Time for the games to stop!

GameStop: Everyone's talking about GameStop! Did I mention GameStop? GameStop! $GME

There’s been a huge amount of coverage about the swarm-buying of $GME by Reddit, /WallStreetBets users, mostly using Robinhood.

In markets, however, it takes at least two to tango (trade), so the retail crowd buying is really only one part of the story, albeit a controversial side. There’s been much less reporting about the shorts, other than the focus on a couple of hedge funds that were spanked by the crowd.

There is more to this side of the story.

Most informed commentators talk about the need to maintain confidence in the integrity of the market – and I firmly agree – so it is important to address the sell-side of the $GME trade as well.  

So, what happened and what went wrong?  

The first-order problem was the sheer magnitude of the hedge funds’ and the markets’ reported aggregate position. If the short interest position had not gone into triple digits, or anywhere close, the Reddit crowd may not have been as bold as it was to attack the shorts. 

To the Reddit crowd, the sell-side was acting irresponsibly, attacking a brand many of them had grown up with, and without much recourse, hoping GameStop would go to zero. Many markets watchers and commentators are asking how such a large short position was even orchestrated.

Gaming the system is perhaps something both sides were doing.  A lot of focus is on the Reddit crowd, whether ‘Payment for Order Flow” should be scrapped; and how net capital obligations are calculated through a clearing house to manage a broker’s settlement risk....and whether this should be more transparent. 

And again, how was such a large aggregate short position allowed in the first instance?

So, what should be done on the supply side of the trade?  

Here's a few ideas to balance up the conversation.  After all, both sides of the trade need some review and change.

In an effort to stimulate discussion among practitioners and policy makers, here are ten suggested recommendations, that may help the industry plug some of the apparent gaps that became clearer, in my mind, as a result of the GameStop trade.  These gaps may be relevant for all short positions – not just GameStop.

These 10 points are intended to stimulate conversation and aid any review and reform that will strengthen market infrastructure and various trading and settlement protocols to enable all market users to participate in the market with confidence.  

1. Impose Short Selling Limits

Ensure sellers can't short more than 100% of an issuer's share capital (ISC). This should be an absolute no-brainer. The right ceiling might be (say) 10%-20% of the ISC (but others much smarter than me can argue about the threshold(s) and whether it should be higher or lower, or tiered based on market-cap at a point in time).

Who Should Be Primarily Responsible?

The primary exchange where the issuer is listed, e.g. NYSE or Nasdaq, together with DTCC supplying settlement data (with compliance support from FINRA).

2. Enforce Settlement Discipline

Ensure settlement takes place on settlement date (T+2) and don't allow fails to continuously roll-forward in a net settlement system.  Penalize failed settlements.  Allow buying-in. See #5. below.

Who Should Be Primarily Responsible?

DTCC (with support from FINRA).

3. Stock Borrowing to cover Short Sales

Ensure short sellers (i) have a contractual right to receive delivery of securities from a lender at the time they effect a short, & (ii) receive them before T+2 settlement of their short falls due.

Who Should Be Primarily Responsible?  

FINRA in terms of compliance, supported by DTCC for data on failed transactions, with support from SEC.

4. Securities Lending

Ensure that shares that are lent by banks & brokers are (i) always covered by a written lending agreement and (ii) always debited from the clients account, so they know the securities are on loan. Particular attention to apply to broker margin accounts.

Who Should Be Primarily Responsible?

FINRA, with support from SEC.

5. Failed Settlements / Buy-in

Allow for mandatory buying-in against a failed settlement (FS) after N days.  Others smarter than me can debate whether N should be FS+1 or + 2 days, or something longer.  This principle is an important one. Mandatory buying-in stops prices being artificially held or pushed down.

Who Should Be Primarily Responsible?  

The exchange where issuer is officially listed (based on support, and data, from DTCC).

6. Improve Transparency of Share Ownership

Improve transparency of ownership: specifically overhaul the 13F reporting obligation to bring it closer to the end of quarter, e.g. 5 business days.  Additionally, give issuers the ability to seek disclosure of beneficial ownership, at any time, by request to the street name bank and broker nominees (similar to s672A in Australia, s793 in the U.K. or recently introduced provisions in the EU-SRDII, Article 3a).  Allow issuers to communicate directly with those investors who do not object to direct communication by the issuer.

Who Should Be Primarily Responsible?  

The SEC to consider changing regulations, supported by exchange rules (supported by FINRA for compliance by brokers and banks), as needed.

