The Game Stop trading scam has brought public attention to the destabilizing relationship between hedge funds and the underlying stocks. Briefly, a hedge trade is a pair of transactions with a specified closing date. The investor can either buy or sell at the current price, and benefits respectively if the price is up or down (respectively) at the future date.
In theory, this is intended to allow corporations to mitigate against price rises in commodities such as grain or steel. They promise to buy the commodity at a price higher than the current market value, but are protected if the price rises beyond that point. That risk is borne by traders who get a guaranteed profit if the price remains stable. In this scenario, hedge funds are a kind of insurance.
The extension of hedge funds to stocks has no inherent economic utility. Such traders are akin to gamblers on sporting events. The possibility for manipulation arises when market-makers are also hedge traders. When a market maker announces a forecast, they reorganize their portfolios to match, in effect making the forecast come true. When hedge traders get involved, the effect of the forecast is amplified. It is exactly this process that caused the 2008 mortgage melt-down.
The solution is already known to us. This was the same phenomenon that almost destroyed the Euro market. Short-sellers were betting against the Italian, Spanish, and Greek currencies. Because the Euro zone required each government to keep its currency in a trading band, they were forced to shore it up, borrowing money that caused the currency to continue to soften. The manipulation stopped when the German government stepped in tactically to shore up the Greek currency, reversing the short-sellers’ positions and wiping them out.
In American investment markets, this was the role meant to be played by the Consumer Financial Protection Bureau – which bought up one of the more sophisticated electronic trading companies during the Obama Administration. Lacking that governance, the RobinHood investors are playing that role. Unfortunately, many of those who piled on are not sophisticated enough to monitor the contracts placed by short-sellers. They will get stuck holding the bag when the price softens.