Last July, Citadel announced retail had accounted for 25% of the US stock market’s activity during the pandemic, up from just 10% the year before. On the FX front, GAIN Capital announced volumes in June that were up 60% year-over-year.
To some, this is just the natural result of increased volatility, attracting more traders to play the swings. To others, we’re seeing the emergence of the long-awaited new generation of retail trader. While both are correct in their own ways, these explanations fail to account for how the unprecedented events of the past few years have also created the conditions for retail money to have a far larger say in markets. If this is so, it’s a crucial moment for brokerages flush with 2020’s gains, to upgrade, evolve, and emerge as leaders in the new normal.
YOLO in a time of Covid
We’re now 10 months removed from the Covid-crash that saw asset prices tanking in unison. US equities tumbled 35%, crude oil futures briefly went negative, even the supposedly uncorrelated crypto market experienced its biggest drawdown since the crash of 2018. Beyond the financial consequences, the pandemic turned the world upside down and changed the manner in which we do almost everything.
You’ll recall that retail traders were touted as early catalysts of the “recovery trade.” These were the foolhardy speculators signing up for zero commission accounts from their smartphones. They deposited their student loans and stimulus cheques en masse, and started scooping up shares in decimated companies like Hertz, J.C Penny and Carnival. Companies that had zero chance to perform on fundamentals in a world locked down. Or perennially shorted stocks like Blackberry, well past their prime and with their all-time highs more than a decade behind them. These retail traders led a broader recovery that surpassed the market highs pre-Covid, and has gone on to incredible excesses. More on these below.
The Underestimation of the retail trader, in two headlines
On July 9, 2020, Business Insider published an article, quoted above, titled Retail traders make up nearly 25% of the stock market following COVID-driven volatility, Citadel Securities says. It discussed the boost in volumes by retail traders, but painted them as being along for the ride, taking advantage of zero commissions and a Federal Reserve backstopping risk assets to speculate during a pandemic when there’s not much else happening.
The article quotes from a recent Bloomberg interview with Joe Mecane, Head of Execution Services at Citadel Securities, who outlines retail’s increasing interest in trading options, while confirming that their influence in markets is growing, but not enough to “drive valuation or market levels.”
Cut to article 2, again from Business Insider, six months later, on January 26, 2021. GameStop short-seller down 30% this year gets $2.8 billion bailout from the firms of billionaire investors Steve Cohen and Ken Griffin. The firms in question are none other than Point 72 and Citadel, which are now bailing out a fellow hedge fund (Melvin Capital Management) that’s been brought to its knees by a retail-led short squeeze in one of those aforementioned heavily shorted stocks. To make things even juicier, Citadel was one of the market makers that caused the stock to shoot up through its own hedging activities.
The instrument of choice for this retail-led crowd attack was the very options Joe Mecane was referencing in the July 9 article. By purchasing wildly out-of-the-money call options on GameStop stock, these retail traders initiated a “gamma squeeze,” in which the market maker had to hedge by purchasing the underlying stock. This, in turn, drove up the price, putting existing short positions under water, the owners of which were also forced to purchase the stock in order to cover their shorts or to close them entirely (which sent the stock even higher).
To put it all into context, GameStop stock is currently up around 700% over the past 10 days. It’s up around 1800% since the New Year and around 14,000% since last April’s lows. At the time of writing, the ability to buy the stock has been halted by some brokerages citing clearing problems. It’s even been rumoured that the White House has had to have a word. Still think retail doesn’t move markets?
So, in six months, retail money went from being a mildly interesting phenomenon, to a systemic threat for hedge funds on the other side of its trades. It came down to a perfect combination of factors. A fearful populace locked down and robbed of their routine engagements, an investment landscape dominated by passive indexation strategies, unprecedented monetary and fiscal stimulus, democratised access to markets through zero commission brokerage apps, and the growth of Internet forums like the infamous WallStreetBets subreddit.
It’s been a long time coming
This isn’t the first time retail money has made its presence felt in global markets. In the early 2000s there was talk of Mrs Watanabe, the quintessential Japanese matriarch who headed out onto FX markets with the family savings, seeking higher yields in foreign currencies than the terminally depressed yen could provide.
