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How the stock market works has changed significantly in the last 20 years.

Hosts
Aaron Ross Powell
Director and Editor
Trevor Burrus
Research Fellow, Constitutional Studies
Guests

A credit market professional who goes by “Silent Cal” on Twitter, he’s worked on the sell‐​side and buy‐​side of Wall Street for 20 years.

Shownotes:

A stock market professional joins the show to discuss how investors and hedge fund managers work differently. In recent stock market news, we had a front seat to witness the short‐​selling of small companies, like Gamestop. We discuss why short‐​selling happens and how technology has changed accessibility to the stock market.

What is a stock? What is a corporation? What is a hedge fund? How has the stock market changed in the last 30 years?

Further Reading:

Transcript

[music]

0:00:07.3 Aaron Powell: Welcome to Free Thoughts. I’m Aaron Powell.

0:00:09.4 Trevor Burrus: And I’m Trevor Burrus.

0:00:11.2 Aaron Powell: Our guest today goes by Silent Cal on Twitter. He’s a credit market professional who has worked on the sell side and buy side of Wall Street for 20 years. Welcome to Free Thoughts.

0:00:21.1 Silent Cal: Thanks, Aaron, pleasure to be here, long‐​time listener, and I’ve enjoyed conversations with you guys over the years.

0:00:28.1 Aaron Powell: What’s a stock?

0:00:30.7 Silent Cal: What is a stock? Very foundational question. So we’ll start with what’s a corporation. So corporations in the United States are state law creations, where people come together by contract and say, we want to form a corporation, and the way they own that corporation is through stock and it represents an ownership interest in the corporation, which in our country is a state law entity.

0:00:54.2 Aaron Powell: And so when I buy a stock, I’m not buying it necessarily because I want to participate in the management decisions of this company, especially if I’m buying something like an index fund, or I’m owning hundreds of thousands of stocks. So what is the value to me of an investor when I buy this thing, what makes it valuable and worth spending my money on?

0:01:16.1 Silent Cal: Right. So just to clarify there, you’re talking about a public stock now, now you’re talking about a publicly‐​owned stock. So to be clear, you asked what a stock is, and a stock covers a whole host of things, of which one type is a public stock. So that’s maybe something just to clarify right off the top. But it’s important to understand that from a legal perspective, before we get into all the rules around public stocks, my parents ran pizza places, they had stock, they created it as an S corporation and they own stock in the pizza place, that’s how they legally own the pizza place.

0:01:50.4 Silent Cal: You can organize things as partnerships, whether something’s a corporation for tax or for legal is different in our country, you can form a partnership, have it taxed as a corporation, and you can form an LLC, which is a type of corporation and have it taxed as a partnership. So we start with what stock is, it’s ownership in some business or enterprise under some set of state law. We tend to have stocks in this country, especially big public stocks, tend to be organized under Delaware state law. That’s kind of odd, like Delaware, you don’t think of it as where it’s happening, it’s not Silicon Valley, it’s not New York City.

0:02:27.0 Silent Cal: The reasons, really, that Delaware state law, or what they call Delaware general corporate law, the DGCL, is really good for management, so if you’re gonna run a company, you want to do it in Delaware. You want to be organized in Delaware. So Delaware sees a lot of bankruptcy cases, as does Texas and Southern District, New York, but Delaware is where most of our companies are formed, especially companies that either are public or hope to someday go public. So I’ll answer your question, what does a stock represent? It’s your fractional ownership in that company, and so people buy stocks for a variety of reasons. We can talk about the episode that just happened with GameStop, some people had very different motivations in buying that stock than saving, but mostly people own stocks as a way to invest their savings to own a small piece of a company.

0:03:17.6 Trevor Burrus: I think getting into the GameStop scenario, which so much of this episode will show so much of my ignorance about how these things work, but getting into this situation, one of the things that was discussed and is discussed generally is the price to earnings ratio, because I can see a stock being purchased and then going up in value, and we saw this, say, with the dotcom boom of like pets​.com and things like this, but how do people like you… What is the price to earnings ratio and how do people like you use that and look at that when you’re looking at the stock market?

0:03:49.2 Silent Cal: Right, so you start from this very general idea that you own part of a business, and then people start to say, well, what is that worth? And there’s not a purely scientific answer to that, but people really want a shorthand to talk about what the price of a business should be. So if I came to you and I said, my parents’ pizza place makes 200 grand a year, you want to buy 10% of it? You might say, okay, well, then I’m gonna get $20,000 a year. And then the question would be, well, how much should you pay for that? So if you could buy that for $50,000, and then every year you got $20,000, that would be a great deal.

0:04:23.3 Silent Cal: So on Wall Street, what we would say is, oh, that’s way too low of a price, because you’re only paying two‐​and‐​a‐​half times how much money you’re gonna get every year in earnings. So if you look at a business and how much it earns, and then you look at what you propose to pay for the business, you can think of that as a multiple, how many years of earnings would it get to pay back your initial purchase of the company, and so that’s the price to earnings multiple. It’s literally all the stock together, the total market capitalization of the company, so if you have a company, they say it’s a $9 billion company, they’re generally referring to the market capitalization. If you owned all of the stock, what would its value be based on where the last 100 shares traded, and then divide that by what the company earns.

0:05:01.1 Silent Cal: So if a company is making $100 million a year of earnings, which is an accounting concept that is just very complicated, but it’s basically how much does the company earn in profits to the shareholders. It makes $100 million a year, but it has a $9 billion capitalization, and then we would say it trades at a 90 PE, meaning take $9 billion divided by $100 million… Some people might have been promised there was no math, but that’s 90, and it’s the total value of the company divided by its earnings every year. We call that a PE ratio. I really like to think of the reciprocal of that, like earnings divided by price, that’s kind of the yield you’re making on your investment. If you buy a company for a… You buy your little share, whether you buy $1000 worth or $50 million worth, it doesn’t matter.

0:05:46.9 Silent Cal: If you buy in at a valuation of $9 billion and the company makes $100 million a year, then you’re earning a little over 1% per year of what you invested is the earnings of the business, and you would generally do that ’cause you think the earnings are gonna grow. Most people don’t want to save at a 1% earnings rate, so that you see companies that trade at something like a 90 PE, somebody will say, oh, that’s a growth multiple. It’s easier for me to think of it the other way. One over 90 is actually the earnings yield you’re getting. How much earnings am I getting versus how much I paid. I bought in at a price equivalent to $9 billion for my share, it’s earning $100 million a year, I’m only earning a little over 1%, I’m earning 1.1% per year, but as those earnings grow, I continue to get a larger and larger percentage return on my stock. And then the stock market is more like a casino, that price can go up and down day to day based on whether the crowd thinks it’s worth more or less.

