Griffin's Problem: Microstructure, Citadel and GameStop
What happens when noise traders gang up?
Ken Griffin has a problem. He is worth about 20 billion and runs a 35 billion hedge fund called Citadel Securities. He and another hedge fund titan, Steven A. Cohen of Point72, formerly known as SAC Capital, that Preet Bahara went after for insider trading, are invested in Mervin Capital. The latter is run by former SAC traders and is in the business of shorting losers. That is, it makes leveraged positional bets wagering that selected firms are overvalued. One of the firms it was shorting was GameStop. Citadel is also in the business of market-making for Robinhood. This means that Citadel is prepared to take the other side of the trade when a retail trader wants to make a directional bet, with the result that it has an unpredictable inventory of stocks that depend at least in part on order flow by retail traders.
Microstructure theory tells us that the market marker’s problem is to detect the presence of informed traders. On their part, informed traders like Mervin exploit the order flow from noise traders to mask their presence. What does it mean for a trader to be informed? It means that the trader has a private signal that is not visible to the market maker — that it is somehow more informed about the future price of the security than the market maker. Now Citadel pays Robinhood to relay order flow information — information that it uses to, if not to front-run the order flow, which is illegal, then at least to manage the risk posed by its constantly changing market-making inventory. In order to manage this inventory risk, it must constantly hedge its net position. This hedging is procyclical — if Citadel has a net short position on a stock, it must hedge that by going long that stock, which pushes up the stock further. In other words, faced with an order flow that is net positive for a stock on Robinhood, as the main market maker, Citadel would be forced to neutralize that exposure by wagering that the stock would go up further.
Meanwhile, if an informed investor like Mervin is shorting a stock that is rising in value, she must post margin and pencil in a mark-to-market loss. Moreover, in order to manage the risk posed by her short position, a positive revaluation of the stock also forces the short seller to hedge her exposure by wagering that the stock would go up. So the short seller’s response function is also procyclical. Now, what happens if a hedge fund mogul like Ken Griffin is invested in both the short selling and market-making business for the same stock? Well, usually this is not a problem as long as most traders in the market are noise traders — that is, if they know less about the future value of the security than Ken Griffin and his armies. Griffin has hired the sharpest minds in the business and is potentially taking positions against basement traders who hang out on Reddit. So, in the normal course of events, Griffin systematically makes more than them.
Note that Griffin’s business is highly profitable and stable as long as traders on Robinhood trade on their own individual private information. Essentially, he has been betting that he is in a privileged position relative to the Robinhood small fry because he and his guys, unlike the small fry, have eyeballs on the order flow, greater risk-bearing capacity, and more informed fundamental analysis of the security in question.
But what happens when noise traders can coordinate their trades on social media platforms like Reddit? If they can coordinate, their herd trading would swamp the smooth impounding of information into asset prices by Griffin’s machines and those of other market-based financial intermediaries. The small fry would no longer be trading on their own individual private information. They would be trading on systemic information about future order flow based on their own coordinated joint trading activity. Having discovered reflexivity — a fundamental condition of the market as Soros has put it, if indeed not of modernity itself, as in Beck’s schema in Risk Society — they could exploit the possibilities for large-scale coordination opened up by social media platforms to take on Griffin’s industrial-scale machines for price discovery.
What happened in the GameStop drama is thus the weaponization of herd behavior. When noise traders started coordinating their bullish bets on the stock, they squeezed both of Griffin’s businesses. The short sellers were served margin calls and forced to cover their positions. His market-making business was forced to hedge the net short positions imposed by the strongly biased order flow. Both responses pushed the price further up. Meanwhile, his losses kept mounting. What was to be done?
There was only one solution to Griffin’s troubles. And that was the stay one step ahead of the mob. The machines had to be trained to track noise traders’ coordination on social media platforms. Griffin’s armies are now in the social media surveillance business, using natural language processing to track the mob’s intentions in real-time.
What will happen in this surreal confrontation between the weaponized herd behavior of the financial lumpenproletariat and capitalism? In the very short run, perhaps Griffin will continue to lose some more. But given the scale of resources available to solve the problem, Griffin’s armies should be able to neutralize the threat posed by the mob. Further down the line, mobs may congregate behind securely encrypted platforms and be in a position to mount further attacks on Wall Street’s fortifications. Is the long-run future of finance then decentralized and democratic? I wouldn’t bet on it. To do so would be to severely underestimate the agility of financial capitalism.
"Melvin", not "Mervin"...
Do we have reliable estimates on the amount of trading in GME type positions that's by the Reddit/WSB "gang" vs what I would assume to be a more well-financed group of "symmetry-breaking yields price momentum trend followers"? GME traded almost 200m shares on 1/22. At $55/sh (just a guess as I don't have the VWAP), that's $11b. That's a lot of $600 checks!