Tag: hedge funds

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Stopping the Game? Big traders vs. the swarm

Bubbles

Speculation in markets can lead to wild swings in prices as exuberance drives up prices and
pessimism leads to price crashes. When the rise in price exceeds underlying fundamentals, such as profit, the result is a bubble. And bubbles burst.

There have been many examples of bubbles throughout history. One of the most famous is that of tulips in the 17th century. As Box 2.4 in Essential Economics for Business (6th edition) explains:

Between November 1636 and February 1637, there was a 20-fold increase in the price of tulip bulbs, such that a skilled worker’s annual salary would not even cover the price of one bulb. Some were even worth more than a luxury home! But, only three months later, their price had fallen by 99 per cent. Some traders refused to pay the high price and others began to sell their tulips. Prices began falling. This dampened demand (as tulips were seen to be a poor investment) and encouraged more people to sell their tulips. Soon the price was in freefall, with everyone selling. The bubble had burst .

Another example was the South Sea Bubble of 1720. Here, shares in the South Sea Company, given a monopoly by the British government to trade with South America, increased by 900% before collapsing through a lack of trade.

Another, more recent, example is that of Poseidon. This was an Australian nickel mining company which announced in September 1969 that it had discovered a large seam of nickel at Mount Windarra, WA. What followed was a bubble. The share price rose from $0.80 in mid-1969 to a peak of $280 in February 1970 and then crashed to just a few dollars.

Other examples are the Dotcom bubble of the 1990s, the US housing bubble of the mid-2000s and BitCoin, which has seen more than one bubble.

Bubbles always burst eventually. If you buy at a low price and sell at the peak, you can make a lot of money. But many will get their fingers burnt. Those who come late into the market may pay a high price and, if they are slow to sell, can then make a large loss.

GameStop shares – an unlikely candidate for a bubble

The most recent example of a bubble is GameStop. This is a chain of shops in the USA selling games, consoles and other electronic items. During the pandemic it has struggled, as games consumers have turned to online sellers of consoles and online games. It has been forced to close a number of stores. In July 2020, its share price was around $4. With the general recovery in stock markets, this drifted upwards to just under $20 by 12 January 2021.

Then the bubble began.

Hedge fund shorting

Believing that the GameStop shares were now overvalued and likely to fall, many hedge funds started shorting the shares. Shorting (or ‘short selling’) is where investors borrow shares for a fee and immediately sell them on at the current price, agreeing to return them to the lender on a specified day in the near future (the ‘expiration date’). But as the investors have sold the shares they borrowed, they must now buy them at the current price on or before the expiration date so they can return them to the lenders. If the price falls between the two dates, the investors will gain. For example, if you borrow shares and immediately sell them at a current price of £5 and then by the expiration date the price has fallen to $2 and you buy them back at that price to return them to the lender, you make a £3 profit.

But this is a risky strategy. If the price rises between the two dates, investors will lose – as events were to prove.

The swarm of small investors

Enter the ‘armchair investor’. During lockdown, small-scale amateur investing in shares has become a popular activity, with people seeking to make easy gains from the comfort of their own homes. This has been facilitated by online trading platforms such as Robinhood and Trading212. These are easy and cheap, or even free, to use.

What is more, many users of these sites were also collaborating on social media platforms, such as Reddit. They were encouraging each other to buy shares in GameStop and some other companies. In fact, many of these small investors were seeing it as a battle with large-scale institutional investors, such as hedge funds – a David vs. Goliath battle.

With swarms of small investors buying GameStop, its share price surged. From $20 on 12 January, it doubled in price within two days and had reached $77 by 25 January. The frenzy on Reddit then really gathered pace. The share price peaked at $468 early on 28 January. It then fell to $126 less than two hours later, only to rise again to $354 at the beginning of the next day.

Many large investors who had shorted GameStop shares made big losses. Analytics firm Ortex estimated that hedge funds lost a total of $12.5 billion in January. Many small investors, however, who bought early and sold at the peak made huge gains. Other small investors who got the timing wrong made large losses.

And it was not just GameStop. Social media were buzzing with suggestions about buying shares in other poorly performing companies that large-scale institutional investors were shorting. Another target was silver and silver mines. At one point, silver prices rose by more than 10% on 1 February. However, money invested in silver is huge relative to GameStop and hence small investors were unlikely to shift prices by anything like as much as GameStop shares.

Amidst this turmoil, the US Securities and Exchange Commission (SEC) issued a statement on 29 January. It warned that it was working closely with other regulators and the US stock exchange ‘to ensure that regulated entities uphold their obligations to protect investors and to identify and pursue potential wrongdoing’. It remains to be seen, however, what it can do to curb the concerted activities of small investors. Perhaps, only the experience of bubbles bursting and the severe losses that can result will make small investors think twice about backing failing companies. Some Davids may beat Goliath; others will be defeated.

