David, Goliath & Don Quixote

The evolution of language has a strong connection to being able to tell stories. Not so surprisingly, these stories often tend to follow a narrative of conflict or struggle. The listeners are in favour of the party overcoming the agony caused by the struggle and we have our protagonist right there. There is the other party in the same story which is essentially the antecedent of the agony caused and becomes the antagonist. We are suckers for stories where the protagonist is faced with an insurmountable challenge. A story that fits this is the one of David & Goliath. Right on the flipside, we have the story of Don Quixote, a man who thinks he’s fighting demons which in reality are windmills. He is someone who is convinced he’s facing an insurmountable challenge, and therefore his fight is justified.

Nearly everyone is talking about the tussle between a page on Reddit & a Wall Street hedge fund as one of David & Goliath, with Goliath being the Wall Street while the retail “investors” being the manifestation of David. I am of the opinion that this is a quixotic fight. There are several errors of judgment, mostly promulgated based on colloquial beliefs. Anyone who picks up some skin in the game at a bourse doesn’t become an investor, just as much as a cargo train differs from a passenger train. To invest means that assets are being allocated & exchanged with deliberation. Going to school means that the time that could have been spent by doing something else are being allocated to learning & gaining knowledge. If one indulges in the activity of buying & selling on a regular basis, that activity cannot be called investing. It should be called the more appropriate term of trading. A trader looks at the margins of buying & selling to evaluate the merit of the purchase. An investor gets to claim ownership in more ways than just monetary terms. An investment at the heart of it is private property and has to be treated as such. A homeowner is different from the organisations that hold the houses in escrow until the purchase is finished.

The semantics make more sense once we consider the second-order effects of investing & trading. An investor assumes that the business underlying the security is what he/she owns, the trader stops with the security itself. It isn’t a comment at saying that trading is in any manner inferior to investing. What one considers an asset, is what one assigns the telos of the asset in their ratiocination. This distinction is key and has to be given its due importance with the events in consideration.

The activity at the centre of this imbroglio is short-selling. Many definitions of the term have been offered with the legality under the scanner as well. Shorting, as it’s quite ironically shortened to, is a simple activity. But it becomes simple to understand only after one knows what the apriori antecedents are. A security as a financial instrument offers ownership of a business. If one takes the basic accounting equation, it is this.

Assets = Liabilities + Equity

What it means is one could either pay for a certainty of return of the capital or, own the business generating the revenue. The former is a liability, the latter is equity. Multiple forms of liability & equity exist, with their own clauses. These complications are out of the scope of this essay. The existence of credit & lending a la Lombard Street is a debt incurred by the business. It has to be repaid at any cost, and hence is a bet on the certainty of return of the capital. Equity exists when the business is incorporated where ownership is devolved in stocks/shares. Each share is a part ownership of the business itself. When these stocks/shares or the debt instruments are linked to the activity of buying & selling, a capital market is formed. In this particular scenario, the stocks are the ones under the scrutiny. A business can sell its own stock; but the burgeoning of businesses since the industrial economy, it led to the creation of specialists who only deal in selling the shares/stocks. They don’t own the stocks, but merely take custody of the sale. In other words, they are brokers for stocks, now more commonly known as stockbrokers. The second order effect of brokerage firms proliferating leads to the institutionalization of another entity known as a clearing house. Someone has got to keep track of the transactions happening every second.

Every transaction has four steps –

1. The item of transaction is disclosed by the seller to the buyer.
2. The buyer & seller agree at a price of exchange between money & the item of transaction.
3. The buyer pays seller the agreed price.
4. The seller settles the transaction in case of any difference of payments.

If millions of participants exist in a market, millions of transactions happen. Price remains volatile for the same reason. In the time between the transaction to buy a stock gets initiated to the settlement, the price may change. The buyer & the seller have agreed, and therefore a higher number cannot be quoted. A clearing house exists for the same reason. A brokerage holds a trading margin per user of their services to make things more efficient. Instead of having to call a broker for every decision, a margin incentivises a go-no-go structure for selling or buying.