7. Integrity of Record-keeping

Add a regulation that requires banks and brokers to ensure that upper tier holdings (including their position at DTCC) and any nominee or custody positions below it, reconcile up and down the chain to long client positions reported to investors. (Refer to #4 (ii) above).  A very practical example of this is to ensure that a buying client’s position is not updated on T+2, where the broker does not receive the delivery of the securities purchased from the market, i.e. where market or net settlement failed (i.e. a “fail-to-receive”).

Who Should Be Primarily Responsible?  

The SEC or FINRA could introduce rules to give effect to this principle, with FINRA to enforce them.

8. Trading Halts/Suspensions

Introduce brief trading halts for securities that hit specific short interest thresholds. So, if acceptable short interest is determined to be 20%, trading is suspended automatically if the short interest hits 20%, and for longer should it later go to 25% etc.  This will give regulatory authorities an opportunity to assess what’s really going on and whether the market is operating fairly and with integrity.  It may also provide breathing space to find a more logical unwind should one be needed.  The GameStop duel became a cluster-squeeze before various parties intervened. Some parties are still very upset about how market access and margin arrangements operated last week (ending February 5th).

Who Should Be Primarily Responsible?

Exchange where the security is listed (other trading venues to follow the lead of the primary exchange).

9. Short Interest Reporting

Speed up the reporting of short interest.  At present, short interest reporting only takes place twice per month and reporting to the market is on a deferred basis, some 5 business days after firms report positions (filings are due to FINRA 2 business days after the end of each two week period). Ensure that short interest captures all short positions, including borrowing and loans by non-brokers.

Who Should Be Primarily Responsible?

FINRA and the primary exchange where the security is listed.

10. Reduce Market Settlement Period

Consider overhauling the T+2 settlement period in order to further minimize settlement risk. As of February 6th, this suggestion is getting some press coverage. Don’t assume however that changing settlement period on its own will necessarily solve the short sale problem.  It will help but won’t fix it.  Such a change could be 2 or 3 years away based on how long it took the US market to move from T+3 to T+2 in a controlled way. The bottom line: most of the above recommendations will likely be needed anyway. That’s why, we shouldn’t get too distracted by over-focusing on the buy-side problems with the Reddit crowd.  We likely need to make changes anyway, even if the settlement period is reduced to T+1, T+0 (end of day) or to introduce an even tighter discipline of real-time settlement.

Who Should Be Primarily Responsible?  

DTCC and major US exchanges; in consultation with all major stakeholders, including those acting for investors and issuers.

And two more for good measure.

These are ancillary to the primary focus of this note and others are looking at these points:

11. Transaction Tax

Don’t implement a transaction tax.  That may take some of the heat out of the duel but, alone, it won’t solve the short selling issue. It may address other agendas.

Who Should Be Primarily Responsible?  

Government (asking the Government to do nothing shouldn’t be the hardest thing to achieve here unless others are pushing the r/WallStreetBets saga as a means of advancing a different agenda).

12. The Reddit Crowd /Coordinating buying

In parallel, regulators will undoubtedly look to see if any changes are needed to prevent any harm by a large group of retail traders banding and acting 'together' in a co-ordinated way, e.g. to mount an attack on the shorts.  Ensuring the shorts can’t do what they did in GameStop in the first place, is one way to reduce the motivation and incentive of the crowd.  Reviewing leverage arrangements and the rules that apply in highly volatile market situations may be worthwhile, if only so the public better understands the principles of central clearing obligations and the rules that apply even in these rare and extreme situations.

Who Should Be Primarily Responsible?

Many groups are already hyper-focused on the buy side of this trade, the actions of the r/WallStreetBets group, etc.

Summary

To be clear, I don’t have anything against short selling, hedge funds or free markets.  I don’t.  Period.  I’ve worked in the capital markets for 40 years and have seen some weird market snafus, including short squeezes and weak settlement infrastructure that detracted from efficient markets and undermined confidence.

Being clear on the overarching policies, adjusting the rules and refining the way market infrastructure and back-office procedures work, and how the many platforms should inter-operate on a system-wide basis, will go a long way to improving confidence.  There are many smart people operating in the capital markets, and many smart users of the markets.  Together it should be possible to fully identify the problems and plug the gaps.

Today, in my view, there are some material gaps in the overall US market system, and these can be exploited, as we’ve seen with GameStop and other meme companies.

These gaps, when exposed for all to see, do nothing to instil trust or confidence in our markets or protect the retail investor.  In fact, in the GameStop situation, these gaps may have endangered the wealth of some of a wide range of investors.

Some changes will be needed to maintain confidence in (and preserve the integrity of), this corner of the market. Pun intended. It’s time for the games to stop.

Paul Conn

February 9th, 2021

https://www.dhirubhai.net/in/paulconn/