Why we should worry about trading frenzies

Itay Goldstein

Trading frenzies — marked surges in trading where investors all rush to trade an asset in the same direction — have rattled financial markets in recent weeks. Frenzied buying of GameStop stock is by far the most talked-about example, even appearing in international news. However, despite the spotlight on GameStop, it was not alone, and other stocks exhibited closely related patterns.

Cause for concern

Public discussions focus on the resulting volatility in prices, which implies that a lot of money is changing hands, with some traders suffering big losses. This is true, of course, but it is not the main reason for concern — the nature of financial markets is that some traders win and others lose, and traders need to be prepared for that when taking on risky trades.

What is more concerning is what trading frenzies might do to capital allocation in the real economy. Capital allocation is the main function of financial markets, and the ability of the market to channel resources efficiently is its ultimate measure of success. Markets affect capital allocation through various channels. We can broadly talk about a ‘primary market’ channel, where firms raise capital directly in the market, and a ‘secondary market’ channel, where market prices act as signals that guide decisions by stakeholders in the real economy. For both channels, market prices play a critical role in assuring that capital goes where it should and that the right investments are being made.

Silver lining

Recent events have demonstrated that trading frenzies can have a fast feedback effect on the real economy, potentially endangering the capital allocation process. As stock prices were rising above their fundamental values, firms were able to benefit and raise cheap capital.

A striking example is AMC Entertainment, which actively raised new capital based on the attractive prices that seemed to have no relation to economic fundamentals. This move by AMC was critical for its survival and helped it avoid bankruptcy. Another, less dramatic example, is American Airlines, who also benefited from the boost in stock prices to raise money under favourable terms.

While there is something uplifting in seeing a firm escaping bankruptcy thanks to the work of traders coordinated through a Reddit trading forum, we have to be wary of such episodes. There is a lot to consider when thinking about the implications for the way financial markets operate and their impact on the real economy.

Warning bells

First, imagine the opposite scenario: speculators coordinate on short-selling a stock, sending its price on a nosedive, depriving the firm of capital and hurting its business. For years, corporate managers expressed concerns about this possibility, fearing bear raids led by herds of short sellers, and calling for tighter restrictions on short sales. The kind of coordination that sent stocks upwards can just as as easily trigger this kind of avalanche.

Second, it is important to understand the dynamics behind a trading frenzy. Usually, market forces tend to keep things in balance — as more people buy the stock, its price increases, and this makes it more attractive for other people to sell. Similarly, increased selling pushes prices down and encourages others to buy. So, frenzies come to life only in particular circumstances. It turns out that the feedback effect from the stock price to firms’ access to capital and investment can be key in providing fuel to the trading frenzy in the first place.

When a higher stock price improves the firm’s financial standing, this justifies the increase in stock price, and so gives speculators an extra benefit to join in. Similar dynamics would happen on the downside in a short-selling frenzy. So, there is a dangerous reinforcing feedback loop between the market price and the firm’s ability to raise capital, which can be very destabilising.

Third, while occasionally a trading frenzy may help a firm overcome inefficiency in its access to capital and investment, for example by avoiding an inefficient bankruptcy process, we cannot trust the dynamics behind a frenzy to push in the direction of efficiency. What motivates traders in a frenzy is very different from the efficiency of capital allocation. For the market to help in capital allocation, prices ought to be informative. Trading frenzies by their very nature push prices away from being informative.

So, recent events, exposing a new opening for frenzies to form, should alarm regulators and market participants, and call for a thorough review of market practices. As frenzies were triggered by coordination on an internet forum and facilitated by the increased swiftness with which trading can happen on online trading platforms, it would be important to inspect these practices and ask whether adjustments are needed. While open communication online and easy access to the market are goals to aspire to, the credibility of financial markets in the capital allocation process should not be endangered.

Itay Goldstein is professor of finance at the Wharton School of the University of Pennsylvania.