GameStop stock is all the topic this week as a number of people on various social media platforms decided to target public companies who held large short positions with enough small volume that it caused a “squeeze”. Regardless of how we feel, it appears this was an illegal act. Let’s examine the facts in detail.
Let’s clarify what is happening here, which are 3 different acts. First, there are the actions by the Hedge Funds of shorting the GameStop stock. Second, are the retail investors conspiring to go long on the stock. And third is the actions taken by Robinhood and others.
As citizen journalists, we at Omnia News are not fans of Hedge Funds, but that is for another article. Nor are we fans of any big tech. However, we do always seek the truth, even when it tries to elude us or makes us uncomfortable. It is, for this reason, we will examine the legality of the second item, the conspiring of going long on GameStop stock to manipulate the price.
“Shorting” a company is an act of selling shares you don’t own, but borrow from a bank or another investor, with the promise of interest payment and an eventual repurchase to cover the trade. You would do this if you were convinced that a company’s stock was overvalued and likely to go down by more than your carry cost. You profit when you buy to close the transaction.
For example, XYZ company is trading at $100 a share. You think it is overvalued, so you ask a bank to lend you 100 shares, which you then sell. You are obligated to buy them back at some point, and the hope is that XYZ trades lower than your carry cost, which is the cost of your margin interest and trade commissions.
If you are mistaken and the price of the stock goes up, you lose the difference between your borrow price and your repurchase price. Going back to our example, if you shorted XYZ at $100 and bought it back at $75, you would make a $25 profit, less interest, and commissions. If you guessed wrong and had to buy back at $120, you would have a corresponding loss of $25 plus commissions and interest. It is the opposite of a normal stock trade.
Not only is shorting a tool of speculators, it is also used by banks to maintain fair and orderly markets. When a bank agrees to “make a market”, they agree to buy or sell a specific stock at a listed price. If they don’t have enough shares to fill an order, often they sell short to cover. Banks spend billions of dollars a year doing this to ensure a fair trading environment for investors. If they get caught in a volatile stock, they face the possibility of losing money because of their commitment to market making. The risk is more acute on the NASDAQ, which has no “exchange”, but rather, is a broker to broker network.
About a week ago, some individuals decided to get together and spoof a company, GameStop, higher in an attempt to cause a short squeeze. They were aware that a Hedge Fund named Melvin Capital had aggressively shorted the security. They began when the stock was around $17 a share. Then on Thursday, it hit a high of $483, causing a catastrophic loss when the fund covered. They have also engaged in this type of activity with several other companies and have had mixed results.
This movie has been cheered by many as a way that the “little guy” stuck it to the establishment. In reality, it was in all likelihood illegal. 15 USC §78j(b) and §78ff make it a federal crime to use any manipulative or deceptive device in connection with the purchase or sale of any security registered on a national securities exchange and that is exactly what these people have done. It has been reported that the Securities and Exchange Commission has already been looking into this, as they should.
Stock markets are not “free”. They haven’t been since the Knickerbocker panic of 1907. No one actually wants “free” markets because the volatility would do far more harm than good. We have, and need, fair and orderly markets where people can exchange shares with some confidence that they aren’t manipulated. The ripples of this go much farther than anyone thinks. For example: if you are a participant in your company Employee Stock Purchase Plan, and your GameStop stock is $10. You put money aside every paycheck for 3 months fully expecting execution at or near that price. But when the window to purchase it opens, when you go to buy it, criminal speculators had run it to $450 which is now your cost basis.
A far larger concern is what happens to the capital structure of the market. When a company implodes because of a cash crunch, it doesn’t simply vanish. The debt is assumed somewhere else, in this case, by the lenders. If this type of activity is allowed to continue, the unsecured debt will severely harm banks at a time when businesses really need capital simply to survive. Also, fewer banks will be willing to make markets providing less liquidity, and no one will be able to blame them. You could see evidence of stress this week when a number of firms restricted trading in several speculative names as a way to manage risk. The Robinhood app stopping the purchase of GameStop stock was the biggest story in this area.
The underlying companies will have issues because of an unexpected and illegitimate move in their stock. Options awards, and restricted stock grants will never be profitable. Balance sheet distortions would also prevent transactions, for example, if a company was in the process of selling itself, this would end that process unfairly.
Another group that will be hurt by this are retail investors, many of whom are unsophisticated. They are chasing these stocks and in many cases buying them at the top. When the speculative bubble bursts, most of these people will end up losing most of their money, and although ultimately it will be their own fault, they were led to this by bad actors.
Many people bought these stocks on margin, which means they borrowed money for a part of their purchase. If the proof of the underlying stock declines too fast, and the investor is unable to cover, they can actually end up indebted because of their trade, and in this case, with no underlying fundamental justification for the share price, its likely this is going to be the outcome.
I do not like professional short-sellers. I also don’t particularly like Hedge Funds. I think they are corrosive. Having said that, they are legal and will be until the laws are changed. Conspiring to fix GameStop stock prices isn’t. The people who are cheering this on are simply wrong.