Too small to win: Why WallStreetBets is the least responsible for the financial market madness.

2008: Too big to fail.

2021: Too small to win.

The financial market took a break from Covid-19 headlines this week with an old problem in a new version. The massive stock surge of GameStop (GME), Nokia (NOK), among other companies brought growing concerns about the use of social media and the manipulation of information that can potentially influence the prices of securities.

At the top of the discussion, GME.

GME shares were trading at around $15 at the beginning of the year when a group in the Reddit platform called r/wallstreetbets started to promote the stock.

The usual comments in the group go from "Let's go!", "I am putting my life savings on it!", "This is going to the moon!", and so on.

For those who know the forum, this is nothing new, quite frankly.

The stock surged. Amidst the frenzy, reached $350 in less than 2 weeks before collapsing 40% at a similar speed. The financial world did not take long to blame the internet forum for exposing stocks as a gambling product and WallStreetBets and its individuals for manipulation.

But looking deeper into the stock movement, the players and stakeholders, and how all the actions unfolded, give us a little more to think about.

1. GME stock had as much as 140% of short interest.

Basically, the short-interest percentage represents the amount of short position taken to the actual float of tradable security.

To explain it simply, "short" means to bet against a stock. If you sell short a stock, you actually need to borrow it from a stockholder, sell it, and re-buy it at a later date to close the position. In a "short" operation, you earn money when the price drops.

If the short-interest percentage is 20% of the float, it means that the number of stocks sold short represents 20% of all stocks available to trade.

In the case of GME, at the beginning of the year, it had 140% short interest.

Amazingly, literally, there were more stocks short sold than really available in the market.

Think about that.

When you have thousands of people buying a stock that is trading at a relatively low price, it starts to go up and the short sellers start to lose money. As it rises, remember that the short seller borrowed that security to sell, and the counterparty that provides the margin to operate this borrowed operation starts to worry about the short capability to pay-off the debt.

As the trend keeps going upwards, the short seller, based on alarming flags from their risk department (it is losing more than it should, it should not be that exposed, etc), must liquidate positions at any price, re-buying the stocks. This process adds more oxygen to a burning hearth and takes the prices further up.

Usually, this process heals itself, through exhaustion of buyers or reallocation of more short sellers.

However, because of the short-interest at 140%, there was no limit in sight for this momentum to end. Since there were no sellers, the WallStreetBets (to open position) and the short sellers (to close position) were buying it at an incredible rate. Ultimately, there were more stocks sold short than available in the market. Given that, GME could potentially reach any given price.

Any. $300, $4,000, $10,000, $100,000...

The problem created for allowing such a big short-interest size could be catastrophic.

2. The option problem.

Options are derivatives instruments that give the holder the right to buy (or sell) a security at a specific price at a specific time. It is used to hedge a position or to leverage (since its movements usually have a greater magnitude than the underlying security).

WallStreetBets community loves options.

One characteristic of the options is that there is a counterparty of the operation called market-maker. Whenever it is writing/selling ("creating") the "buy" option to a buyer, the market-maker needs to hedge its operation with the underlying security.

By hedge, it means that if the market-maker SELLS a "buy" option, it automatically needs to BUY the underlying stock itself so it compensates its exposure. The market-maker then will have a net exposure close to zero and no risk. This process inflates the shares, bringing prices up.

So, in addition to the regular stock buying and the short covering, there is the market-maker buying the underlying to hedge their positions.

GME is now a wildfire.

3. Robinhood margin requirements and the ban on buying.

Robinhood is a trading platform that allows investors to buy stocks without paying any commission fee. Also, it allows investors to purchase stocks on margin, requiring margin maintenance of just 25% of the value of the security. As an example, if you deposit $2,500, you can trade stocks and build a portfolio up to $10,000 and pay 2,5% a year of interest by using that margin.

Since the WallStreetBets users massively use Robinhood, they could essentially be buying stocks worth 4 times the money invested.

On January 28th, concerned about their liquidity and the increasing volatility of the market, Robinhood and other brokerage firms decided to not allow "buying" (you could still sell) on GME and other volatile stocks, provoking massive fury among the clients and the internet.

It is reported that half of the Robinhood users had GME in their portfolios.

With the impossibility of buying the stocks through various platforms, the GME, NOK, and other well-discussed stocks from the WallStreetBets community plunged as much as 40% on January 28th.

Rage.

4. The repercussion.

The stock movement and the Robinhood and other brokerage firms' decision to shut down buying options for traders had a big impact in New York and Washington. Senators took action against the unilateral decision taken by the company, claiming that the fairness of the market was compromised and demanding an explanation of the company and other players regarding these actions. A lawsuit was initialized on the same day against Robinhood.

5.

Wall Street was blamed to leave naked short selling as common practice for hedge funds, but when the individual investors strike back, it changes the rules of the game.

This episode reminds those who work in the financial industry, to never take regulations and consequences for granted. The system still needs attention concerning risk, leverage, and margins, to provide a fair and safe environment for business conduction.

When I first heard the news I did not hesitate to blame WallStreetBets and their lack of morals and reckless behavior. Especially, given the fact that putting pressure (squeezing) on the market is a type of manipulation.

But the participation of the players on brokerage firms, banks, hedge funds, and any other financial institution must be as controlled and regulated as the internet community discussions.

For that reason, although still being a big part of the problem, I believe that the WallStreetBets community (and their empty discussions with lack of fundamentals) is the least responsible for the madness that we witnessed today.

• Why do we allow naked short selling?
• Why is allowed to have 150% of the outstanding shares sold short?
• Why don't we have notional limits on option open interest?
• Why can someone with $2.5k be able to buy $10k worth of securities paying just 2.5% interest on it? (Did get a loan like that from the bank?)
• Why can brokerage firms legally just prevent their users from buying, and not prevent them from selling the stock? Isn't this going to potentially bring the price down? If yes, isn't it manipulation?

Given all presented here, I started to minimize the responsibility (not fully) of the group and reassess the current state of the financial markets, the stakeholders, and all the investor community in general.

I believe these developing episodes should create a time of reflection on how Wall Street treats all players.

What is wrong, who is wrong, how is wrong?

Unfortunately, today's developments are not new and by being that, it is the duty of government/regulators, to expose/punish the responsibles and provide a quick public response in order to restore the credibility and reputation of the financial system.

And we, as active pieces within the industry, must always be aware of our own responsibilities and strive to create a system that is as fair as possible, as secure as possible, and as transparent as possible for the greater good of the society.