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Reddit trading frenzy could cause ‘systemic event’ in markets, strategist says

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Key Points
  • A flurry of retail buying led by Reddit thread WallStreetBets sent shares of heavily shorted stocks like GameStop and AMC Entertainment skyrocketing last week.
  • GameStop shares surged 1,625% in January and inflicted a mark-to-market loss of almost $20 billion to hedge funds with short positions against the stock, according to data from S3 Partners.
The GameStop Corp. website on a laptop computer and Robinhood application on a smartphone.
Tiffany Hagler-Geard | Bloomberg | Getty Images

The retail trading flood fueled by Reddit could pose a systemic risk to markets, according to Paul Gambles, co-founder of investment advisory firm MBMG Group.

A flurry of retail buying led by Reddit thread WallStreetBets sent shares of heavily shorted stocks like GameStop and AMC Entertainment skyrocketing last week, squeezing the short positions of Wall Street hedge funds.

GameStop shares surged 1,625% in January and inflicted a mark-to-market loss of almost $20 billion to hedge funds with short positions against the stock, according to data from S3 Partners.

The trend spilled over into metal markets on Monday, sending silver prices surging more than 7% by late afternoon in Europe.

"If this is telling us something about the general health of the markets, that is a broader concern," Gambles told CNBC's "Squawk Box Europe" on Monday, adding that there is "no way" GameStop stock is worth its current price, but noting that those buying it "don't actually care."

"We have got a market where there is what we would traditionally call a bubble, where there is an awful lot of equities out there that are absolutely priced for perfection and beyond," he said.

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Reddit investing trend could cause 'systemic event' in markets, strategist says

Gambles said this could cause a "systemic event" if brokerages begin to fail, highlighting Robinhood's trading restrictions in various stocks last week. The commission-free trading app introduced the new controls after receiving a $3 billion security deposit request from the National Securities Clearing Corporation on Thursday, its CEO Vlad Tenev revealed on Monday.

However, Gambles also suggested that there could be a systemic risk from the hedge fund side.

"If a hedge fund blows up, that could cause a lot of damage to prime brokers. We could be back to a Long-Term Capital Management, 1998-type moment," he added.

LTCM was a U.S. hedge fund that collapsed in 1998 and almost took down the global financial system due to a series of highly leveraged trading strategies, before eventually receiving a Wall Street bailout.

'Localized tussle'

The rise of GameStop and other unfavored stocks led to a ramping up of short-covering and options hedging that rippled through various stocks and sectors last week.

Short selling is a strategy in which investors borrow shares of a stock at a certain price on expectations that the market value will fall below that level when it's time to pay for the borrowed shares. Buying back borrowed shares to close out a short position, whether for a profit or loss, is known as short-covering.

Paul O'Connor, head of multi-asset at Janus Henderson Investors, highlighted in a note Friday that the pain has mostly been felt by "equity long-short hedge funds, which have seen some copy-cat short-squeezes in stocks with high short interest," leading to a "frantic de-risking of positions and reduction in gross equity exposures."

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GameStop mania: How Reddit traders took on Wall Street

"While the brawl between retail speculators and hedge funds over GameStop has been distracting and at times bewildering, we see it more as being a localized tussle over a highly-contested stock, than something with broader or enduring market significance," O'Connor said.

"Equity markets have, of course, seen a few days of significant volatility, as these battles played out, but the overall impact on long-only investors, quant funds and macro investors has been modest."

O'Connor said spillovers to credit markets, commodities and foreign exchange markets have been fairly inconsequential thus far, and suggested that while regulators in Europe may take some remedial actions, the GameStop story is "largely a U.S. one."