Everything We Thought About Gamestop is Wrong-An Analysis of Gamestop and Robinhood
"Josh? Robinhood restricted trading because Citadel and Melvin Capital told them to!"
Actually... not quite... Once you read this article thoroughly, you will see the statements by the media and even sometimes... Congress is not always accurate as they are learning about the situation. This article is going to briefly explore some of the common narratives about Gamestop and Robinhood. Though a very popular narrative, The David-versus-Goliath narrative has some serious flaws to it. In fact, when you look into the details, there are no clear heroes and villains to this story. The main takeaway from these events is that it is important to understand the mechanics of the rules and regulatory systems we implement and how they intertwine with markets. In the end, what transpired is a result of multiple cause-and-effect relationships between retail investors, broker-dealers (E.g Robinhood), hedge funds, market-makers (E.g Citadel), and the requirements imposed by the SEC.
To make the correct steps to improve the way markets operate, we need to understand what happened between these parties and the systems implemented.?The goal is to ensure stock markets are fair and reward people who take the time to study companies and make informed decisions.?
The SEC provides a detailed analysis of what happened during the events in Gamestop. Here is the link: https://www.sec.gov/files/staff-report-equity-options-market-struction-conditions-early-2021.pdf
I am going to refer to this document in this analysis. It is a difficult read but worthwhile if you want to understand how stock markets work. With all the conspiracies going on, some people might ask me, "But why are you trusting the SEC's analysis on this issue?" Funnily enough, the SEC's mandate is to protect investors even though they sometimes make mistakes. A topic for another time but listen to Gary Gensler's lectures on cryptocurrencies back in 2018. A lot of the criticisms gone to government officials tend to be unfair. These individuals are incredibly smart and knowledgeable. Anyway, I am going to go through some of the major narratives about Gamestop. Let's begin:
1) Robinhood stopped retail trading under pressures from Hedge Funds
At the end of January 2021, Rohinhood stopped retail investors from buying stocks like Gamestop, AMC, Blackberry, and other meme stocks. When you combine the facts that Citadel is a partner of Robinhood and Melvin Capital is one of the few funds that shorted Gamestop, it initially made sense that these institutions supposedly forced Robinhood to halt trading. Typically, institutions like these take the opposite side of the trade of retail investors and profit from them. In options markets, it is the seller that profits off the buyers consisting of retail traders. When you combine these facts, it is easy to see why it is perceived that these big institutions made Robinhood halt trading so they could close their short positions and minimize their losses. Congress also seemed to believe in this narrative. During the hearing, many questions were asked as to why Robinhood halted trading. Here is my explanation.
At a high level, Robinhood got margin called from its clearing agencies. That is right! The dreaded margin call that investors face also applies to brokers like Robinhood! Every broker has to set aside capital to meet regulatory requirements from its clearing agencies, set in place by the SEC. These clearing agencies have rules and systems like the margin requirement to ensure these brokers don't go bankrupt, which would be detrimental for markets. A broker going bankrupt would mean the other brokers would have to cover for the inadequacies of the broker that went bankrupt. Additionally, Brokers are penalized if they don't meet the margin requirements of the regulatory clearing agencies. These charges are called ECP charges. The SEC gives a decent explanation of their purpose.
