The ongoing roller-coaster ride of GameStop, dogecoin and other so-called meme stocks has led day traders, market makers and exchanges to attack each other with knee-jerk accusations of “market manipulation.” When this happens, the primary winners are government regulators seeking to expand the scope of their authority. Industry cries of market “manipulation” – from all sides – are not only shortsighted. They also risk setting the market on a path towards an enforcement framework that all market participants may come to regret, no matter what side they think they are currently on.
Reddit takes on Wall Street
Since early this year, by sharing tips and organizing on social media platforms such as Reddit and Twitter, individual traders have been able to rally prices of meme stocks to unbelievable heights. First, it was GameStop, AMC and a handful of other targets, with traders sending prices skyward 1,500% or more. Then, traders set their sights beyond the securities markets: dogecoin (DOGE) rose over 800% in 24 hours after a tweet from Elon Musk rallied the masses behind it.
Naturally, not everyone was happy with these developments. As institutional investors and short sellers proceeded to lose huge amounts of money, they accused the day traders and social media platforms of market manipulation by banding together to buy assets for the purpose of raising the price – and worse, doing so with the specific intention of inflicting pain on Wall Street. In turn, the day traders are throwing these accusations right back at Wall Street, arguing that trading platforms and market makers mounted a defense by unlawfully colluding to stamp out their trading.
As both sides bray for blood, government regulators, legislators and opportunistic lawsuit filers are wading in a move that threatens both the institutional players as well as individual traders.
This is not good for either side: While some traders and investors may welcome government intervention and reallocation of trading profits today, they may not realize that, in the long run, loose accusations of “market manipulation” may create a lose-lose situation that promotes precisely the type of expansive enforcement theories regulators have been pushing for – and the industry has been fighting against – for years.
A Trojan Horse for broader regulation
By inviting government intervention, the industry may be ushering in a new era of regulatory oversight over not only financial markets, but also the act of discussing and organizing investments on social media.
That’s not to say existing financial regulations should be free from scrutiny. Social media creates a world where anyone can become an investment adviser for large audiences, and the existing regulatory regime may not be up to the task of the digital age. In the U.S., there is currently no coherent regulatory approach to digital assets. But in attempting to shoehorn the recent GameStop and dogecoin rallies under the umbrella of “market manipulation,” the industry is setting a trap for itself.
Regulators have long argued that people who trade securities or commodities for the purpose of changing their price can be guilty of market manipulation. An example can be found as recently as just last month, when the U.S. Commodity Futures Trading Commission (CFTC) accused a swaps trader of manipulation simply for selling swaps to move its price down.
This type of theory is flawed, bordering on nonsensical. The financial industry – including individual traders, market makers, and institutions alike – has valiantly opposed such amorphous theories of “market manipulation” for years, with notable success in the courts. The current round of finger pointing, however, threatens to undo these industry gains.
The folly of intent or price impact
A trader’s subjective intent in placing an order is not a rational standard for policing global financial markets. Regardless of a trader’s true intent in his heart of hearts, any executable order placed into the market is exactly what it purports to be: an offer to buy or sell at a particular price. All bids and offers placed in an electronic marketplace represent true and actionable market depth, and that does not change simply because one trader intends one thing while another trader intends something different. An intent-based standard for market manipulation poses a serious risk of arbitrary enforcement – and a risk that the government will pick winners and losers by singling out politically-unfavored traders.
Nor is price impact a rational standard. Any order can theoretically impact price, whether of the particular asset in question or of a derivative or correlated asset. A trade’s impact on price, like a trader’s subjective intent, is not a meaningful standard by which to distinguish lawful from unlawful trading in today’s interrelated markets.
Market transactions should not be distorted by the deliberate spreading of falsehoods and misrepresentations, which is what the concept of “market manipulation” was originally designed to address. But claims that GameStop traders “manipulated” the market because they intended to or in fact did drive the price up (or short positions down) are reckless and simplistic. Placing real orders to buy or sell at prevailing market prices, whatever the intent of those orders, should not be seen as manipulative in an unlawful sense.
In debating GameStop and dogecoin, investors seem to have lost sight of a concept the industry has been fighting to uphold for years. The two landmark cases in this ongoing struggle over what constitutes market manipulation are the CFTC’s enforcement actions against DRW Investments and Kraft Mondelez. In both cases, the industry fought back against the government’s overreach and was vindicated in court.
In the DRW case, the CFTC argued the defendants’ orders for a swap contract were “inherently manipulative” because the defendants “understood and intended that their bids would affect the settlement price” of that contract. As the court summarized, the CFTC’s position was that the defendants “had intent to affect the prices, and because they had intent to affect the prices, that means [the prices] were illegitimate, which means that the prices were artificial.” The court rejected that logic as “circular,” concluding the government’s “theory, which taken to its logical conclusion would effectively bar market participants with open positions from ever making additional bids to pursue future transactions, finds no basis in law.”
In the Kraft case, the CFTC again pursued an expansive theory of manipulation, arguing it had authority to bring claims against manipulative “schemes” regardless of whether those schemes involved fraudulent conduct. At issue in Kraft were orders allegedly intended to drive up the price of wheat futures and drive down the price of cash wheat. The court rejected the government’s manipulation theory as over-broad, reasoning that “[s]uch an interpretation would be unreasonable, as the vast majority of law abiding participants in the commodities market engage in ‘schemes’ of one type or another ... a commodities-based scheme could be something as simple as ‘buy low, sell high,’ trading based on market trend lines, or any other plan for trading aimed at profit making.”
Ultimately, the court found that “an interpretation prohibiting such activity would be absurd, and declines to adopt that reading of the text.”
The key lesson from these cases applies to the GameStop saga: Trading schemes, even ones intended to affect price, should not be considered unlawful as long as they do not involve fraud. The industry has successfully resisted recent attempts by the federal government to pursue more expansive (and incoherent) theories of market manipulation. If investors and institutions continue to play into regulators’ hands, however, years of progress made through costly litigation could be lost.
GameStop deep breath
While traders debate the interaction between the financial markets and social media, they are inadvertently arguing for arbitrary government enforcement to fill the void. We’re not seeing the scrutiny and due care that would usually accompany such regulatory evolution. The industry needs to think carefully about taking a more nuanced approach to addressing the admittedly complicated issues that the GameStop episode poses.
These issues are particularly relevant to the crypto community, where the underlying value of the assets is harder to evaluate and much of the information we have about these assets comes from platforms like Twitter and Reddit. Whatever rules and laws come out of this saga are likely to have a disproportionate impact on crypto and digital currency markets.
Traders and investors on both sides of the GameStop short squeeze should step back and consider what exactly they are arguing for before they try to tear each other down, because if they continue, neither side will be left standing.
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