0:06:44.0 Aaron Powell: Is that then the value to the investor of the stock, because I’m thinking there’s a lot of stocks out there that trade at really high values, so I just pulled up, Google is trading at just over $2000 a share right now. And a lot of us who have invested in various funds or in our 401Ks own Google stock, but Google stock doesn’t pay out a lot in terms of dividends. And so the amount… The number of years of dividend growth that I would need to get at the current rate to recoup that $2000 investment or gain beyond it is very high. And so when I buy Google, am I buying it, is it valuable for me to own it because at some point the dividends… I think the dividends are going to increase enough to have made it worthwhile, or am I buying it because they always say the stock market goes up and down, but over time, it always goes up, is that because I’m basically predicting that in the future, when I decide I want to sell my stock, there’s going to be someone who is willing to buy it at the higher price because they think that its potential dividends at some point down the road is going to be even higher.

0:08:00.9 Silent Cal: A complicated question, and the answer is sort of it’s not either/​or what you just said. So if you were gonna buy Google and you intended to own it for 50 years, you might be looking at based on what the dividends would ultimately be, what your share of the earnings that Google chose to distribute to you. So just two quick concepts. We just talked about the earnings of the company. Let’s again, go back to the pizza place example, ’cause it’s so simple to me. The pizza place makes $200,000. We might need to buy a new oven, that doesn’t mean we wire out $200,000 to the owners of the business as a dividend. So earnings, how much the business makes, dividends is a choice by the people who own the business about how much of the earnings to send out to the shareholders as a cash payment.

0:08:44.0 Silent Cal: Okay, so there’s two different concepts, earnings and dividends. The ratio of them, what percentage of the earnings get distributed as dividends, we call that the payout ratio, what percentage of our earnings do we pay out as dividends to our shareholders. So there’s companies like pipelines or REITs that own apartment buildings and things, where they pay out basically 100%, 90% plus of their earnings as dividends, and then there’s companies like Google or Amazon are ones that for a very long time paid no dividends. Whether they had earnings or not, they didn’t distribute, they reinvested all of the money in their own business, so that’s just as a starting point, it’s a difference between dividends and earnings, which is a choice by the company of what to do with the money it generates. It might have opportunities to reinvest that money in its own business and grow, and the shareholders benefit from the fruition of those investments.

0:09:29.3 Silent Cal: The second thing you said is, really, what am I trying to do? I buy this thing for $2000 a share. What am I betting on? What do I get? Well, if you’re gonna hold it for 50 years, you get all the cash they send you along the way and whatever you can sell it for in 50 years, and the value of that has a whole lot to do with what are they gonna distribute to you over 50 years. If you’re buying it to hold it for three days, you are entirely betting on what somebody’s gonna pay you three days from now. What dividends end up being over the next 20 or 30 years is not gonna enter into your calculation a lot. So the time horizon of your investment is gonna determine a lot about what you care about as a person today buying Google stock. And so we talk about something, I think since… It might have been Burton Malkiel who came up with the term of the greater fool concept, which is, if everyone agrees there’s no way Google is ever gonna send $2000 a share out to its shareholders, then the only reason you would buy it would be the hope that there’s some greater fool you’re gonna sell it to in the future.

0:10:32.7 Silent Cal: When we get to that point in a stock, the majority of intelligent commentators will say, oh, it’s just a spec, at this point, it’s purely a speculative play, it has nothing to do with the value of the business, people are just speculating on what someone else will pay me for it in the future, and your purchase at this point is that you don’t want to own the business for 50 years. No one would want to do that. You’re just speculating on what somebody will pay you for it in three days or in a month, and that’s typical of market frenzies, or when there’s a lot of froth.

0:11:02.9 Trevor Burrus: In the traditional view of the stock market, which is what we’re talking about in the way we’re talking about it now, where you have those images of traders going down to the floor holding big handfuls of actual stock certificates and people individually saying, this is a company super hot, this company is super cold, this company is making a discovery… These kind of ideas, but it seems that that’s not what’s really happening in the way that it maybe did in the ‘50s anymore. And one of them that strikes me as the kind of the ways that people get involved with the market via things like 401K, but they’re not down there trading their stocks, or other sorts of big conglomerations like mutual funds, what do those things actually do? And how have they changed the way that the stock market is being played now?

0:11:50.5 Silent Cal: Yeah, there’s maybe two broad categories I’d quickly comment on about stock market history. So if you go back to the 1940s or ‘50s or ‘60s, the consensus of intelligent opinion would be that if you’re gonna invest in the stock market, you want it done professionally by somebody who studies the businesses and picks the stocks for you. And in furtherance of that, people hire money managers to go do that for them, and money managers created pools of stock, so if you want to… You have $50,000 of savings and you want to save it in something, you don’t have the ability to go out and spend your time researching maybe hundreds of companies, there’s a benefit for you to hire somebody else to go and manage a portfolio of stocks that includes your $50,000, maybe alongside 1000 other people, so that they have $50 million and can form an entity that buys a whole basket of stocks. So that’s what a mutual fund is is some money manager has created a legal entity, typically under the two founding securities market rules we have in the United States, are the 1933 Securities Act and the 1934 Exchange Act, which set the framework for this type of legal structure, which would say, we’re gonna run a mutual fund, and we’re gonna go out, and that’s probably the [0:13:07.9] ____.

0:13:08.9 Silent Cal: I’m gonna run a mutual fund that goes and buys a whole portfolio of stocks, and you’re gonna own just a little piece of it, so if you go $50,000 and there’s 1000 people in, you own a thousandth of the value of that whole portfolio of stocks, and that allows somebody to maybe pay the cost of researching the companies they buy and some of the advantages of scale of investing $50 million as opposed to trying to diversify and buy a basket of stocks with $50,000. So the trading costs, the research costs, everything was sort of spread over a larger pool. So that’s like the pre‐​1970s world, but post‐​Depression is the era of the mutual fund that comes up, where savers give their money to a professional money manager to buy a portfolio of stocks for them.

0:13:52.8 Silent Cal: That’s really changed quite a lot, primarily with the rise of index funds, where people said, why am I spending this money to research, that sort of very strong arguments were made that all the active money managers trying to get a better deal betting against each other, they all spent money on research, but what if you just bought little pieces of everything across the whole market, could you avoid having any of those expenses of an active person spending a lot of effort trying to pick the best stocks? Initially, that was viewed as insane by people, like we’re gonna have somebody who doesn’t even understand what they’re buying, they’re just gonna trust that the price is reasonable and buy a whole basket, was viewed as literally like the height of irresponsibility to invest in an index fund initially.

0:14:34.7 Silent Cal: And what has proven true is that the numbers are pretty dominant, which is if you’re spending 1% of your money every year researching the companies across the whole market, all of that money is just a cost on the whole collective. Investors can’t out‐​earn the entire market, if they’re buying from that basket of whatever, the 3000 or so listed stocks. So what’s ended up happening is, it’s almost a free lunch to say, I’ll just buy a basket of stocks. On average, I will out‐​perform all these other people who are trying to beat each other. And so the equity market has divided into active management and passive management. We call the index fund passive management. I don’t try to beat the average return of all the stocks, I’m just gonna buy a little bits of all the stocks, diversify across the whole market, there’s different indices that the funds try to track, but I’m gonna save on the cost by having a very low expense ratio for my fund, and very little cost to pay smart people to try to beat each other.