Anyway, the benefit of clearing agencies like the NSCC is that they provide a 98% guarantee on the settlement of stocks between buyers and sellers. This guarantee means they are a buyer/seller at last resort. To fulfill this mandate, they need to ensure brokers like Robinhood are not allowing their customers to engage in risky activities (E.g Borrowing money to buy derivatives). When a broker's customers are engaging in said risky activities, the clearing agencies place higher margin requirements on the broker. In the events of Gamestop, brokers like Robinhood were getting more and more undercapitalized as meme stocks like Gamestop kept going up. Note that Robinhood has to provide its own money as a margin deposit,?not its customer's money. This is a good thing for its customers as it protects customer assets.?However, it is?not a good thing for Robinhood or its customers as it has to scrounge up funds from somewhere to meet SEC requirements. That is because if a broker doesn't meet a margin call, there is a possibility all of its customer's portfolios get liquidated as per NSCC requirements. Imagine waking up the next day to realize that your broker sold off all your stocks and options trades regardless if you were profitable or not. On January 27th, 2021, due to the market volatility of meme stocks, the NSCC made intraday margin calls of $6.9 billion. Ouch! It is important to note that one of the main factors that make up the NSCC's margin requirement is historical volatility. Historical volatility is the fluctuation in a stock's price. So while a broker is well capitalized one day, they can be undercapitalized the next day if there are significant price movements. Online broker Robinhood said, "that it put temporary buying restrictions on a small number of securities because central Wall Street clearinghouse-mandated deposit requirements for equities increased tenfold."?Ultimately, to comply with SEC regulations, Robinhood felt it was necessary to halt the trading of Robinhood and other meme stocks. To not comply would mean massive penalties and the possible liquidation of its entire portfolio. This would be the ultimate worst-case scenario for retail investors which is something that is not being talked about in the news.?
The NSCC made it clear that it did not make Robinhood halt trading and the actions that Robinhood took were their own. However, questions need to be asked about NSCC requirements. These requirements can result in brokers feeling forced to make drastic decisions. One of the things the SEC wants to explore is reducing settlement dates of regulatory clearinghouses. That's a topic of discussion for another time.?Ultimately, it is a bit of an irony that it was regulatory requirements that caused Robinhood to halt trading in the name of "investor protection." Funny how the world works, huh.
2) Gamestop prices went up because of the short squeeze
A short squeeze did happen for a brief period, resulting in funds buying to cover their short positions. However, if you look at the chart below, short-sellers made up very little of the buying activity in Gamestop. I remember browsing Reddit threads about Gamestop. I saw frequent mentions about how the short squeeze is working. People were encouraging others to buy the stock to maintain it and have "diamond hands." It is perceived that this squeeze drove Gamestop's price to unbelievable levels. This notion is the opposite of the truth. What created Gamestop's price movement is the?massive surge in retail buying activity of Gamestop.?
While you do see some spikes in short-seller buying volume especially from Jan 22th-Jan 25th, that volume is a fraction of the total volume. If you scroll down a bit, you will see the proportion of institutional investors and retail investors that were trading Gamestop. A lot of the buying volume was driven by retail investors. Whether driven by a desire to squeeze short-sellers and thus to profit from the resultant price rise, or by belief in the fundamentals of GameStop, it was the positive sentiment of investors, not the buying-to-cover, that sustained the weeks-long price appreciation of GameStop stock. The SEC provided some facts about retail investors account openings:
What is problematic is some retail traders borrowed the broker's money to buy Gamestop. This excessive borrowing contributed to higher margin requirements to Robinhood, a factor that contributed to Robinhood halting trading so they could comply with the NSCC and the SEC. The SEC doesn't provide any data on this but settlement agencies are generally created to manage events when the buyer/seller cannot meet their obligations. That is only when they are indebted and don't have the capital to meet their obligations. There is also a chance that Robinhood didn't implement the necessary risk policies to prevent its customers from engaging in risky trading behaviour. But this argument gets tricky. Do the regulators and companies get to tell customers what to buy and what not to buy in the name of "investor protection?" Some people say yes, and some people say no. It's a very tricky tightrope to walk through. In my opinion, I'm a fan of giving people choice in what they choose to invest in, but I acknowledge that comes with consequences. Regulators have to be willing to accept these consequences if they give customers that freedom of choice. The best they can do is provide investors with the tools to make successful investment decisions. Another question is should retail customers get access to leverage? I believe when properly done, leverage is an excellent tool to expedite your investment returns. Unfortunately, it is also a double-edged sword which is why I understand the concerns from regulators.
