By Julian Molina, Co-Founder at Superalgos.org
Open-waters foodchain analogies have always been the market’s favorites for describing the relative weight of different market actors. Whales, representing institutions, eat fish, that is, retail investors—or so goes the typical thinking.
However, the popular adage was put in question when the WallStreetBets phenomenon exploded unexpectedly back in January 2021, proving that even a loosely-coordinated school of fish may go after whales.
Just in case you didn’t pay attention to the weeks-long saga, the event I’m referring to involved roughly three million retail investors setting up a short squeeze on GameStop (NYSE: GME), coordinating the action through the now-famous r/WallStreetBets subreddit. The collective trade drove the stock price up by 30X, producing significant losses to hedge funds with short positions on the stock.
It was the first time financial markets registered such an event, and even though the action was discussed in the open, no one saw it coming.
The new wave of retail investors flooding the markets during the pandemic is slowly reshaping the demographics of the ecosystem. Millennials are the first generation of investors that grew up with the Internet, smartphones, and massively multiplayer online role-playing games. Their natural relationship with technology, their predisposition to massive online collaboration learned from online gaming, and their inclination to communicate and coordinate over social media will have an impact on the markets that few can even imagine.
My line of work with an open-source community has opened up a window into the minds of young and not-that-young adults throwing part of their disposable income at the markets. What I see is a major shift in the tide building up, unlike anything we’ve seen before.
I foresee such a dramatic change in market dynamics that a whole new paradigm of maritime analogies will be necessary to describe the new game. Millennials are going to war, and the oceans where whales used to thrive will turn into naval military theaters.
The WallStreetBets saga didn’t go that well—after all—for many of the retail investors involved in the plot. Although they did manage to make a dent in the deep pockets of hedge funds like Melvin Capital, the collective trade was disrupted by external forces in a confusing series of events involving several retail brokers who unilaterally halted purchases while continuing to allow sales of the stock.
The arbitrary intervention of intermediaries disrupted the momentum of the operation, the plot lost steam, and the collective disbanded after a few days.
The coordinated action born within the famous subreddit suffered from three major limitations, all of which will be lifted by Web 3.0 tech sooner than later.
First of all, the three million investors used ancient technology to coordinate the collective trade: Reddit is mostly a Web1 Internet forum with some Web2 social capabilities. Secondly, the crowd was trading manually. These two characteristics of the collaboration resulted in a severe inefficiency: It took more than three weeks to build up the collective position, giving competitors ample time to react and to pull the levers of power that whales usually have access to.
The third major hindrance came from the fact that investors were accessing the market through an intermediary that constituted a central point of failure. It’s not hard to picture the affected hedge funds picking up the phone and making a few calls until they got the broker to pull the plug, arbitrarily stopping the coordinated action.
What will happen when Web3 technology gets to empower millions of investors with trading bots seamlessly coordinated via a peer-to-peer network that no one may shut down?
Trading algorithms have been around since the 80s’. They evolved rapidly as investment firms entered an unprecedented R&D arms race in search of the holy grail: a super algorithm that would beat everyone else’s.
Although such dominance amongst algorithms never materialized—not even with the outburst of AI—the arms race resulted in an extreme imbalance in the capabilities of institutional and retail investors. For decades, algorithms remained a domain of institutions.
However, the advent of cryptocurrency markets fueled a new industry around trading technology. Trading bot companies and open-source projects serving retail cryptocurrency traders are riding the swell produced by the growing inflow of venture capital into the Web 3.0 space.
For the first time in history, retail investors have access to trading automation technology that is growing in sophistication and capabilities. Add the Web 3 paradigm by which community-owned projects build open and censorship-resistant networks, and you have the first hint as to where things may lead to.
Pretty much like Bitcoin gave us unstoppable money and Ethereum gave us unstoppable execution, decentralized trading will give us unstoppable coordination.
What will happen when the next collective trade aggregating the capital of millions of retail investors takes three minutes to coordinate instead of three weeks?
How will the market react when this seemingly once-in-a-lifetime event starts occurring regularly? First, once per month, then once per week, then every day, and—finally—any time or all of the time?
In the Web 3.0 era, decentralized organizations counting millions of retail investors, each deploying entire fleets of coordinated trading bots, will dominate the deep, turbulent waters of financial markets. Retail traders, the world over, will join forces in both open and closed collaborations.
In a way, closed collaborations will resemble investment firms. Players with different specialties will come together, pooling both intellectual and material resources to become smarter, stronger, and faster. Developers, system administrators, mathematicians, data scientists, AI engineers, market analysts, professional traders, portfolio managers… will all work together to collectively produce and deploy trading intelligence, using software and a tech infrastructure designed to enable frictionless collaboration.
Closed retail trading groups will compete with larger, open, and trustless collaborations counting thousands of contributors.
Yet, they will all trade without counterparty risks.
Instead of pooling capital together to trade from within a central account, each member of the collaboration will deploy their own bots feeding on the collective intelligence but trading from within their own premises and their own accounts.
Both open and closed collaborations will extend their reach by letting outsiders copy their trades without revealing their strategies. The tactic will garner them unbelievable influence, as they will pool capital from millions of investors who will be happy to follow those who know more.
Investors will form inextricable webs of connections by following each other using a new generation of social trading apps operating over decentralized peer-to-peer networks.
Because of the disruptive nature of such collaborations, the underlying technology infrastructure will be built with pseudonymity and censorship resistance as core design criteria.
No one will be able to stop the peer-to-peer connections, and no one will be able to tell who is being coordinated.
The new players will be spotted in cryptocurrency markets first—the wild-west of financial markets. Major market players will regard their first few actions as piracy acts. They will decisively condemn their conduct and demand for regulators to step in.
Indeed, the once-dominant players will feel the pressure early on. Many of their usual tactics will become extremely risky. Actors perceived as unethical players will be targeted systematically.
No matter how much whales disapprove of the new paradigm, if free markets are to remain free, they will have to adapt to the new game. The rules will remain unchanged, but retail players will have evolved their toolkit to such an extent that they will effectively change the nature of the game at its core.