0:15:28.5 Silent Cal: And so you’ve just seen, especially in the last decade, even when I… Even long ago, when I was in college, there was… The numbers were abundantly clear that it was a terrible deal to buy an actively managed stock fund, but it’s really slow sometimes for some of these things to change, and so it’s taken a long time for passive funds to grow at the expense of active funds, and even now you hear people continuing to say that somehow passive investing activity is like a deep threat to either the integrity of the market or the efficiency of prices, etcetera.

0:15:57.2 Aaron Powell: Is it, though, because if the market is a mechanism for allocating capital between these companies efficiently, like we want capital to flow to companies that are profitable or have the potential for growth, we want it to flee companies that are on their way out. If everyone is simply buying baskets of stock weighted by market cap, whether that’s the S&P 500 or something like that, at some point, if there’s enough of that, then there’s no longer any information signals in the stock market, where just all the money just kind of follows whatever happens to be growing, which… And then, so I can imagine tremendous bubbles or bursts, but also just that information function would seem to fall away.

0:16:43.8 Silent Cal: Yeah, that’s a very good point. And you said all. And so if somehow, suppose 329‐​odd million Americans all decided they were gonna try to buy the S&P 500 Index Fund for all their stock market investing, and you and I were the only two people who decided not to do it, right, so no one else would buy a stock in America, unless it was in the S&P 500. We would be able to make unbelievable investments. Any company that wanted to go public that wasn’t in the S&P 500, you and I could set the price for where to buy it, we’re the only two people willing to do it. We would become very wealthy, we would be very successful, right. That’s at an absurd level of passive investment.

0:17:25.4 Silent Cal: So any limit… You would destroy the information content and prices because no one would want a good deal, everyone would have decided to be brain dead, and you and I would be the last two people who were willing to buy public stocks other than the S&P 500. So in extreme that argument is correct. Where it’s not correct is if 5% of the money says, hey, the other 95% of you seem to be competing really hard, I’m not gonna pay to compete, I just want the average return, that 5% can do it, 15% can do it, 25% can do it, right. 75% of the money is spending billions of dollars a year researching. How many people that get paid hundreds of thousands of dollars a year are studying these companies and researching them and trying to get every little possible advantage versus each other, and that’s just even among the long investors, and there’s long and short investors and institution.

0:18:11.4 Silent Cal: So the amount of competitiveness that goes into the stock market price every day is billions of dollars of research and effort, and in that world, the unbelievable screaming that goes on about whether 15% or 20% of money is gonna be passively managed, I think is really most comically wrong in terms of the level of concern about passive investing. In the extreme, it would become a problem. One of the ways you would know it was a problem is the people who did an index would just absolutely start dominating. We would just be making easy money, and that has been the exact opposite for 50 years, which is every year the people who pay money to try to beat each other do worse on average. Last year is a little different. So sometimes when there’s big shifts, the passive money can do worse, and it matters when things get added to the S&P 500, etcetera.

0:19:02.6 Silent Cal: So there are things that happen with active management that make money, but we’ve been living in a world for decades in which active management charges a price that is well above the value it delivers versus passive investment.

0:19:15.2 Trevor Burrus: The other big concept that I’d like, I personally would love to hear about more, ’cause this is getting into my ignorance, and it also stands as like a totem that stands for this kind of Occupy Wall Street, which is the hedge fund and the hedge fund manager. These are these kind of people who seem to do inscrutable things, maybe we got to a point where, okay, I get you own part of a company and I get that it goes up and down, and then you can buy groups of those parts of companies and hope they go up and down, but then we have this really bizarre thing or this different thing called a hedge fund. So what is a hedge fund? And well, to start with, what is a hedge fund?

0:19:53.7 Silent Cal: The hedge fund industry today is very different than what a hedge fund was originally. So originally, what a hedge fund was was just a private partnership that was gonna speculate on financial assets, and it was not a mutual fund that was going to be regulated, it was going to be a private partnership formed to manage capital for a select set of institutions, usually there’s regulations, retail investors can’t buy them, there’s rules that prevent you. Unless you’re an accredited an investor, the SEC won’t let you buy into a private partnership for the purposes of investments, which illegal for you to invest in most hedge funds, unless you have a certain amount of money and a certain amount of sophistication. And there were private partnerships formed to speculate on financial assets.

0:20:31.6 Silent Cal: So when that didn’t exist, back in the 1960s and into the ‘70s, people saw that there were inefficiencies in market prices, and so a few things were possible. One was using leverage, speculating on foreign exchange or commodities prices. Another was the ability to go short stocks. One of the ways, Bruce Kovner, who started Caxton, he would read the Financial Times, the news coming out of Europe, and he would look at the European markets before the markets opened in the US, and he said this was a huge advantage versus the people who were waking up late and reading the Journal and trading, he would trade, open pre‐​market hours in the US and make very good money on inefficient prices that hadn’t moved.

0:21:11.0 Silent Cal: So the world’s a lot more competitive than it was in 1990, but what’s happened as things have evolved is hedge funds have become much more institutional in nature, and at the end of the day, they’re effectively unconstrained mutual funds, so if a mutual fund is regulated to go out and buy a basket of stocks, the hedge fund is much less regulated and can do things like borrow money to leverage their positions. It’s a private partnership, so that whatever rules they make in the partnership are gonna govern what the hedge fund does. So if the hedge fund is going to have a long and short portfolio or trade, the difference in prices in one location versus weak prices in another location, whatever the private partnership agrees to do, it’s an unconstrained financial vehicle as opposed to a highly regulated mutual fund.

0:22:00.0 Trevor Burrus: So let me just clarify, so, okay, we all get together and decide to start a hedge fund, and so by financial assets you mean… Do you mean that could include stocks, but it could also include futures and currency markets and bonds and almost anything else, right?

0:22:14.8 Silent Cal: Including the almost anything else, exactly. Meaning there are hedge funds that went out and when companies go bankrupt, they’ll go to the vendors of the company and acquire claims on the bankrupt company’s assets, they’re literally acquiring claims on a bankrupt estate, so it’s really very broad. Whatever we can write in a private partnership contract as the scope of what we want to do, that’s what governs, not… They are now regulated by the SEC, but very loosely in the sense that they’re just sort of post‐​Madoff, anti‐​fraud more than telling them what they can and can’t do.

0:22:46.0 Trevor Burrus: Okay, so we decide we’re gonna speculate on the price of baseball cards into the future, if we could find such a thing. It’s an asset, possibly. Let’s say, pork belly futures is a classic. So we’re going to buy… So now we’re speculating, we think that they’re going to go up, so we just buy a bunch of pork belly futures and then hope that they go up in our partnership.

