Some thoughts on GameStop
The recent phenomenon of a Reddit-driven short squeeze on GameStop is a fascinating display of the interplay of investor behavior, crowdsourced investment ideas, market dynamics, and the internal regulatory mechanisms that govern Wall Street procedures. What it is not is an easy story to tell, despite the convenient Main Street vs. Wall Street narrative. This is an effort to explain much of what has gone on and what the implications are for the future.
Reddit (r/wallstreetbets) embraced an investment thesis from one of its members that the share price of GameStop was being artificially suppressed by short-selling hedge funds including Melvin Capital. It should be noted that the term “hedge funds” is an imprecise catch-all for a number of strategies, many of which hold many long positions and a handful of short positions. What they do have is a lot of leverage, which through options and borrowed funds enables them to take on a great amount of risk for a great amount of potential reward. However, short sellers are susceptible to an organized short squeeze; with brick-and-mortar, seemingly antiquated businesses like GameStop, this risk was perceived by Melvin to be relatively low.
Reddit users banded together to force the price of GameStop to rise through both share purchases and option contract buys, resulting in losses for Melvin and requiring their ilk of short-sellers to ultimately buy back the stock to close out their positions, futher fueling rising prices. The supply/demand imbalance was remarkable, driven by the viral nature of Reddit and social media, as the pitchforks were out. Small investors were getting their revenge on Wall Street vultures. The stock reached a high of $483, up from a 52-week low of just $2.57. Early long investors produced stunning paper profits and became celebrated paper millionaires. Melvin and others lost billions into the pockets of the retail longs.
Robinhood was the preferred trading platform for the meme stock crowd for its attractive mobile user interface (especially versus legacy brokerages), ease of use, and the fact that trades are free. The latter two characteristics, however, are critical parts of its recent challenges. To allow investors to trade right away, Robinhood defaulted people into margin accounts that they likely did not understand. In margin accounts, the investor doesn’t technically own the stocks in their name and are effectively borrowing funds to finance their immediate purchase. When the price goes down, investors face margin calls and are required to put up funds or be closed out.
Additionally, Robinhood is required by the DTCC to put up collateral for the value of the shares on their books prior to the trades being settled over the two days following the trade. This is a regulatory requirement to reduce counterparty risk. Due to the price volatility of GameStop, DTCC raised the collateral requirement thirty-fold. Robinhood simply didn’t have the money to post this collateral. That is why they limited new purchases of GameStop while allowing sales. Selling GameStop shares reduced its financial requirement and improved its ability to function. This wasn’t a moral or Big Brother decision, nor collusion with hedge funds. It was necessary to stay solvent.
What are the implications for the future? Let’s explore by each of the players:
• Reddit – it’s likely that r/wallstreetbets will be further infiltrated by market players looking to “talk their book” and influence message boarders to buy shares in their existing positions. It is the Wild West, with few rules applying to anonymous posters. The SEC will be identifying users and reviewing posting activity versus trading activity, because this dialogue is technically market manipulation. The renewed interest in the stock market, however, will be a net positive as long as too many folks don’t lose their shirts. That is unfortunately inevitable for GameStop shareholders.
• Robinhood – the brokerage needs to continue to find lines of credit and additional capital to avoid having to throttle its customers by limiting their ability to by these meme stocks. Additionally, they are taking a lot of heat for an industry practice known as payment for order flow, which is how they are able to offer free trades. Robinhood routes your order to certain market makers in exchange for commissions that allow them to offer “free” trading. Their largest market maker is Citadel Securities, who quite ironically operates one of the most successful hedge funds in the industry. The key consideration for Robinhood is how tarnished is their brand now that people are starting to understand how the internal machinery of Wall Street works.
• Short sellers/hedge funds – this episode is a reminder of tail risk. Hedge funds are rapidly de-risking their portfolios and will likely take different short bets in the future, involving anonymous options rather than disclosed overt short positions. Without a doubt, the last several weeks have shaken the hedge fund industry and will invite further inquiry and regulation from Congress and the SEC.
• Institutional investors – pensions and endowments lean heavily on hedge funds to produce risk-adjusted returns necessary to juice the results of underfunded liabilities. Long-short hedge funds are critically important to produce all-weather performance. While it was entertaining to take out a hedge fund manager, that performance impact will be felt by firefighters, policemen, and teachers. There will be heightened scrutiny of the use of hedge funds by both asset allocators and the general public.
• Individual investors – the guess is that there will be more scrutiny over allowing small investors to trade options. They are sophisticated instruments that juice returns in one-way momentum markets like we have at current. The democratization of trading is a good thing, but there needs to be improved guardrails to prevent less experienced traders and investors from the endemic risks that may not be apparent to all.