate at the cost of limiting their leverage.

All original content copyright James Litsios, 2021.