0:23:06.8 Silent Cal: The structure isn’t so much the partners, generally, there’s a manager who’s the general partner, and there’s limited partners, that are either high net worth individuals, endowments, pensions, those are really the hedge fund investors today. It started out much more high net worth individuals in very small partnerships back when somebody like George Soros was pioneeringly doing hedge funds. There’s really two different main hedge fund traditions, one came out of the US equities market, and then the other really came out of the foreign exchange markets and the bond market, there’s two very big different traditions. The Commodities Corporation in Princeton, New Jersey, was one of the early in futures in US futures markets, cash settlement hedge funds that kind of laid the groundwork for some of that history.

0:23:54.5 Trevor Burrus: It doesn’t sound that dangerous, it sounds like pretty standard investing, right? It doesn’t sound like that… Is it just that they allowed the legal creation of them? Speculating on the price of something to go up or down about anything that can be speculated on in groups, that’s pretty standard investing, right?

0:24:13.1 Silent Cal: No, I’d say why are hedge funds viewed as important or aggressive or sort of take on this role, because they’re unconstrained, they tend to be much, much higher turnover, they’re also one of the reasons they’re very valuable to Wall Street. So if you were on a mutual fund, Trevor, and you own 120 stocks and money comes in and out of your mutual fund, eventually maybe you start to like a company more or don’t like it, but one of the things you need to do for your investors is not go out and go crazy buying and selling stocks every day for no reason. If you’re just churning your portfolio by buying and selling every random instinct you have, you’re gonna do really badly, ’cause you’re gonna pay away a lot of transaction costs and do very poorly.

0:24:53.6 Silent Cal: So mutual funds tend not to have super high turnover, and the passive funds are just matching the index, they have very little turnover. So as a customer to Wall Street, they’re these big pools of capital, but they don’t call up every day and have lots and lots of money to pay as transaction costs. The hedge funds, however, are long and short, unconstrained, can be much more concentrated. They are a big percentage of the volume in a lot of these markets, because they’re not only actively managed where they need to try to outperform, but they’re, I would say, very actively managed. I mean, a lot of these actively managed funds, we call them benchmark huggers. They say that they’re actively managed, but they really match the benchmark quite a lot.

0:25:29.3 Silent Cal: If you’re a mutual fund and you want to really be different than the S&P 500, you can’t just buy like 500 companies and have a slightly different weighting than the S&P 500, you’re going to perform just like the S&P 500. You should hold probably 15 stocks if you truly want to be very different than the S&P 500. And so once you get up to 50, 60, 70 stocks, unless you’re doing something highly, highly unusual in picking the 50 or 60, you start to diversify quite a lot and look like the benchmark, look like the index. Hedge funds really don’t look like the index. They can be doing things that are not just concentrated, but the turnover and their holding period really changes the nature of what the returns stream looks like for an investor, and so in theory, not being constrained should allow them to go after inefficiencies.

0:26:15.3 Silent Cal: What I’d say has happened is, if there was $200 million of hedge fund unconstrained capital in the markets, I think they would all do very well, you wouldn’t need… You wouldn’t need to have the smartest guy on the block to out‐​perform… You would be the only guy that was unconstrained, you’d do very well. You’ve got something like $2 to $3 trillion dollars of hedge funds at this point, that’s probably too much money for the amount of available inefficiencies in the market for them to go grab easy money. And so they end up doing things that are sort of the hedge fund things to do, and I think that’s one of the things we saw in game stock is one of the hedge fund things to do is short bet against the stocks of little companies that on average did worse than… Not just worse than the S&P 500, but worse than the Russell… And you could say, if you looked at the basket of the most shorted stocks, I think they’ve kind of underperformed the broad market by 5 or 6% over multiple decades. What we just saw was an incredible reversal of that in the last month, that looks very different than a mutual fund return series.

0:27:16.8 Aaron Powell: I want to get to the story of GameStop, because I think it’s a fascinating one that a lot of us have a lot of questions about, but I had one last question about hedge funds, and that’s… Trevor started this conversation about hedge funds by mentioning that they play this outsized mythological antagonist role for Occupy Wall Street people and people who think that Wall Street is out of control. And one aspect of that is, we hear a lot about hedge funds consuming companies and selling them, stripping them for parts, wiping out these legacy businesses, engaging in quote hostile takeovers and so on. Is that part of what hedge funds do? And is that… Do they deserve like a bad rep for that kind of stuff?

0:28:04.5 Silent Cal: Okay, so that gets into a whole other part of the world, which is private equity firms. So corporate governance, we’ve talked about all these companies form in Delaware, I will give you a narrative version of this, which is that in the 1960s and ‘70s and into the ‘80s, you had a lot of companies that were run by people who were not trying to do right by shareholders, and it could have been that they cared about the employees, it’s not that Elizabeth Warren has lost her mind, it might be that somebody was a patriarchal owner‐​operator and they didn’t want to close down the loss‐​making division. You also had a whole lot of people who wanted to build an empire, and even if they were making bad investments with shareholders’ money, the guy that ran Kodak, or Eastman Kodak, I remember, Eastman Kodak made like film and those little kiosks where you would print out your film.

0:28:55.5 Silent Cal: And the Eastman Kodak guy was like, I’m gonna get into printers, we’re gonna make a commercial printer that costs more than the Hewlett Packard printer, but if you hold it for like six years, it’ll cost less to run, when it was already like the writing was on the wall, that was a terrible business, and he destroyed like a billion dollars of Kodak shareholders’ money on this idiotic investment, and why don’t they get rid of him? Because there’s really been capture of the board of directors that controls the company, so the shareholders are represented by a board of directors in most big public companies, it’s a requirement of being listed on the New York stock change, there’s a board of directors that hires the management.

0:29:27.7 Silent Cal: So that’s actually a good idea. Board of directors controls management, right. And if the CEO is bad, he wants to go waste a billion dollars, you fire him and you bring somebody else in. Just in practice, we’ve had really terrible corporate governance in the United States, and what’s happening is the CEO likes to put his buddies or people who are part of the managerial class on the board and pay himself a lot of money, ’cause he’s invaluable to deciding to destroy a billion dollars, and then you kinda have… It’s not regulatory capture, but it’s board of directors captures, so Carl Icahn has been really a champion of talking about reforms to improve corporate governance. So you start with that set‐​up.

0:30:04.5 Silent Cal: What happened in the 1980s? In the 1980s, people said, you know what, some of the companies are so badly run that I could actually buy the company and immediately borrow enough money against the company to pay the shareholders the entire value of their stock immediately in cash and own the company for nothing. They’re that badly run that if you change management, the debt capacity, the ability to borrow money against the assets of this company, exceeds what people will pay for its stock, it’s that badly run. That existed in the 1980s, and so you had these people they called barbarians or the barbarians at the gate, the Michael Milken group, people like Icahn, including some people who committed unbelievably obvious fraudulent crimes, go in and start acquiring companies that were not managed well, or that had assets that were under‐​performing, things that needed to be closed down, people that needed to be fired, poorly run assets that will be worth more with a change in governance, and they went in and they conducted what they call hostile takeovers.