Articles

Data

Questions

  1. Distinguish between stabilising and destabilising speculation.
  2. Use a demand and supply diagram to illustrate destabilising speculation.
  3. Explain how short selling contributed to the financial crisis of 2007/8 (see Box 2.7 in Economics (10th edition) or Box 3.4 in Essentials of Economics (8th edition)).
  4. Why won’t shares such as GameStop go on rising rapidly in price for ever? What limits the rise?
  5. Find out some other shares that have been trending among small investors. Why were these specific shares targeted?
  6. How has quantitative easing impacted on stock markets? What might be the effect of a winding down of QE or even the use of quantitative tightening?
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Haven knows the answer to this taxing question

The UK has always been an attractive place for investment, as foreign companies look to cities such as London for stable investment opportunities. This provides not only jobs and output, but also tax revenue for the government. However, one drawback is the lost tax revenue through tax avoidance schemes and big businesses say that if the UK is to remain competitive it needs to look at cutting taxes and bureaucracy.

In recent months, we have seen cases of individuals being prosecuted for tax evasion and more recently in the USA, Microsoft and Hewlett-Packard have been criticized by the Senate for allegedly moving an estimated £13bn to offshore accounts. (Microsoft and HP deny any wrong-doing). It is cases like this that provide an argument for governments to cut business rates and avoid losing business and jobs to other tax havens. Lord Fink, who is a Director of Firms located in a variety of tax havens said:

’I don’t see why the UK should not compete for jobs that at present are going to the Cayman Islands’

Tax havens are obviously attractive to firms, as they provide a means of retaining more of a firm’s earnings and hence their profits. By offering a much lower rate of tax than countries such as the UK, they help to ease the tax burden on wealthy individuals and investors in hedge funds, along with many others.

The question is, do these lower tax rates discourage investment into the UK and thus would a relaxation of Revenue Customs’ rules mean an increase in inward investment and the other positive things that this would bring? Or would a decrease in tax rates for wealthy investors send the wrong message?

In a time of austerity, tax cuts for the rich are never going to be a popular policy – at least not amongst the ‘non-rich’ – in truth, the majority of the population. Furthermore, many simply see tax havens as morally wrong – or as George Osborne put it ‘morally repugnant’. The use of them provides the better off with a means of paying less to the taxman, whilst the worse off continue to pay their share.

The controversy surrounding tax havens is perhaps even more of an issue given the size of the public-sector deficit. With tax havens being used by those who should be paying the most, tax revenues are lower than would be the case without tax evasion and avoidance. Is this adding to the burden of basic rate tax payers?

This doesn’t help the gap between government expenditure and revenue, which has contributed to the largest amount of UK public-sector borrowing in August 2012 since records began. Net borrowing reached £14.4bn, as things like corporation tax receipts fell and benefit payments rose. Money that should go in to the government’s coffers is undoubtedly making its way into tax havens, but does that also mean that jobs are making their way out of the country? If tax rates in the UK were cut, cities such as London may become even more attractive places to invest, which could potentially create a much needed boost for the economy. But, at what cost? The following articles consider the controversy of tax havens.

Microsoft and HP rapped by US Senate over tax havens BBC News (20/9/12)
Morally repugnant tax avoiders can rest easy under David Cameron Guardian, Tanya Gold (21/9/12)
Britain could prevent the use of tax havens by ending ‘archaic’ business rules Telegraph, Rowena Mason (21/9/12)
UK public-sector borrowing hits record high of £14.4bn BBC News (21/9/12)
The top Tory who wants to make Britain a tax haven for millionaires Guardian, Martin Williams and Rajeev Syal (20/9/12)
Make UK a tax haven to attract investment from millionaires, urges Tory treasurer Mail Online, Daniel Martin (21/9/12)
Microsoft saved billions using Irish tax havens Irish Times, Genevieve Carbery (21/9/12)
Microsoft, HP skirted taxes via offshore units: U.S. Senate Panel Reuters, Kim Dixon (21/9/12)
Danny Alexander says tax avoidance ‘adds 2p in every £1 to basic tax rate’ Independent, Oliver Wright (24/6/12)

Questions

  1. What are the key features of tax havens?
  2. Briefly explain the arguments in favour of tax havens and those against. Think about them from all points of view.
  3. Explain the way in which a cut in UK tax rates could create jobs and how the multiplier effect may provide a boost for the UK economy.
  4. If tax rates were cut, how might this affect an individual’s decision to work? What about an individual’s decision to invest? Use indifference analysis to help explain your answer.
  5. How does tax avoidance and evasion affect public sector borrowing? Is there any way a cut in tax rates on foreign investment could improve the government’s finances?
  6. Do you think there is any truth in the argument that the UK is losing out to other countries because of its higher tax rates? Is a reduction in tax rates necessary to help us compete?