Understanding Meme Economyby@gcuofano
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Understanding Meme Economy

by Gennaro CuofanoJune 19th, 2021
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A Reddit community turned against hedge funds who were short-selling (betting on the downside) a few brick and mortar stocks. Redditors took over GameStop by making its price shoot over $400 per share, thus “squeezing” hedge funds like Melvin Capital, who had massive short bets on the company. In turn, one of the primary platform used by Redditors, Robinhood restricted the trades on Game Stop, de facto making it harder for those retail investors to squeeze further hedge funds involved in the trade. Robinhood is an app that helps to invest in stocks, ETFs, options, and cryptocurrencies.

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It was the beginning of 2021 when a group of private investors through a Reddit community called WallStreetBets turned against multi-billion dollar hedge funds who were short-selling (betting on the downside) a few brick and mortar stocks. 

The symbol of this “digital revolution” started with GameStop. As the community-driven trade was unraveling, traditional investing wasn’t looking at it with a good eye.

In a few words, starting from the WallStreetBets board, private investors all agreed to buy GameStop on what they later called a “diamond hand” (those private investors were ready to hold their position even though that meant losing all the money). 

They started from GameStop, which was rumored to be shorted by large hedge funds taking advantage of how the pandemic affected the business. 

In a few days, some of these hedge funds, who until now were the market makers, had to close their own positions, burning billions of dollars of their portfolio. 

As the trade further unraveled and the loss for these hedge funds widened, platforms like Robinhood restricted trades on the GameStop stocks, claiming liquidity issues. From there, meme investments also helped expose the conflict of interests existing in the business models of some of the stock brokerage firms.

How do stockbrokers make their money?

This situation opened up discussions on whether platforms like Robinhood making money on fees coming from these same Wall Street institutions – to sell the retail investors trades are legitimate, what’s known as “payment for order flow.”

*A quick side note on how payments for order flow or “PFOF” work: apps like Robinhood or other stock brokerage firms make money by selling trades of their customers. In short, a market is made when ask and bid offers are fulfilled. Indeed that is what provides liquidity to the market. Therefore brokerage firms that like Robinhood pass along their customers’ trades to other market makers are compensated on top of the spread between the bid and ask price with a fee for each trade as a “market maker fee” (the largest market maker for options in the US is called Citadel Securities – owned by Citadel LLC, which during the short squeeze from Redditors bailed out the hedge fund Melvin Capital).

Robinhood is an app that helps to invest in stocks, ETFs, options, and cryptocurrencies, all commission-free. Robinhood earns money by offering: Robinhood Gold, a margin trading service, which starts at $6 a month, it earns interest from customer cash and stocks and rebates from market makers and trading venues.

So to recap, Redditors took over Game Stop by making its price shoot over $400 per share, thus “squeezing” hedge funds like Melvin Capital, who had massive short bets on the company (thus creating a lack of liquidity as those short-sales determined millions of losses for the hedge fund).

In turn, one of the primary platform used by those Redditors, Robinhood (which claimed mission is “to democratize finance”) restricted the trades on Game Stop, de facto making it harder for those retail investors to squeeze further hedge funds involved in the trade. At the same time, Robinhood claimed liquidity issues as the reason for restricting these trades.

Redditors also questioned Robinhood’s mission to democratize investing. When faced with the dilemma, Robinhood favored market makers rather than retail investors.

Thus, while we can believe that the high volatility created a difficult situation for Robinhood to handle, we can also leave it open here whether it still makes sense for a company that stands on democratizing investing, to have among its largest clients a market maker, which can retaliate the platform against retail investors in these scenarios.

Therefore, even though this is a legal practice, is it still legitimate?

The role of Reddit and Twitter

While it fits a narrative to give the birth of the meme investing phenomenon to a single event, this “digital revolution” has been building up for decades, and even though the web has become much more centralized starting in the 2010s, the crowd’s potential is still a built-in feature of the Internet. 