0:31:01.8 Silent Cal: They said to the shareholders of the company, this guy who’s destroying your value, get rid of him, I’ll pay you this much for all your stock. And that really is not a hedge fund thing so much as it was an entrepreneur activity primarily done by what became private equity firms, and the value creation was better management of the assets, so that’s something that really started in the ‘80s and especially into the ‘90s. It had a huge effect on American corporate, corporate America, corporate governance. Corporations to this day will hire firms like Goldman Sachs and Morgan Stanley to design packages to prevent people from offering their shareholders a bunch of cash for their stock.

0:31:43.1 Silent Cal: So they don’t describe this business activity as, oh, my God, never offer my shareholders money for their stock, but they design poison pills and other governance that they say, this will prevent us from something terrible happening, like a firm calling up and trying to buy all the stock at a higher price. I typically think If I own some property that somebody calling up and offering me a lot of cash for, it is a good day or a bad day. But if you run a company or you’re a part of a board of directors of one of these large businesses, that’s a terrible day for you, somebody calling up all your shareholders and offering them much more cash than the current trading price for their stock on the condition that they get control and can fire all of you is a bad day, and the banks will sell their services to avoid this.

0:32:21.6 Silent Cal: So it’s less of a hedge fund thing than an American corporate governance phenomena that led to the private equity industry. And the private equity industry does a lot of things very aggressively, they’ve made a ton of money, there’s a lot of leverage involved there, but at the fundamental core of it, they are producing value by taking control of companies that are badly run and running them better.

0:32:43.6 Trevor Burrus: Now, since we’ve covered the basics, and I think good understanding now. There’s a few things, we had hedge funds. You’ve mentioned something a couple of times, short selling, which I think is the other piece we need to get into the GameStop story. So what is short selling? I know it’s betting on a stock to go down, but how could you possibly make money on betting on a stock to go down?

0:33:06.4 Silent Cal: Yeah, so in a normal world, people just own the shares of the company, and that’s it. So what shorting is, is if I think that the value of a company share is gonna go down, how can I profit by it? And what people came up with was the following: Go to a shareholder of the company, say, hey, Trevor, you own stock in DoorDash. You think DoorDash is gonna become the dominant… Everybody’s meals for the rest of their life are gonna come from DoorDash. You think the price is gonna go up over time, you want to own it. Let me borrow those shares from you, give them to me, I’ll give you cash for the shares now that you can go on [0:33:43.8] ____, and have cash instead, and two months from now, I’ll give your shares back, so you’re not gonna be harmed at all.

0:33:49.9 Silent Cal: In the meantime you’ll have some cash you can go invest, etcetera, you can buy a government bond with it, for all you want, or maybe even if you really are like, I don’t want to give it to you, Bob, there are two that I just really like having them in my possession. Yeah, I might even need to offer you some money for them, like I’ll pay you 1% of the value of your shares for the next month, just please let me have them. And why do I want them? And I tell you I want them because then I have them, I can sell them. My intent is before I have to give them back to you, Trevor, I will go buy them back, so we call that borrowing shares, so that’s stock loan, you loan me your shares, then I go out in the market and I sell those shares.

0:34:20.8 Silent Cal: Now, critical thing that people who are following GameStop and complaining about it sometimes don’t understand is, Trevor, when you lend me your shares, you don’t just transfer me the shares and you retain the right to vote them, I now have the right to vote them, I have bonafide shares that have been lent to me that I can vote. You retain an economic interest in them, I owe them back to you, so if the price goes up and down, the shares coming back to you who are gonna be worth more or less, you retain your economic interest in them in terms of the price, but when you lend them to me, you sign over and you give up your voting rights, okay. So you might think you still own DoorDash, but DoorDash doesn’t think you own DoorDash anymore, DoorDash knows that Trevor’s not voting those shares. When I go sell them to somebody, that person votes those shares.

0:35:00.6 Silent Cal: So people get very excited about what they call naked shorting and how much short interest there is. And the concept that if you don’t understand voting rights, I would put to you that you do not understand the mechanics of shorting a stock. At all times, 100% of the stock can be voted. If you own a voting share in your account, you own what I would call a real share, a base share, a voting share. If it says you own DoorDash in your account on Fidelity, you might not own it, it might have been lent out and you have no right to vote DoorDash. So that’s an important concept. But basically what the short seller intends to do is sell that stock on the exchange, in the market, and then later when I have to give it back to you, I hope to buy it back at the lower price and give it back to you.

0:35:45.1 Silent Cal: So if I sell DoorDash at $200 a share, and then people start to think, well, is this really a good business? Maybe not. What’s the price? Oh, I don’t want it. And it goes down to $100 a share. I buy it back at $100 a share, I send it back to you, I sold it for $200, I bought it back for $100, I made $100 a share profit as a short seller, less whatever I had to pay you to borrow the shares.

0:36:04.9 Aaron Powell: So then, what does this have to do with GameStop? What happened there? Besides a whole bunch of people on Reddit having a lot of fun.

0:36:13.1 Silent Cal: Yeah, fascinating as a sociological thing. GameStop, everybody knows what it is, it’s in the mall, and they got a bunch of retail outlets, they sell video games, new and used video games. Business not doing well, especially not doing well, already not doing it before the pandemic, but especially if nobody goes to the mall doing particularly badly. So the company owed about a billion dollars of debt. The market cap was about $350 million. Last summer they’d issued 70 million shares, so people owned 70 million shares of GameStop. Those shares traded for around $5 a share, 5 times $70 million, $350 million is the value of the whole business, meaning in theory, if you could have bought or sold the whole, all the shares at once at that last price where 100 shares traded, that adds up to $350 million, it’s what we call the market capitalization.

0:37:01.3 Silent Cal: What happened was some people bought it, thought it would do better, thought it should become… It has a great community around it, I mean, remember we bought GameStop professionally, 2012, I think it was. It’s a long, long time ago, long time issues in the business, but very dedicated base of consumers and they kind of almost are like a club for the gamers. If you told me there was a gamer club that was everybody’s favorite gamer club, might sound like a good business. So some people had this more contrarian view like, it’s not a mall, it’s not a thing in the mall. It’s like the gamer club, and it should be able to move its business online and be like the gamer club, and it has a role in the ecosystem for gaming. Gaming is a huge growing business, people, like my kids watch people play video games, which I don’t really… I used to watch people waiting to get the controller to play video games, I never thought I would watch somebody play a video game for fun, but yeah, my kids don’t watch NBA, they watch people playing video games.

0:37:52.3 Trevor Burrus: You just said the exact thing that I always say. When we grew up, watching people play video games was the worst thing to do, and now people do it all the time. Anyway, continue.

