Hedge Funds Eye Reddit for Red Flags, But It Won't Bring the Next Storm

By Luiz Molina, Co-Founder and Lead Developer at Superalgos

In 2021, Wall Street stumbled upon a new Web page to bookmark and check up on daily: a certain subreddit that left Melvin Capital, a $13 billion hedge fund, reeling by torpedoing its GameStock short position. Yes, r/WallStreetBets made a splash, and the financial world sat up and took notice, moving to keep tabs on the unruly message board.

Make no mistake, the GameStop saga, alongside the AMC rally and Reddit’s other forays into market adventurism, are indeed harbingers of a larger storm to come. But the storm won’t come from Reddit, which took days to mount a joint effort, still plagued by self-interested speculation of individual members. Instead, it will come from the blockchain world, driven by decentralized organizations uniting retail investors to harness the wisdom of the crowd.

In essence, a decentralized organization is a community of peers working on a common cause or project. The organization either lacks or de-emphasizes clearly-defined leadership and hierarchies, instead focusing on the power of participants’ contributions as the driver of progress. To incentivize members to contribute, the organization can issue various rewards to members who help to advance the cause.

DAOs, which are now making headlines for projects like purchasing a historical copy of the U.S. Constitution (didn’t go as planned, by the way, thanks to the CEO of Citadel, a hedge fund that poured $2 billion into Melvin after the GameStop fiasco), are a more specific instance of such groups. Their main distinction lies in formalizing their operational rules as smart contracts, decentralized, auto-executing, and unkillable apps deployed on blockchain. As long as the blockchain network carries on, the DAO lives on too.

DAOs can sometimes replicate the standard publicly-traded company model by also issuing their own native tokens, which grant the holder voting rights in the organization and can be sold for profit. This allows them to fundraise, welcoming both private and institutional investors as new members who can take part in the procedures that determine the group’s strategic course and specific policies. Some DAOs also set up specialist committees and groups, open for all members with relevant experience and ideas to take part in, to manage their day-to-day operations. 

Even without codifying and immortalizing its rules with smart contracts, a decentralized organization can still tap blockchain to reward its users with native tokens. From messaging apps helping its members organize to more advanced tools such as AI and automation, it can also utilize a plethora of other technologies brought about by the digital era in line with its needs.

Channeling the wisdom of the crowd

The decentralized format can work for groups working on all sorts of causes, but one of the trends that is slowly ramping up in the blockchain community right now is coming together to trade. In the long run, the results can be truly awe-inspiring, as we can infer from the WallStreetBets rally of early 2021. The GameStop story is a good example of how much of a juggernaut retail investors can turn into by coming together to stage even a loosely-organized financial operation.

Granted, this endeavor was not fully decentralized. One of the key figures behind the GameStop push is a seasoned, market-savvy financist, who shared his knowledge of the way the financial world works to rally others around the flag and get the ball rolling. In doing so, he showcased how retail investors can beat the Wall Street big-shots at their own game with their own tricks, but organized in a collaborative manner.

This also plays into another curious problem. Some theorists of finance tend to view market operations through the prism of the so-called wisdom of the crowd. When making informed decisions, the theory goes, the crowd can be smarter than its individual members, correcting their mistakes in its general course of action or averaged estimate. The idea here resonates a bit with WallStreetBets’ warcry “Apes together strong,” doesn’t it?

A curious international study from a few years ago moved this idea along further, suggesting that crowds within crowds could be wiser than the crowd itself. The researchers first asked the participants several questions individually, then split them into smaller groups and allowed them to come to a consensus answer. The groups fared better than the averaged individual answers, which, in turn, were supposed to outdo individual answers as per the wisdom of the crowd theory.

From a certain perspective, this is exactly what had happened with WallStreetBets. A group within the crowd (the subreddit, which likely involved a plethora of people with good financial pedigree) outwitted the larger crowd (the market) and reaped the benefits. A similar approach was put on display by investment clubs, investor collectives dating back to 1950s, which didn’t have the digital tools that enabled redditors to move together at the speed and scale of today. An investment-focused DAO is simply the logical next step in this sequence.

The storm of the century

On their own, a retail investor is a small fish in an ocean dominated by whales. They are outgunned in every aspect, from the pool of finances available for investment to their understanding of finance, mathematics, market research, artificial intelligence, programming, and every other tool employed by hedge funds. Even if they happen to have a PhD in one of these fields, they’re hardly a jack of all trades.

When coming together, though, retail investors can play off each others’ strengths, while compensating for each others’ lack of knowledge and skill. Even though investing is sometimes thought of as a zero-sum game, which is not conducive to collaboration, the promise of shared gains could be the incentive for teaming up. At the same time, though, as we already mentioned, individual defections from the common cause can make dents in the fundament of the joint effort. 

The DAO format adds an extra incentive for collaboration in the form of its native tokens, which can be programmed to give its holders various benefits and rewards. At the same time, selling these tokens can bring in extra revenues, which amps up the promised gains. This results in a double positive reinforcement loop, keeping up the momentum of the project and helping to bring more and more contributors in.

By tapping smart contracts, DAOs can also prevent individual defections, organizing collaboration into a self-fulfilling prophecy. Their members can build custom software enabling rapid and efficient joint efforts from a potentially unlimited number of participants. Acting as an army of talents, not as a disjointed school of fish, they will move faster and hit harder. Collaborating and polishing off their strategies, they will eventually morph into a force to rival the bigger fish of the Wall Street pond.

The genie is out of the bottle: WallStreetBets has given rise to a new wave of investor collaboration projects, which is now gaining pace and momentum. Once it matures enough, GameStop-like hikes will not be rare and individual events. They will take place every day, if not every hour, coordinated over unkillable peer-to-peer networks and unraveling at a pace and scale that will make hedge funds move over as the apex predators of finance.

About the Author

Luiz Fernando Molina is the Lead Developer and Co-Founder of Superalgos, an open-source, community-centric decentralized trading intelligence ecosystem. Starting his career as a software developer for banks at Kepler Technology, he went on to found and lead multiple companies, including development studio Frame Labs, architectural products company Nomad Inception, and Internet of People project 

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.