In a short sale, a participant in the market borrows securities from the margin of their broker. These stocks are sold in anticipation that the stock price falls further, and before the stocks are to be cleared at the clearing house, the sold stock should be replenished. After all, the broker lent stock. Pocketing this difference is a short sale. Such activity largely falls under speculation. One might argue that this is a bet against a business, as if one were wishing it to end. It might appear so, but a stock price falling or rising has little to do with the business activity in a given day’s period. It is purely a function on how buying and selling balances out. When there are more buyers than sellers, price moves up and moves down when the sellers outnumber the buyers. Pocketing the difference of such an arbitrary activity is not an easy thing to do and is definitely not worthy of being called a criminal activity. If a business is truly failing, short selling as a strategy makes no sense. In such a case, a derivative contract based on the failure of the business meeting its liabilities holds far greater value. A short position against a business, in other words.

Onto the matter at hand, to see commentators arrogate the halting of trade to suspension of free speech and an oligarchy of tech platforms is simply appalling. It is a comment befitting naïve minds that cannot see beyond the existing situation. A behavioural economist might figure out that this is the availability heuristic of the mind; a clear lack of an ability to process the second order effects or anything external to the situation. Unlike many times before, the situation involving the reddit page is almost as pure an economic bubble as it can get. The price of the stocks went up purely because of how much they traded, with no connection to the underlying business. To put it crudely, a market of fools trying to find a greater fool to sell to. The efforts of these “investors”, or more accurately, traders, is being lauded as an uprising a la the proverbial David & Goliath story. David is trying to bring Goliath down by buying stocks that Melvin Capital, a hedge fund Goliath in this story, had shorted.

As a spectator, it appears more closely to be pure tribal rage, where a group of people sharing the agony find unity in their pain. It is tribal because the individuals have subjugated themselves to the collective and are mere representatives of the collective effort. These wolves are hunting as a pack now. In the effort to run a hedge fund down, a bubble is being engineered into existence. Much like the South Sea company of 1720, which led to the coining of the word and the concept of “Bubble”, the stocks being advertised by the reddit page are going to end up where they started. However, tribal rage rarely forgives. One shouldn’t be surprised to see that this will end up affecting them in ways never foreseen. In the 2008 crisis, 401Ks of the employed class got reduced to nothing. Speculation in bubbles always ends unfavourably. Eventually the value will be inescapable from and selling will overtake buying.

The higher order effects of bubbles are always more disastrous than the bubbles themselves. Money has been exchanged to acquire assets that had no value in the first place. Overpaying for an obnoxiously high value would mean that money was lost in transactions. Wealth can grow infinitely. Money cannot do that, unfortunately. Money works on multiplier effects. Overpaying is a way of describing irrational exuberance, the stage in a cycle of Mania, Panic & Crash.

Right now, the whole of the story is in the mania stage. Everyone is rooting for David to win against Goliath. Not to be a downer but in this version of the story, David & Goliath are entangled. If Goliath falls, so shall David & vice versa. To wish for the destruction of a hedge fund is to wish for the eventual destruction that follows. If Melvin Capital made a bad bet and lost, that would’ve been a totally insignificant outcome in the larger scheme of things. With the prices being pushed up artificially, the margin requirements to hold the trade would mean that the trading platforms would have to borrow to comply with regulatory requirements. Never did excessive borrowing end well, even for bankers. Credit cycles & business cycles intertwine to swing from extreme to another extreme. When this happens due to millions of transactions, like millions of atoms colliding, the change is slow.

The reddit page is doing nothing less criminal than insider trading – except they are a group of discrete users acting as one. In the name of cosmic justice and to restore the tenets of free trade, idiocy is being distributed like a subsidised good. If someone truly perceives value in this act of trade, they should hold their position and not be bothered by the fact that buying has been halted. The stock prices moved up faster than anything imaginable, and it is rational to see that there’s unusual activity. For a trading platform, unusual activity is good enough reason to halt the trade as it is in the larger interest of maintaining the ideals of free trade. What is being requested here isn’t free trade; rather, it’s unabashed laissez-faire markets where the swing from extreme to extreme is never desirable. In such situations, the swing is from anarchy to totalitarianism and not limited to the market moving from one point to another. The fight moves from who controls the market to no control. Such a system isn’t conducive to generating or creating wealth. Both the extremes would be where individuals have to fear acquiring property out of fear from who might claim authority.

Private property & wealth grow in a society where there’s an incentive to acquire wealth. To constantly be on guard, either against the fellow man or the government, is a situation where there is no incentive to acquire wealth. This bubble will leave us wondering why humans ever pursued wealth. The only hope is that this question doesn’t remain a rhetorical one, and where we realise that the driver of human advancement has always been the pursuit of wealth.