The GameStop saga has been mainly portrayed as the revenge of the retail day trader against the mighty hedge funds. While we all love the romanticised version of this story, the reality is more complex than that and it may well be just the result of a regulatory failure made in USA.
The Price Spiral Fed by the Squeeze
GameStop is also known as the ‘Blockbuster of the videogames’ and was, for some analysts, destined to go out of business in a world where videogames are accessed and played online. But GameStop, for many, is also the story of the rebellion of thousands of Reddit users against greedy hedge fund managers. Some have argued that we are in front of a paradigm shift in retail trading, where social media become a tool to interfere with the normal course of activities for businesses and markets, or even a new form of market manipulation. As always, the truth is less straightforward and in the coming weeks the attention will continue to shift towards the current regulatory framework for short selling in the United States.
Meanwhile, in the last weeks, we have heard stories of traders becoming rich by successfully riding the price spike from $20 to almost $500 combined with stories of hedge funds, like Melvin Capital, losing more than 50% of funds under management in the attempt to hold their short positions during the squeeze (with a net loss estimated between $4 and $5 billion). But the squeeze was relentless in pushing prices so much that many of those holding short positions, financed by brokers at an interest rate, were forced to close them by buying the stock to be given back to the lender. By doing so, though, they pushed prices even further up to levels that have clearly nothing to do with the fundamentals of the company.
Let's look at the dimension of this squeeze. Short interest on GameStop in the past weeks reached up to 132% of the floating (shares available for negotiation) and roughly 90% of all the shares outstanding (source: ShortSqueeze and Yahoo Finance). A list of other US stocks also reached similar levels and were subject to squeezes, but in a smaller scale. To give an idea of the dimension, the most shorted European stocks exhibited a ratio of short interest over floating not higher than 20%. In fact, attempts to replicate squeezes on stocks like Pearson and a few others have miserably failed.
These data cast doubt on the dominant view that this situation was merely the result of the irrational behaviour of bored retail day traders. It rather gives the impression of a calculated, rational battle between two professional camps. For what concerns retail investors, there is actually no proof yet that those who triggered the squeeze were mainly retail investors. When it comes to irrationality as potential trigger, it may well be that some small investors acted irrationally, but presumably later when caught into the upward spiral and wanted a bit of the cake when prices were closer to the peak. However, before and for most of the squeeze, it was absolutely rational for investors to consider a bet against unsustainable levels of short interest by going long, especially if these short positions have not effective availability of the underlying share when sold in the market that need to be later purchased when the trade fails to deliver (so called ‘naked shorts’). In fact, due to the dimension of the short interest, the data clearly suggest that GameStop had large naked short positions financed by brokers. These naked short positions are evidently very short-term, as the broker needs to purchase the share at some point to remedy to the settlement failure (since the share was sold without owning it). Nonetheless, if prices move higher and it becomes too costly or even difficult to get shares in the market, this further raises the risks of large settlement failures for the brokers, possibly exposing them to sanctions, litigation and operational problems. If the rush happens on a large scale, it might set off a reaction chain of purchases (‘fire purchases’), so feeding the squeeze at least until a sufficient amount of shorts are gone. And it did.
The End Game
As for the May 2010 flash crash, a short squeeze of this dimension is an artificial price movement that will be studied in the years to come and, thanks to the results of research studies and investigations, we will surely know more about it. But preliminary analysis of the data and the regulatory framework point at a peculiar situation very much specific to the US market structure.
Regulation SHO of the Securities and Exchange Commission (17 CFR §242,203) allows naked shorts on the mere basis of the broker having a ‘reasonable ground’ to believe that will be able to borrow the share to be available at settlement date. The same regulation (17 CFR §242,204) gives the broker one additional day on top of the standard US settlement cycle (T+2) to close out the failure with the penalty that the clearing broker may not effect further short sale orders. Moreover, the broker is given 13 business days to bring a threshold security, a share that has reached a threshold of settlement failures equal to 10,000 or more at a given date and equivalent to 0.5% of shares outstanding, below the acceptable level of failures. This de facto allows the broker to finance large naked short positions, at least in the short time.
In effect, during the days of high volatility, GameStop shares remained classified as ‘Threshold Security’. Such delays in the delivery of shares, combined with the gigantic size of the underlying short interest, should have rung the alarm bell of too large naked short positions that can cause an artificial price movement even under normal market circumstances (as it did).
The regulatory framework on this side of the Atlantic leaves, on the contrary, much less flexibility when it comes to building up large short interest positions. European Regulation (EU) No 236/2012 on Short Selling, Article 12 in particular, prohibits naked short sales, unless there is direct availability of the stock or via binding agreement with third parties. This makes the US magnitude of naked short sales practically impossible in Europe.
From a regulatory perspective, the key question should therefore not be who triggered the squeeze, but shall the system be allowed to produce a squeeze of these dimensions even in normal market conditions? Hence, are such levels of (naked) short positions sustainable and should they be allowed even temporarily? European and US rules are clearly diverging on this point.
In the coming months, we will know what is the role that social media have really played in the upward spiral of the share price. Investigations will have a difficult time to prove manipulation on a large scale, as making public an interest to buy or the actual purchase per se does not amount to manipulation, unless the information is deliberately false or misleading to push prices in a certain direction and then trade against these public intentions.
While this is still to be proven, there is no doubt that regulation played a key role in the build-up of such high level of short positions, which ultimately created the conditions for a squeeze of these dimensions to happen. As a result, GameStop is also the story of regulatory and supervisory failure, which is dearly costing investors of all backgrounds, whether they have bet short or long on this share.
Diego Valiante is an Adjunct Professor at the Department of Sociology and Business Law, University of Bologna and team leader at the European Commission.
The views and errors in this blog post can only be attributed to the author and not to the institutions of his affiliation.