WallStreetBets and GameStop’s Potential Regulatory Impact

WallStreetBets and GameStop’s Potential Regulatory Impact

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On January 27, 2021, as the market trading day ended, GameStop (NY: GME), a brick and mortar retailer which might be expected to be reeling from Covid retailer concerns, continued a streak of impressive gains closing at $348 up 1,800% from January 1. r/wallstreetbets, a subreddit of almost 2.8 million users focused on stock speculation, had coordinated a short squeeze against hedge fund managers by highlighting GameStop’s surprisingly improving financials, publicizing the high levels of short interest held by institutional investors, and mobilizing users to buy and hold longer term.

Short squeezes, first made famous by legendary 19th century stock market operators, are the result of a mass of investors looking to cover short positions needing to buy shares when the price rises. If the price continues to rise more short investors will need to accelerate attempts to cover their position due to margin calls or other liquidity concerns. The resulting feeding frenzy and stock price surge upward famously led Daniel Drew, one of the original stock market operators, to quip after a short squeeze nearly ruined him, “He who sells what isn’t his’n, must buy it back or go to pris’n”.

The r/wallstreetbets users had been talking about the positive fundamentals of GameStop since September 2019 and chatter on the subreddit picked up significantly in September 2020 as the price slowly rose. The r/wallstreetbets users also later identified an extraordinarily high level of short interest of 140% of total shares from prominent hedge fund managers including Melvin Capital. Most holders of GameStop are likely long-term holders, and therefore short interest was at least 300% of GameStop’s “float” or how much shares are actually traded. Such unusually high short interest levels provided additional fuel to the fire; more price increases led to more users on r/wallstreetbets, which led to more chatter and more purchases. The price increase intensified significantly last Friday when the market for GameStop’s shares experienced what some market participants refer to as a gamma squeeze.

A gamma squeeze is created by options transactions as market makers are required by law to remain neutral and need to cover their positions required to write options. Gamma, one of the Greeks on options, is a number between 0-1 that changes on a call as the price of a stock gets closer to the call price. If the call is at $100 and the stock is at $90, the gamma would be 90 and market makers need to buy 90 shares to remain neutral. On Friday, the price was over every available call strike which meant the market makers had to buy millions of shares because if a call is “in the money” then the market makers need to deliver the shares.

The price run caused by the combined short squeeze and gamma squeeze caused Melvin Capital to reportedly close out their position in GameStop at a catastrophic loss, and it caused the exchanges and trading platforms to halt trading on these stocks several times over the last few days due to volatility.  Prominent hedge fund managers Citadel and Point72 reportedly lent Melvin Capital $3 billion to shore up its finances and avoid a bankruptcy filing.

The trading halts in some cases limited investors from purchasing additional shares but did not limit sales. That one-sided restriction enacted by Robinhood and other brokers seemingly benefits the short-selling hedge fund managers allowing them to cover or initiate new short positions at a more advantageous higher cost basis. The trading halts combined with the shutdown of the Discord server which the r/wallstreetbets users utilized for communication sparked criticism from an eclectic group with business (Mark Cuban), social media (Dave Portnoy) and political (Alexandria Ocasio-Cortez, D-N.Y., Ted Cruz, R-Texas) personalities weighing in. Robinhood defended its decision to limit trading as necessary for risk-management citing SEC net capital obligations and clearinghouse deposits which can fluctuate based on market volatility.

Regulatory Impact: It is unclear at this point what the SEC response will be, but there are reports that they are looking into posts from the r/wallstreetbets subreddit. There may not be a case for insider trading, but there is a likely case against the Reddit users for securities fraud or market manipulation. If the SEC examines the language used by r/wallstreetbets and determines users were disseminating false or misleading information with the purpose of manipulating investors into buying securities, the SEC may pursue investigations and ultimately enforcement actions.

Nasdaq chief Adena Friedman said exchanges and regulators need to pay attention to the potential for pump and dump schemes driven by chatter on social media. “If we see a significant rise in the chatter on social media … and we also match that up against unusual trading activity, we will potentially halt that stock to allow ourselves to investigate the situation,” Friedman said on CNBC. “If we do think or contemplate that there may be some manipulation, we then engage with FINRA and the SEC to evaluate and investigate that.”

This type of coordination among amateur traders, made easy because of the internet, is likely to continue occurring for at least the immediate future. Similar, albeit less dramatic, short squeezes in other stocks, such as AMC and Blackberry, suggest hedge fund managers that take large short positions may consider disclosing the risk of this sort of “attack” to investors via Form ADV Part 2A brochures, offering documents and due diligence questionnaires.

Political pressure and/or lawsuits may require Robinhood and other brokers to substantiate their claims that net capital was its primary concern when halting trading. Regulators may require Robinhood and other brokers to disprove the accusations that they coordinated their trading halts and sided with hedge fund managers for other benefits in contradiction with their public pronouncements and to the detriment of their own individual investor clients. Due to the unusually high level of short interest, broker dealers involved in effecting short positions for their clients may also experience additional scrutiny from regulators to provide documentation for their reasonable basis to believe that the security can be delivered. Regulation SHO requires that this “locate” must be made and documented prior to effecting the short sale.

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