0:38:03.8 Silent Cal: Happened. So people started buying it, then this guy who started a business called Chewy, Chewy’s an amazing business, they like give dog food, so not an amazing business, it’s like an amazing thing in the world. They ship your dog food to your door, you don’t have to go pick it up and carry around. They lose money on every order they take, they just are like, I’m gonna lose money shipping your dog food, so you don’t have to carry it or deal with it. They’ve been around, they’ve grown, they’re literally paying you to get dog food from them. They lose money every year. People have decided this business is worth like $10 million.

0:38:29.0 Silent Cal: They’re like, this what GameStop should be. So the guy who started and ran Chewy joined the board of GameStop, that emboldened these people who had this theory that GameStop should become something just awesome like Chewy, why don’t they just start losing money on everything they do, but become this massive institution. And so the price started going up, and so all of the what I would say traditional smart guys who had said, yeah, this thing that looks like it’s gonna die, it’s gonna die, and the $350 million of hope, that’s $350 million of money I’m gonna eat for my family and my investors, right, I’m gonna short that stock at $350 million, it’s gonna go to zero, I’m gonna eat that $350 million.

0:39:04.1 Silent Cal: So one of the reasons short sellers get a bad name is ’cause the way I just talked, right? I saw $350 million of market cap, and my thought was, I’m gonna eat that, I’m gonna short 1% of that company and I’m gonna eat $3.5 million based on the people who own GameStop losing all their money and me eating their money. So short sellers are sort of, not anti‐​social, they think they provide a positive social function, but they fundamentally profit when everyone else is losing their money. So they’re not liked, right, they’re the person who bets on the party ending and the cops showing up or runs out of beer and everybody goes home. They’re not like… It’s natural that people don’t like short sellers in a sense.

0:39:38.8 Silent Cal: So what happened was the stock started going up, huge amounts had been bet against this company, so even though there was only 50 million of the 70 million shares that the company had issued were out in non‐​insider hands and freely trading, people borrowed those shares and sold them and kept borrowing them and selling them. And if you understand what I said with Trevor about shorting, after I sell that share, somebody has it, I can go borrow it again. Trevor can buy another share of DoorDash. I can show up and borrow it from him again, sell it again. He gets a voting share again, I borrow a voting share, I sell it again, there’s no limit to that. It’s like a side bet on the Super Bowl, right, like there’s no limit to how much money can be bet on the Super Bowl. In the same sense, there’s no limit to how much side bets can happen on GameStop or any of these stocks.

0:40:19.1 Silent Cal: The limit would be when the people who own the voting shares stop lending them out, then you can’t short anymore, so the limit on how much can be sold short of a stock is not how many shares exist, it’s how many times the people who own voting shares will lend them out. There is no physical limit on that, and there’s no regulatory limit on that. So it turned out that of the 50 million shares that freely traded of GameStop’s 70 million issued shares, around 70 million, a little over 70 million of them, it’s about 140% of what we call the free float, the freely trading shares, were sold short, and some people looked at that and said ooh, like 100% is a magical thing. If over 100% are short, then they’re trapped, like as if it’s like you’ve cornered them.

0:41:02.0 Silent Cal: Against that, if people have bet on shorting 140%, that means 240% are long. So it’s not like… Nobody fraudulently counterfeited a share and issued it, right, it’s just that there’s 100% of voting shares that are owned by somebody, and then there’s 140% versus 140% of long and short side bet on the price of GameStop. That’s what had happened. So you can see why that’s an explosive situation, though, and the main reason is, if I buy a stock, say I buy Solyndra stock and then Solyndra goes to zero. Every day Solyndra goes down, my investment just goes down, so I care less and less, right. I invest $100,000 in it, it goes down 50%. Now I only have $50,000 in it. It goes down 99% more, I’ve got 500 bucks, it’s just not a problem for me.

0:41:50.4 Silent Cal: If it goes the other way, it’s a problem, so if I thought Tesla was terrible and shorted Tesla last year before it went up, when it doubles, now I have twice as big a bet. It doubles again, I have 400% of what I originally had. It doubles again, it’s a… So I just can’t… By its nature, the shorts don’t plan for these crazy increases, and the sizing of their position given how they behave is such that it’s what we call a short squeeze, in a sense, or what has now become known as a short squeeze, which is the shorts by their very nature… Let’s say I took 1% of my investors’ money and I had shorted GameStop at $5 last year. When it goes to $20, now I have a bet, I’ve not only lost 3% of my investors’ money, I now have bet 4% of their money that it’ll go down from there.

0:42:31.5 Silent Cal: If it doubles again, now I’ve bet 8% of their money, so it went to $20 a share, became a 4% position. It goes from $20 a share to $40 a share, now I have 8% of my investors’ money bet where I initially sized it to be 1%. By its nature, that’s gonna be a problem for my business. And so hedge funds may be a lot of things, desirous of going out of business is not one of the things they are. And so when a stock goes up that’s heavily shorted, the people who are short, by the very nature of their sizing decisions, if they have any material amount, start to feel great pressure to cover and reduce their bet ’cause it’s bigger than they want it to be.

0:43:06.6 Silent Cal: And there was a group of very sophisticated people on GameStop who explained this phenomena, explain the potential that if it started going up, the people who had bet against it would by the nature of their own decision‐​making be forced to cover it. Some people believed that the fact it was 140% short would cause them to be trapped and almost like required to short it. That’s a different thing as what we used to call a short squeeze. If the lenders of the stock stopped lending it, that creates a physical problem. If the lenders all say, give me the shares back, then the shorts have to buy it back to deliver it, okay. You see that more in the fixed income market, where large holders of bonds will stop lending them to squeeze the shorts.

0:43:41.6 Silent Cal: I don’t believe that happened here in any material way. The stock market largely operates where shares are freely lendable in most customers’ accounts, and so this was not a physical short squeeze in the sense that people who had lent shares said, ha‐​ha, I’m not gonna lend them anymore, that would have caused a big, big… There’s a huge move, that’s a forced buying move, so really, at all times through the GameStop phenomena, you could borrow shares. This was not a stock that entered a physical short squeeze, like Volkswagen is a thing that’s commonly talked about that happened a little after the financial crisis, where Porsche basically acquired stock plus options to acquire stock, in physical stock, voting shares, that were almost 100% of the shares of the company, and then started taking them and nobody could get stock. And so there was a physical squeeze where you couldn’t bet against the price. It happened to Tilray, I remember, last in maybe the fall 2019.

0:44:35.5 Silent Cal: If I thought the price of, that’s a marijuana company, if I thought its price was gonna go down, there was really no way for me to borrow shares and short them, because you couldn’t borrow shares, and the people who had borrowed shares were told they couldn’t borrow them anymore and had to go buy them. That’s a physical short squeeze. What people now colloquially call a short squeeze is just the shorts lost and have decided to throw in the towel, that’s what we call a short squeeze now. And I think words take on their own meaning, short squeeze now is the shorts lost and decided to quit, and that’s what happened in GameStop is the shorts lost extraordinarily, and they decided to quit and they started buying the stock back. And this was really, as far as we know, you can always learn something else, but it appears to be a decentralized speculative attack by a bunch of people on Reddit.