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While it seems I am blaming retail investors, I am not. To be clear, I believe all of us have a role to play in this event. If you look at Robinhood, they should probably have better risk-management tools to keep up with margin requirements. Robinhood can also provide resources and warnings to retail investors about the potential risks of trading and investing. In terms of regulators, they need to communicate with their broker-dealers and set up better risk-management mechanisms so they don't have to suddenly increase their margin deposits. Perhaps the SEC has to make large strides to improve the clearing agency settlement times so brokers don't have to leave so much margin. If you look at retail investors, they should probably understand the markets they are trading in, be mindful of the leverage they are utilizing to make trades, and understand some of the financial derivatives they are buying such as options. The effects of social media on stock markets should also be researched. Does a random guy promoting a stock on the internet constitute insider trading? I hope it isn't because what makes the internet fantastic is that it enables us to share ideas at scale. From the SEC report, we now know that?retail investors can?make a big difference in stock markets, contrary to popular opinion. So r/wallstreetbets investors can rejoice. They almost singlehandedly toppled the entire U.S market structure. However, it almost came at the cost of their investments getting liquidated.?As I said already, no one is the hero or villain here.
3) How Can A Stock's Short Interest Be More than 100%
"Josh, how can someone can short more than 100% of a stock! There is obviously something corrupt going on in the background." That was me 6 months ago. In my head, it made no sense how a group of entities can short more than the shares available in the market. Even after finding the answer, I'm still not entirely satisfied but the SEC's explanation made sense. The SEC explained short interest by giving an example:
So basically, there can be periods where two investors can short the same number of shares just simply due to the mechanics of how short selling works. Very dubious if you ask me but it's enabled because of leverage and debt.
These are the main narratives I wanted to cover. There are still a few additional things I want to cover:
1) Payment for order flow and the role of Off-Exchange Market Makers
I think the SEC has to explore how off-exchange market makers operate. For context, let me summarize what happens when you click the "buy" or "sell" button on your brokerage account. Typically, the brokerage account routes your trade to these parties that can execute your order:
I want to focus on off-exchange market makers because these entities process a large majority of retail trades. To provide their customers with excellent trade processing at no cost to the customer, Robinhood provides customer trade orders to off-exchange market makers like Citadel, that use this order flow to make their trading strategies. Companies like Citadel know what stocks you are buying or selling, in what quantities, and when you place these orders. Citadel is an example of an off-exchange market maker. The role of a market maker is to take the opposite side of market trades to ensure customer orders are executed quickly and cost-effectively. In finance speak, they provide liquidity to the market because buyers and sellers arrive at different times from each other. They serve an important purpose to stock markets because they remove unnecessary volatility and reduce bid-ask spreads. The biggest risk a market maker faces is that they take the opposite side of the trade. If a retail investor makes money, a market-maker that takes the other side of the trade loses money. So they have an incentive to minimize this risk and what better way to minimize this risk than to get the orders of the retail market! Market makers like Citadel pay Robinhood for this order flow which is how companies like Robinhood can offer their customers commission-free trades.
Note if Citadel does not want to take the opposite side of the trade, they will reroute the customer buy/sell order to an on-exchange entity where that entity will process the customer order. Thus, since Citadel is a for-profit entity, it is not unreasonable to assume they will only engage in trades that make them profitable which might not come in the retail investor's best interest. While these market makers should only make profits on the spread between the bid and the ask, they are also engaged in-stock positions of their own. When I listen to market makers speak, they claim that their statistical models aim for market neutrality. However, they possess a lot of information that they can potentially utilize.?
Ultimately, Market makers serve a useful function in the market because for reasons already mentioned. However, questions should be asked about the potential power these firms hold. The SEC also questions these exchanges because they are also subject to fewer regulations. Here are the SEC's thoughts:
2) Customers have to understand they are the product if they are utilizing a free product/service
I cannot stress this enough. With our world becoming digitalized, companies can collect data on their customers and sell them. Some companies don't do this but will charge customers for their service! Customers have to understand this idea! How well can a company pay its employees and the servers it utilizes to offer these online applications for its customers?
Anyway, these are my thoughts on Gamestop and Robinhood. Feel free to share your thoughts on this article. Did I miss anything?