Diamond hands, short squeezes, bailouts—these terms became mainstream in January 2021 as the story of a grassroots Reddit community disrupting a powerful hedge fund went viral. However, going beyond the headlines, what happened with the Robinhood saga creates a very strong and compelling case for why Decentralized Finance—DeFi—offers solutions to problems that stem from a centralized, inefficient system that lacks transparency.
To understand the context that led to this pivotal moment, it’s important to know that hedge funds often use combinations of shorts & options—and some of them, most notably Melvin Capital—had been shorting a company called GameStop for years. The story began to unfold when some individuals from WallStreetBets—a loosely organized but high-spirited Reddit trading community—noticed excess shorting relative to the company's free float. Essentially, more shares of $GME were being lent to short sellers than were actually available. WSB traders started buying up $GME, massively driving up the stock price. As this happened, what may have begun as simply an opportunity for Reddit investors to make a profit turned into a more formal strategy to take down a hedge fund.
With such a huge rise in stock price over a short period of time, institutional investors were rushing to cover their positions, further exacerbating the upward tick in $GME price and creating a short squeeze. Other stocks, such as movie theater chain AMC Entertainment, also became a target due to having a high amount of shorted stocks in comparison to its float. AMC shares could have been bought for $2 at the beginning of January 2021; by the end of the month, they had risen more than 10x.
Over the next few weeks, the price of these stocks saw a meteoric rise, leaving these hedge funds billions in debt. Melvin Capital, the biggest short seller, was close to liquidating their position when Citadel and Point72 infused close to $3 billion to help cover their position. Later on, sources would discover that Citadel Advisors LLC not only had a significant short position in $GME, but also stood to make money as the stock went up and down. Arguably, large hedge funds exploiting loopholes for financial gain wasn’t shocking news—but the events that unfolded over the following days would be.
On January 28, 2021, after GameStop stock had risen by more than 400%, several mainstream brokerage platforms—including Robinhood—shut down the ability to buy shares of GameStop and other trending stocks, “in light of recent volatility.” With this move, users only had the choice to liquidate or close positions. For an app with a mission to “democratize finance for all,” this did not sit well with users or do Robinhood any favors in terms of public sentiment.
This controversial move did not go unnoticed, but in fact became a viral story. It captivated people around the world who hadn’t even heard of Robinhood, and incited anger among the retail investors closed off from buying stock that larger investment funds still had access to.
The Pivotal Moment
With Robinhood users barred from buying certain stocks, a social movement began to gain traction. While many people may have agreed that traditional finance is rigged in favor of the powerful, this fact became incredibly clear and impossible to ignore. However, after seeing the pitfalls of a centralized system in action, it presented the perfect opportunity for the rapidly-growing DeFi space to demonstrate its value proposition.
In the DeFi space, financial applications exist that allow users to trade without the need of a third party like Robinhood. When users trade assets on Uniswap, they maintain complete control of their assets the entire time, operating under a transparent ruleset that applies to everyone. On Uniswap and other DeFi applications, users can invest money without having to rely on a bank. It is also impossible for any company or third party to prevent a user from buying an asset.
Robinhood’s decision to halt the purchase of various stocks incited outrage in many people, but however you describe it—unethical, disingenuous or hypocritical—it was something that as a platform owner, they were able to do.
What is DeFi?
DeFi is Ethereum’s Decentralized Finance sector, describing a collective mix of non-custodial protocols and projects. With DeFi, users can access lending, borrowing, derivatives, and exchanges just like traditional finance. However, instead of centralized entities like Robinhood making decisions, self-enforceable and automated smart contracts run these decentralized apps (dapps). Because code is public and open-source, it offers true transparency—and, users can be confident that their assets can’t be frozen or their trades limited.
DeFi isn’t perfect. It still needs to scale to achieve the volume of transactions that take place in traditional markets. And, with the ever-increasing amount of funds running through DeFi protocols, projects need to take security seriously. However, the fact remains that DeFi applications can be programmed to be open, permissionless, and operate 24/7 in a completely non-custodial fashion. In DeFi, users unequivocally maintain control of their own funds.
In light of the Robinhood saga, numerous proponents of DeFi have vocalized their thoughts online. Mark Cuban, an American billionaire known for his show Shark Tank, did an AMA with the WallStreetBets community, talking about the largely untapped potential of DeFi and Non-Fungible Tokens (NFTs). In February, Cuban also came onto The Defiant podcast, explaining why he’s bullish on DeFi and his thoughts on ETH as a store of value. Other Twitter influencers suggested people look into Ethereum and its decentralized financial system (and possibly make a lot of money in the process).
One thing is certain: DeFi has continued to experience incredible growth. At the beginning of February 2020, DeFi users celebrated reaching the milestone of $1B total value locked (TVL). Fast forward 12 months, and there is now over $40B TVL. Now, $1B TVL is required for a dapp to even make it into the DeFi Pulse Top 10.
While growth in the DeFi space is thought to be driven predominantly by retail investors, an increasing number of institutional clients have taken positions and begun exploring the DeFi space. On February 8, 2021, the Chicago Mercantile Exchange (CME) launched a futures contract on Ether, three years after Bitcoin futures went live. This move marks an interesting milestone and seems to signal increasing interest from the institutional crowd.
While there are certainly challenges the DeFi sector faces—user experience, volatility, scalability, and more—it also has the potential to completely transform the world of finance.
Staff Writer Derek Thompson recently wrote in The Atlantic, "Waging war against Big Finance by becoming a day trader is like waging war against the casino industry by becoming a gambling addict. Even if you’re winning, you’re still participating in a broader casino economy—buying drinks, eating dinner, throwing chips to dealers, filling out tables—that, over time, guarantees that the house keeps winning."
While the story of the WallStreetBets community banding together to disrupt powerful hedge funds may be inspiring, it doesn’t solve the problem: any centralized system with intermediaries takes away control from the user.
Vlad Tenev, Robinhood’s CEO, still maintains the move was done in good faith—"We absolutely did not do this at the direction of any market maker or hedge fund or anyone we route to or other market participants.” But whether his claim is true or not, traditional finance has forever been exposed for its worse traits: being siloed, non-transparent, permissioned, and built to benefit the powerful. While any new technology comes with challenges to overcome, DeFi’s potential has never been more clear: it’s public, global, open, and offers an entirely new world that gives power back to the people.