Online investing communities on platforms such as Reddit and Stocktwits have been instrumental in the birth of meme stocks and the recent shift in power over market sentiment. While difficult to define, meme stocks are broadly understood to be stocks valued on hype rather than fundamentals, and subject to volatility driven by social media. Their rise, led by individual retail investors aware of their growing influence on the market, has led to hedge funds and retail investors alike nursing deep losses.

Meme stocks gained considerable scrutiny in early 2021 after video game retailer GameStop was transformed from a struggling company to a stock market marvel almost overnight. The shock buying spree in its moribund stocks, launched by the now-notorious WallStreetBets retail investors on Reddit, sought simultaneously to profit and punish large hedge funds holding short positions in the retailer. However, the mania subsided within weeks, wiping $27 billion off GameStop’s valuation.

After the initial shock rise and fall of GameStop, its shares inexplicably surged again towards the end of February 2021, with stocks climbing by 104% over the course of an afternoon. In the same afternoon, Reddit was down for many users. This second move was received with even more consternation than the first, as analysts struggled to work out a reason for the sharp surge, eventually concluding that it may have been caused by the CFO’s resignation. Meanwhile, social media speculation bizarrely attributed the renewed frenzy to an activist investor’s Twitter post of an ice-cream picture.

The rise of online communities and the challenges of moderation

While the GameStop event may have served as a cautionary tale, it appears the meme stock frenzy is far from over – with 16 further US and European stocks up triple digits since the start of the year. Outside observers have not historically paid much attention to discussion groups on websites such as Reddit, but they are now taking heed.

The GameStop activity is just one of a series of recent events showing how much influence internet platforms now have on real-world phenomena. Earlier this year, the storming of the US Capitol building in Washington DC by supporters of former president Donald Trump and far-right groups was largely organised online, and was broadcast live on popular social platforms. The footage and surrounding commentary became grounds for heavy moderation, with Reddit banning forums such as r/donaldtrump for inciting violence.

Within a few weeks, activity on WallStreetBets also became the focus of a moderation controversy, with a surge in membership by more than two million users leading to countless episodes of hate speech that were impossible to moderate due to the rapid growth in numbers.

The questions surrounding the legality of GameStop activity

As the storm around meme stocks failed to die down, the US Securities and Exchange Commission (SEC) moved to suspend trading in various companies, noting that “certain social media accounts may be engaged in a co-ordinated attempt to artificially influence” share prices. The Robinhood online trading platform was the subject of a congressional hearing, facing accusations that it wrongfully halted trading in volatile stocks in support of its hedge fund backers.

In the wake of GameStop’s crash, questions remain as to the legality of the events and actions prompting its share price spike. Following widespread speculation that sophisticated actors may have been involved (and given the extent of trading volumes over the period in question in GameStop stock), Reddit has been forced to respond, denying that any activity on WallStreetBets was driven by bots or foreign agents. The SEC is nonetheless reviewing thousands of social media posts to determine whether the activity amounted to a pump-and-dump scheme – a type of fraud usually ascribed to investors making false claims to drive up the share price of their stocks, and then selling them before the lies are exposed.

There is little to suggest WallStreetBets members disseminated false or misleading information about GameStop, with Philip Moustakis, former senior counsel in the SEC’s Division of Enforcement, referring to it as “decentralised chatter”. However, the weaponisation of social media to artificially drive-up GameStop’s share price may yet prove to fall short of the Securities Exchange Act’s authorised activities.

The SEC’s response to the GameStop saga

Questions over the legality of the GameStop activity have led to a broader interrogation into whether modern trading practices are consistent with investor protection and the fairness of the markets. While some established hedge funds have suffered significant losses from meme stock mania, individual investors are likely to be most at risk. Many of these individuals are novice investors using online platforms that enable them to mirror the moves of established platform users – leaving them susceptible to being drawn into similar frenzies, with little protection from the consequences.

In light of this, the SEC is preparing a report on trading practices relating to the recent volatility. It will investigate all actors involved to identify any possible misconduct – including retail investors’ possible market manipulation, potential breaches of fair access rules by trading apps, and whether there has been any complicity on the part of the targeted corporations.

The commission is also looking to impose new regulations including the addition of reporting and suitability requirements, trading restrictions, increased capital requirements and caps on short interest. While a long road lies ahead for the implementation of these new regulations, their effects will be far-reaching. The focus is on requirements for brokers, with the goal of creating an informed and responsible base of retail investors. However, if meme stock mania can be driven by sophisticated bad actors through inauthentic practices, such regulations are unlikely to put a quick and definitive end to meme stocks.

New risks, new approaches to mitigation

Regulation is currently lacking, and platform moderators are struggling to control the content of online investing communities. For example, bots created to filter hostile language have been quickly thwarted by the introduction of alternative spellings. Consequently, hedge funds have begun to take meme stock mitigation into their own hands. Some are actively working to capture movement and analyse sentiment on online community forums, wishing to protect themselves having witnessed the impact of the GameStop activity on Melvin Capital, among others.

The scale of platform-specific dialect on Reddit presents a significant obstacle to these efforts, with monitoring systems often failing to recognise factors such as the influence and weight of popular commentators or the extremely varied demographic spectrum of the forum’s users. While new solutions that promise to notify every mention of specific stock have appeared, with existing natural language processing technology failing to capture the precise sentiment indicators that hedge funds need to monitor, there is a rising demand for insider perspective.

New York-based quantitative fund Cindicator Capital was recently reportedly looking to hire a ‘sentiment trader’ with very specific attributes, including an active account on WallStreetBets for the past year and a minimum of 1000 karma (a measure of user contribution to Reddit) – as well as an alternative approach to the field outside of ‘mainstream financial brainwash’ – effectively excluding candidates with just a formal economics education. The fact that such high priority is now being given to first-hand knowledge of platforms such as Reddit demonstrates that institutions are facing an urgent need to react to the growing influence of internet communities. There is an increasing demand for effective tools to track and monitor such nuanced and platform-specific discourse.

The media and technology sectors are sure to respond to this new set of challenges, but platforms such as Reddit have a nimble user base that is quick to adopt new language and behaviour. This, coupled with the constant emergence of new platforms and developments to existing ones, means that such monitoring will need a two-pronged approach. Applying advances in monitoring technology, when coupled with human expertise gained from first-hand experience in the relevant online platforms, may enable institutions to limit the risks posed by meme stock activity. But this is an ever-evolving set of challenges – and they will need to stay on their toes to avoid falling prey to meme stock frenzy.