Credit: © rblfmr, Shutterstock

Amateur stock investors raised an uproar on Thursday, January 28, when several investment services temporarily restricted stock transactions related to the video game retailer GameStop. What was going on with GameStop, and why was everyone so upset?

It helps to know about an investment strategy called “shorting.” The stock market is very complicated, so let’s try to keep things as simple as possible. “Shorting” is something investors can do when they expect a stock to go down in price. Basically, the investors borrow shares of the stock and sell them at the current price. Once the price goes down, the investors buy the stock back and return it. By selling a stock at a relatively high price and buying it back at a cheaper price, the investors make a profit.

But, you might ask, what happens if the stock price goes up? You guessed it, investors who shorted the stock have to buy it back at a higher price, taking a loss. This possibility makes shorting a stock a risky investment strategy, and investors can get stuck with disastrous losses. This is pretty much what happened with GameStop.

GameStop’s business was not looking good, so adventurous investment partnerships called hedge funds began shorting the company’s stock. At the same time, many amateur investors started investing in GameStop, driving up the stock price.

Some amateur investors probably bought Gamestop stock in the hopes that it was a good investment. Others may have hopped on the bandwagon, hoping to make some money as the stock price rose. At least some investors worked together in an effort to intentionally drive up GameStop prices, making cash and inflicting huge losses on the hedge funds. The technique of intentionally driving up prices to inflict losses on investors who have shorted a stock is called a “squeeze.”

The squeeze in this case was put on by legions of amateur investors coordinating through online social media platforms, including the forum Wall Street Bets on the service Reddit. The investors made their trades using such online services as E-Trade and the app Robinhood. At least one hedge fund suffered devastating losses.

Many small investors cheered the GameStop squeeze as a victory for amateurs over traditional Wall Street powerhouses. The urge to inflict losses on the hedge funds may have been fueled in part by the COVID-19 pandemic. Many small investors seemed angry that large companies and investors had made huge profits during the pandemic, even as millions of individuals lost their jobs.

GameStop is not the only stock that has been used in this way. More traditional investors worry that such trading strategies artificially inflate the value of stocks such as GameStop, creating “bubbles” that can lead prices to tumble when they pop. They also worry that large investors could sell off other stocks to cover their losses, driving down the market as a whole.

Nasdaq announced this week that it would begin using a type of electronic ledger pioneered by Bitcoin, a popular and somewhat infamous digital currency. The technology is being tested on Nasdaq’s new and relatively limited Private Market, and does not actually use bitcoins as currency. Instead, Nasdaq will replicate Bitcoin’s underlying technological structure to keep track of its marketplace transactions.

Nasdaq is experimenting with a type of electronic transaction system
pioneered by Bitcoin. If successful, the system might eventually be used
for stock trading. Credit: © Matej Kastelic, Shutterstock

As a currency, Bitcoin is controversial. Its supporters promote Bitcoin as a liberating alternative to government-printed money, but its detractors note the currency’s instability and rampant use by criminals. However, even some of Bitcoin’s critics have recognized the potential of the currency’s robust technological foundation.

A bitcoin has value because it is linked to computer files called blocks. Taken together, all the blocks form a long, public record, called a blockchain. The blockchain, distributed over the Internet, forms the backbone of the Bitcoin system. All Bitcoin users have access to the blockchain, which is updated constantly with every bitcoin transaction. The blockchain is also encrypted, so that only proper transactions can interact with its ledger.

Nasdaq is betting that the idea of blockchain-based transactions will make its new marketplace more secure and easier to use. The Nasdaq Private Market facilitates trade between private companies before their initial public offerings. Such companies often handle such transactions “by hand,” by typing information into spreadsheets and other informal systems. Using blockchains, in contrast, would make transactions work automatically. The distributed nature of blockchains could also eliminate bottlenecks and middlemen from the transaction process. If the Private Market blockchain test works well, Nasdaq may eventually use blockchains on its much larger stock market.

Other World Book articles:

• Stock exchange

October 14, 2013

The Royal Swedish Academy of Sciences announced today the winners of the Nobel prize for economics—Americans Eugene Fama, Lars Peter Hansen, and Robert Shiller. The men were awarded the prize for developing methods for studying how prices for assets are arrived at, including stocks and houses.

Eugene Fama, of the University of Chicago, is famous for his “efficient markets hypothesis.” In Fama’s view, markets are good at incorporating new information into the prices of an asset, such as stocks and bonds. Because of this efficiency in markets, Fama believes investors have little opportunity to effectively pick stocks in which to invest and would do better simply investing in a mututal fund based upon a stock index—for example, the Standard & Poor’s 500, which is an index of the stocks of 500 large companies trading on the New York Stock Exchange.

In some ways, Robert Shiller, of Yale University, takes somewhat of the opposite view to that of Fama. Shiller belongs to the school of behavioral economics that studies human psychology and decision making and its effects on economics and finance. Shiller believes markets are not always efficient or rational and that assets can be mispriced for lengthy periods of time. In his book Irrational Exuberance (2000), Schiller claimed that stocks were in a bubble (priced too high) based on enthusiasm for dot-com businesses. Soon after, the stock market fell precipitously. Shiller also predicted in the mid-2000′s that the housing market was in an irrational bubble. Steeply falling housing prices were one piece of the Great Recession that began in 2007 and continued into 2009.

Lars Peter Hansen, also of the University of Chicago, created statistical methods to understand what drives the volatile and irrational prices for assets. His work determined that prices are sometimes linked to how much risk people are willing to accept, rather than on such real-world events as profits and rents. During good times, people are less averse to risk; in bad times, they are far more cautious.

Additional World Book articles:

• Economic Crisis: The Banking Meltdown (a special report)
•  Economic Crisis: The Government Steps In (a special report)