0:45:21.8 Silent Cal: And there were other people who joined in, I’m sure, including sharps and people, institutional money on Wall Street who said, wow, this Reddit mob is crushing the shorts in GameStop, I want to be on their side of it, not on the guys who are short side and jumped in. And I view it, I’ll tell you, at a societal level, like it’s kind of like a transfer scheme. Everybody bets on the Super Bowl. Money gets transferred around, nobody thinks it’s ruining society. The government runs lotteries, people are allowed to go buy lottery tickets for a dollar that aren’t worth a dollar, and I can’t open a competing business to issue lottery tickets. Nobody says, oh, my God, who’s out there saying not only that you shouldn’t be allowed to buy lottery tickets, one, two, maybe the government shouldn’t run a monopoly selling over‐​priced lottery tickets, or especially marketing them as saving schemes, like you see they have piggy banks on them and tell people it’s like a savings scheme. It’s really horrendous.

0:46:13.8 Silent Cal: If I did what we do in writing lottery tickets, Elizabeth Warren would want to put me in jail. She would want to put me in jail, for sure. And so I view this scheme is basically much closer to a bunch of people playing poker with each other or betting on the Super Bowl, and it’s a scheme that’s transferring billions of dollars between people, but unless there was some entity behind it controlling it, I don’t think they violated SEC law. And I don’t think it’s something where we need to say, oh, we can’t trust people to go out and buy a stock they want to buy, and the fact that they were buying it not because they wanted to own GameStop for 50 years, that happens every single day in the American securities markets, that people make speculative positions based on what they think is gonna… People buy things ’cause the weather is gonna be good or bad in New York, right, and there’s patterns they notice and bet on things that have nothing to do with what GameStop will be worth over the next 50 years, so it’s, both as a legal matter and a moral matter, something I think we need to respect what went on. Unless there was some [0:47:07.1] ____ thing behind it that we don’t know about.

0:47:09.9 Trevor Burrus: Well, that’s an interesting question. I love how you brought up lotteries, because I make that point a lot, and lotteries used to be broadly illegal, and then we decided they were… I mean, in like the 19th century. But on this sort of speculation idea, we were talking about this app called Robinhood, and there was this idea that they were sort of sticking it to the hedge funds, but Robinhood had shut down, I believe, at some point the trades on GameStop. Was there something going on untoward there between trying to protect the big players versus this upstart group of Redditors, or is that just the narrative that’s emerged?

0:47:47.0 Silent Cal: Yeah, so I had that question, Trevor. So the reason… So I lived a quiet life on Twitter until GameStop, and one of my tweets about this went viral, and I’ve got like 6000 followers now, ’cause they all read my GameStop thing. The reason I even wrote that and got into it was because when Robinhood shut down trading and said, they said you couldn’t buy GameStop stock, but you could sell it if you’re one of their customers. That made no sense to me, okay. It made no sense to me that they were restricting trading. It made no sense to me that you couldn’t buy, but you could sell, and so my first thought was, okay, I’m fairly familiar with these people and how they work, and I thought, that is not what I expected this morning.

0:48:29.9 Silent Cal: And I looked into it, ’cause I said, okay, I’m generally not somebody who believes in these conspiracy theories that like the six people that run Wall Street called up and said, enough’s enough, let’s do it, and pushed some button and did it. That’s not how it works, right? It’s way more sophisticated than that. People have their jobs, they do their jobs. It isn’t like the man behind the machine calling somebody and making it happen, but this was weird. And so I started to think, what is going on with it? And I pretty quickly came to the realization that what had happened was, since all of Robinhood’s customers were buying GameStop, Robinhood itself, I remembered in Dodd‐​Frank, one of the things we had coming out of Dodd‐​Frank was no more Wall Street losing money and sending the bill to taxpayers.

0:49:12.7 Silent Cal: That was one of the most, the deepest motivating ideas of Dodd‐​Frank was Wall Street bets on stuff, Wall Street lives with the losses, they make gains and losses, they live with it, they don’t send the bill to taxpayers. And so one of the things we did in Dodd‐​Frank, in terms of congressional intent, is they said, okay, people buy these stocks and they’re gonna settle, but it takes two days for them to settle, so when you buy a stock today to when that stock is transferred in your account and the money goes to the other guy who sold it, that takes two days. They said in those two days, we want the entity that does the settling, so there’s an entity down in the stock market plumbing called the NSCC, it’s a subsidiary of DTCC, regulated entity, the primary regulator is the SEC, they’re also overseen by the Federal Reserve on a secondary basis.

0:49:58.1 Silent Cal: And that entity says, Trevor, when you buy stock, even if the guy on the other side gets hit by a bus, blows up, lied to his, broker doesn’t have money in his account, whatever it is, even if his whole brokerage fails on the other side, the NSCC is going to get stock and put it in your account for the price you paid. Even if it… So it doesn’t… When you go buy stock in the market, you never have to be like, oh, I’m buying from which vendor on Amazon, that one’s not gonna ship it to me on time, except like you’re not buying on the… It’s like you’re buying Amazon Prime from Amazon. They’re gonna ship it to you. The NSCC guarantees delivery of the stock to you for the price you paid, to both sides of the trade.

0:50:33.6 Silent Cal: And what they say to their members… Who are their members? Their members are the brokerages, what we call clearing firms, the big brokers. A lot of brokers aren’t real clearing firms, they actually just hire a bigger brokerage that is a real clearing firm to go clear trades for them at the NSCC, and they’re just kind of like a little reseller, overlay broker, what we call an introducing broker. In this case, Robinhood used to be that, the little overlay guy, they actually raised some more money and became a big guy and made themselves a clearing firm. They directly face the NSCC. And what the NSCC says the Robinhood is, okay, your customers buy and sell stocks all day, if they’re buying and selling from each other, we don’t have any risk to you, Robinhood, it’s just you with your customers, that’s your own business.

0:51:11.6 Silent Cal: But if they’re net buying or net selling, let’s look at the net buys of all your customers and the net sells of all your customers across all the stocks, and for two days, you Robinhood have to put up some money so that we know that you’ll be there, so that if you Robinhood explode, like Lehman Brothers or MF Global, in the two days between when your customers bought and when the stock moved for the cash, we NSCC don’t expect to lose money. So the way they do that is they run like a big math thing, and they say with 98% odds you won’t lose more than this amount of money in the next two days, so post enough money, so that 98% of the time, we won’t take a loss on you, and then they have a waterfall which says, after that we NSCC will chunk some money in if you lose more than that, and then after that, all the other clearing members are gonna chunk in billions and billions of dollars, so that clearing fund collecting money for everybody has $35 billion on top of the money NSCC has just to cover any broker failing.