Then, a decade or so later, there was the emergence of bitcoin and the subsequent crypto trading boom, another retail-led phenomenon. Not only did it switch on a completely new generation of traders, it also created generational wealth from scratch. New markets, new money, all retail.
The young traders buying up a beleaguered stock like GameStop, aren’t doing so because they truly believe it can justify a valuation that’s hundreds of times earnings. They’ve grown up in a topsy-turvy world punctuated by one crisis after another. Where money is conjured up out of thin air in staggering quantities but never seems to find its way into their hands. Where they’re guaranteed to have a lower standard of living than their parents. Finally, at the height of yet another crisis that has detrimentally affected both their immediate and future prospects, they found a glaring instance of Wall Street’s excesses (being short more than 100% of a stock’s available shares), and banded together to exploit it.
How to turn your Mustang into a Tesla
This leaves brokers with something of a high quality problem. The new generation you’ve been waiting for is here. It is larger in number, younger, better capitalised, better coordinated, and more savvy than anyone could have predicted. Moreover, as we’ve seen above, it plays by different rules. Saddled with a generational sense of nothing-to-lose, this group is far more tolerant of risk than many in the industry have fully appreciated. Forget the Generation Xers and elder Millennials that you’re used to. This crowd earns bragging rights for how insanely risky its plays are, and legendary status among its peers for how catastrophic its losses. The YOLO trade, where one goes all-in with the entirety of one’s capital, is more often the rule than the exception.
Execution and Risk Management tech
The modern brokerage, at a bare minimum, requires flexible order routing and execution capabilities where order flow can be dynamically segmented and distributed among A/B/C-groups per asset, client, trading session and more. Coupled with robust stress-testing of systems to allow for significant headroom in turbulent times, these steps can build resilience in a climate where Black Swans are becoming all-too commonplace for comfort.
In the past year, it’s been US stock brokers that have borne the brunt of what this new trader can do, but there’s nothing preventing coordinated action in currency markets, or precious metals CFDs. There are already rumours of a retail-led short squeeze in silver markets. Many legacy brokerage systems take for granted that 15 years ago, traders couldn’t hope to communicate and reach consensus rapidly enough to pose a significant risk. Now they can, and so a data-driven response is necessary to spot trends developing from a distance. At the time of writing, the WallStreetBets subreddit has grown to 7.3 million members. The combined buying power of just a fraction of this community is difficult to overlook, especially when it can be directed all in one place.
Automated On-Boarding and Customer Service
Volatility brings more eyes to markets, leading to surges in registrations, which leaves brokers as overwhelmed at the front door, as they are in back office and dealing. Reinvesting a portion of 2020’s profits in an AI virtual assistant, will allow these businesses to field incoming queries, prioritise traffic, maximise conversions, handle KYC/AML, and gather data all at once. This will free up support teams to offer their highest priority clients more of a personal touch. If 2020 taught us anything, it’s that we can rapidly find ourselves in an exclusively online reality on the turn of a penny. Savings from in-person marketing endeavours that weren’t feasible in 2020, are well-invested shoring up how brokerages handle incoming online traffic when it multiplies in a short period of time. These are the market environments that allow businesses that can efficiently scale up to really shine.
Last but not least, the data. With comprehensive positioning data on the back-end, coupled with granular customer behaviour data on the front end, brokers can start developing sophisticated alert systems and response scenarios to market events like the ones we’re witnessing. These can then be back-tested over historical data to find weaknesses. Only through this kind of iterated resilience-building can brokerages hope to meet the complexities and hidden risks of modern markets head on. Both FX and stock brokers are currently sitting on a ton of unused data. Those that are best able to consolidate these data and use them to strengthen their risk management capabilities while also being able to market their services to customers in a more automated and targeted way, will have a clear competitive advantage in the years to come.
The long-awaited next generation of retail trader is here. You promised them democratised access and a level playing field. You paved the way for their arrival with seamless mobile trading, low spreads, and no fees. Now they’re flexing their muscles. For some brokers, this will quickly turn into a “be careful what you wish for” moment. For others it will be an opportunity to grow into the space and truly level-up in a world where retail continues to exert a greater influence.