The pandemic has just amplified something that started over two decades ago, for better or worse. At the same time, many talks about speculations, bubbles, and excess (no doubt we’ll remember this period also for some of these things). 

Indeed, already months before through the Reddit group was pushing for a rise of Game Stop as a digital revolt against hedge funds.

How did this phenomenon develop?

While traditional investing moves along the lines of traditional media (be it TV, Radio, or also online publications with a top-down approach), meme investing instead has developed as a result of “user-generated” investment strategies. The platforms to communicate have been Reddit and Twitter:

Reddit is a social news and discussion website that also rates web content. The platform was created in 2005 after founders Alexis Ohanian and Steve Huffman met venture capitalist Paul Graham and pitched the company as the “front page of the internet.” Reddit makes money primarily via advertising. It also offers premium membership plans.

The most incredible thing about Reddit is that it managed to be a popular platform for user-generated content for a decade. And indeed, those who have tried to build user-generated platforms over the years know how a feat that is.

As angel investor Paul Graham has highlighted about Hacker News:

In short, among the ventures, he had built over the years, Hacker News, the social news website launched in 2007 by startup-incubator Y Combinator, turned out to be the most difficult product.

On the other hand, Twitter has been renamed by many as “Crypto Twitter” as in 2020, going forward, it became the primary platform for those interested in crypto investing. Crypto investing would become unbeknownst to many the next major platform for meme investments, with the rise of Doge.

Dogecoin’s conception was in 2013 as a satire on the flourishing altcoin sector. No one expected that the small community built around a coin inscribed with the famous Shiba Inu “doge” meme would grow as it did. Presently, eight years later, the satirical comment of a coin has and is still pumping in value, aggressively thriving in the ever-competitive altcoin world. And things only got even more interesting when Elon Musk started to tweet more and more frequently about that.

To understand how this was unexpected, also smart people like venture capitalist Fred Wilson highlighted:

I remember when a friend of mine told me five or six years ago that he had bought some Dogecoin. I thought “what is he doing?” and dismissed it as something silly and or crazy.

How did that happen? In part, through the PR stunts of Elon Musk, also renamed the “King of Doge.”

What made things even more interesting is that something that started as a joke became sort of serious.

In fact, as a quick timeline:

  • Elon Musk had announced that Tesla would start accepting payments in Bitcoin, and at the same time to enable that, back in February 2021, it had bought $1.5 billion worth of Bitcoins. 
  • Over the months, Elon Musk had tweeted more and more frequently about Bitcoin first; then, he started to tweet about crypto meme coins (Dogecoin), gathering more and more interest around the coin that was born as a joke. 
  • By May 2021, Elon Musk suddenly came out with a statement announcing that Tesla would not accept Bitcoin payments anymore due to the high coal energy consumption due to the Bitcoin mining process. 
  • That opened Pandora’s box that also showed the fanaticism around the Bitcoin community. At the same time, Elon Musk announced that he would be working with the Doge developer’s community instead of making the former meme coin a potential medium to purchase Tesla in the future.
  • As the debate got heated, though, some fundamental points came up about the evolution of Bitcoin’s blockchain. 

And as the discussion around the inefficiency and electric consumption of Bitcoin, Elon Musk turned to Doge even more:

This proved to be an incredible meme machine that turned a joke into an over $50 billion market cap protocol at its peak!

Understanding meme stocks

Image Source: reddit

Giving a precise definition of a meme stock is difficult. But in general, a meme stock has seen an increase in volume because of social media hype and not superior company performance. Or at least an investment opportunity that a crowd of people across the various social communities find appealing for some reason.

Indeed in the case of GameStop, various reasons drove the hype. First, from a brand that has been iconic for many years, hit further by the pandemic. To the fact, that was easier to take over as shorter in liquidity. And the fact yet that given the many short-selling bets placed on the order, a quick uptake would have liquidated those short bets, thus driving a further increase of the price.