0:52:04.0 Silent Cal: And that’s Dodd‐​Frank, required to say, the bill is not gonna come to the taxpayer, because each broker puts up money, so that 98% of the time, they put up enough to cover if they totally disappear from the earth, there’s enough to liquidate their portfolio and get all the stock that they had bought to the guy who sold it or bought it on the other side. And then even after that you have NSCC’s money, and then even after that, you have all the other clearing brokers who are kind of socialized among the Wall Street people, but they have to pay for it before it comes to the taxpayer. The net of that increases costs, because they all have to hold this tens of billions of dollars at the clearing firm just to support their customers buying and selling, but that was the trade‐​off involved in Dodd‐​Frank.

0:52:40.9 Silent Cal: Okay, maybe that will raise costs a little bit, Dodd‐​Frank raised costs in a variety of ways, they don’t really talk about that as the intent, but that was the trade‐​off, we’re gonna raise costs, we’re gonna impose this regulation, but the bill is never gonna come to the taxpayer. What happened to Robinhood? You can kinda see where the story’s going. As all their customers bought GameStop, the amount of money they had to post to NSCC went up, and that’s the thing I really started to look at and talked about in GameStop that ended up forcing them to make a decision, but in there, there’s a lot we still don’t know.

0:53:10.2 Aaron Powell: We have heard some about policy responses to what happened with GameStop, people are tossing out various cures because this was seen as something that we don’t want to repeat or was particularly damaging. A lot of them sound like just people using GameStop as a way to re‐​up their particular regulatory hobby horses. But what are some of the things that are getting kicked around, and I imagine most of them are bad, because that’s typically the case, but are most of them bad? Are there anything out there that would be good?

0:53:48.1 Silent Cal: Yeah. I think that’s a great question. There’s two main responses I’ve heard. So first of all, people are just mad at Robinhood and are leaving Robinhood and going to Robinhood competitors like Weeble and other… Frankly, Fidelity is not gonna… Fidelity is not gonna run out of money in the middle of the day. So I imagine some people, although it’s not as popular on Twitter, go to something like Fidelity or E*TRADE or something with better financial backing. So there’s some just healthy market stuff. Robinhood in the eyes of its customers, massively failed them, and whether that was caused by Dodd‐​Frank or caused by a hedge fund calling them up and making them do it, which is obviously not what I think happened and there’s no evidence that happened. It wouldn’t be how it would work.

0:54:28.1 Silent Cal: It doesn’t really matter, their customers are mad and leaving them. That has nothing to do with regulation, it’s the market functioning, and frankly, their PR response was woefully lacking. What I was saying on Twitter the night they did it sort of depended on the idea that this was the explanation, but a huge thing I heard from people was, it can’t be the explanation or they would have said this, they can’t be that bad at PR, that there was a regulatory plumbing thing that caused them to have to do this. But then they came out and said, we’re all gonna learn through this volatility. Like that can’t be… And it was. And they just did terrible PR that day, and I think it’s gonna cost them billions and billions of dollars in the ultimate value of Robinhood.

0:55:06.5 Silent Cal: Aside from that, you ask what are the two regulatory… What are the regulatory responses. And I’d say there’s principally two. One of the things that came out of this when people looked into the thing is, it turns out that when Robinhood, Robinhood doesn’t charge its users for trading or for opening an account. And like Facebook… How does Facebook [0:55:26.0] ____? Most people understand that Facebook sells ads and doesn’t charge for Facebook accounts, they also don’t pay you for a Facebook account. Robinhood also doesn’t pay its customers to open and trade stocks. So how does Robinhood generate revenue? They don’t sell ads that they serve you, they actually sell the right to execute your order flow to executing brokers, and principally, the main person they sell it to is a firm called [0:55:50.0] ____ Securities, which also happens to run a hedge fund alongside it, which created a lot of the conspiracy theories here.

0:55:56.8 Silent Cal: So that practice, the practice of selling the order flow, for somebody to pay to execute it, just on its face sounds like, oh, I go into Walmart to buy something and I don’t have to pay for the milk, if somebody else is paying me to get this milk, like something horrible is happening here, you’re like, how can I be in the customer’s interest that somebody’s paying to execute the order flow and making money off it, it just immediately sounds fishy to people and they’re like, we have to ban this. And what I would say on that one, just as the headline is, payment for order flow is the symptom of an underlying regulation called Reg NMS, and that’s the disease. And so I don’t think the payment for order flow is something that would occur naturally in an unregulated free market, it is something that is absolutely a symptom, and if we want payment for order flow to go away, the normal way we would do it is banning payment for order flow, because we never go to the root cause, we always just add regulation on regulation, but the right policy response in my view here is to understand the disease, which is Reg NMS, and make correct reforms and repeals of the 2005 amendments to Reg NMS.

0:57:00.9 Silent Cal: Be happy to get into that and the history there. The other response, Aaron, quickly, is the financial transactions Tax, this is exactly what you said in terms of confirmation bias. One of the disappointing things over the last decade is that whether J P Morgan loses billions of dollars in the London Whale or the banks fail and get bailed out by the taxpayer, the response from people seems to just be to go to their pre‐​existing views and feel them more strongly. So Rashida Tlaib at the hearing last week on GameStop in front of the House Financial Services Committee gave a very impassioned speech that Wall Street’s making all this money off her constituents trading stocks and buying and selling, and it’s high time that we impose a financial transaction tax, so literally have the government charge an amount every time a share trades in America, take that money and put it in the public coffers as a way to reduce what Wall Street’s making and transfer money to the taxpayer and to the politicians to control.

0:57:53.9 Silent Cal: So that’s a terrible idea. If she wants to transfer money to her constituents, putting a financial transactions tax in place will not work. What you need to do if you want customers of all these brokerages to pay less is we need a framework in which lower cost providers are able to provide trading and brokerage services at a lower cost. If you say the person who brings you… If we charge Amazon for every package they deliver to your house, the notion that Amazon’s profits will be reduced by the amount of tax we impose on Amazon is beyond facile, and just is not how it works. So largely what that would do is that cost, the tax will get passed through, we will reduce the liquidity and efficiency of US capital markets, and the pain from that would be borne across a variety of people, first and foremost, the actual people who are trying to trade shares.

0:58:49.9 Silent Cal: And so it’s not a way to achieve the policy objective that she’s trying to achieve, so I really think it almost would be independent of your view, that’s a policy that’s so bad, it’s like rent control, it’s so bad of a policy view that I think it’s almost preference independent, unless you just want to ruin the US capital market ’cause you’re pro‐​China or something, you should be against a financial transactions tax, it’s that strong. And I usually think things are trade‐​offs, the trade‐​off here seems to be like America versus not America, financial transactions tax is one of the most hurt American society policy ideas that’s out there.

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0:59:36.0 Aaron Powell: Thank you for listening. If you enjoy Free Thoughts, make sure to rate and review us in Apple Podcasts or in your favorite podcast app. Free Thoughts is produced by Landry Ayres. If you’d like to learn more about libertarianism, visit us on the web at www​.lib​er​tar​i​an​ism​.org.