In the case of Dogecoin instead, the primary reasons behind the meme take over stood in entertainment, speculation, a new “asset class,” and a life-changing opportunity for many young people to become rich quickly.

Fuelled by hype, and while in a highly liquid market, these stocks become overvalued in a short period of time and experience rapid share price appreciation. They also tend to depreciate just as quickly as the hype dies down and investors look for the next opportunity. Since the share price is not based on company fundamentals, meme stocks are highly volatile.

Meme stocks are becoming increasingly relevant because of the rising popularity of retail investing. For one, services like Robinhood have made it very easy for the average investor to purchase securities in general. Significant stimulus money in the wake of the COVID-19 pandemic has also been invested in the stock market as retail players seek to maximize their returns.

As we saw, most meme stocks are born on social media sites such as Twitter and Reddit.

To describe how a meme stock is formed, consider the following steps which echo a similar mechanism for the uptake of a new product or technology by consumers.

Early adopter phase

Initially, a small number of investors believe a particular stock is undervalued and purchase it in large quantities.

As a result, the share price gradually begins to increase.

Middle phase

The increase in volume is noticed by observant investors who buy-in and cause the share price to appreciate more significantly. Through the virality of social media, more and more investors join the party, so to speak.

FOMO phase

In the FOMO phase, the stock becomes a meme stock as it gains traction across multiple social media channels or forums. Less savvy investors purchase shares in the meme stock for no other reason than a fear of missing out on potential gains.

Profit-taking phase

At some point, the early adopters sell part or all of their holding and take profit.

This sets off a chain reaction causing more investors to sell and lock in profits as the share price begins to decrease. 

New buyers in the profit-taking phase become bag holders. In other words, they have left holding shares in the now worthless stock and will incur large losses once they sell.

Examples of meme stocks

Here are some of the more notable meme stocks in recent times:

  • GameStop (GME) – when Reddit investors noted that GameStop was heavily shorted by hedge funds, they began mass purchasing the stock causing the price to increase by hundreds of dollars in a matter of days.
  • AMC Entertainment (AMC) – after the GameStop short squeeze died down, investors turned their attention toward a similarly shorted stock in AMC. The share price peaked at $63.97, representing a 570% increase in value.
  • BlackBerry (BB) – Canadian enterprise and security software company BlackBerry was also targeted. Before the meme stocks boom, the share price was around $9 – but this more than tripled to a 52-week high of $28.77 in January 2021.

Will 'meme investing' become an accepted investment style?

As Fred Wilson from AVC has noted:

Memes are fun and memes are also something to come together around. Speculating on the popularity of memes and their staying power is no different than any other form of speculation.But more than that, and this is where my head has been going on this topic, the market caps of these memes are also economically powerful. If the board and management teams of the companies with meme stocks choose to issue more shares at these prices, they can raise a lot of capital to transform these companies. Similar opportunities could exist with meme tokens. AMC recently did this with their “meme stock.”I’ve decided that I am going to stop ignoring and dismissing meme investing and start trying to understand it better. I think it is not something that is going away anytime soon and may turn into something even more interesting.

So while meme investing might have become popular in recent times, thanks also to the speculative bubbles formed in the market, there are some fundamental reasons to believe this phenomenon might survive and some aspects that make it worth analyzing:

  1. Retail investors now have platforms that can be used to generate short-term buzz, thus acting as a sort of “liquidity pumps” toward assets that might be, for some reason, undervalued by main players on Wall Street.
  2. Investing in memes might actually help some companies turn around beyond what Wall Street thinks of them and give them a chance. So as a form of crowd-investing where capital can be allocated to restructure an organization.
  3. They can also be used to involve younger generations in the decision-making process that determines the future of organizations that will lead the economic establishment.
  4. At the same time, such investments can be deceiving and leave unprepared retail investors holding the “bag,” thus never recovering their losses.
  5. The question whether the current pay-for-order flow model is still legitimate.

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