Before we examine GameStop, let’s discuss the basics of shorting. When an investor, fund, or institution sells short a share of a security, the clearing firm is required to locate or borrow said shares and place a hold on them for that investor, so when the shareholder who sold the shares short eventually plans on buying it back, they’re available. Until 2007, we had an uptick rule to prevent market manipulation to the downside. This was to prevent a financial bully from continuing to sell short and bombard a particular security with nonstop sell orders, creating a snowball effect where the negative momentum of sell orders drives the security into the ground. In 2010, the SEC found that this uptick rule had little help to prevent manipulation, so it modified the rule to only apply to securities that had closed down 10% from the prior day’s close. In our opinion, this rule is still violated on a daily basis by high frequency trading platforms. Secondly, the process of legally shorting a stock by having your prime broker or clearing firm locate and borrow shares for you is also not followed, especially by large funds or institutions. Unlike the smaller retail investor who is not permitted to short unless the guidelines are met, the rules often do not apply to the larger players on Wall Street. Shares are sold short first and questions are asked later. This process creates what we call a naked short. Tracking the amount of naked shorts is very difficulty for the DTC (Depository Trust Corporation). Naked shorting allows institutions who coordinate together to attack and prey on companies that they can simply overwhelm. Smaller capitalized companies with lower market capitalization and smaller outstanding share counts are a favorite for this nefarious activity. This approach allows hedge funds, banks, and larger individual investors to build short positions with ease. On occasion, a clearing firm will send the selling naked short broker a fail-to-receive notice and request they cover the short – meaning they did not get a locate on the short sale or receive any stock upon completion of the trade. These notices normally take well over 30 days to receive and sometimes never come at all, especially if the selling broker has a lot of financial power and clout in the industry. If a forced buy-in is received, the naked short broker simply buys the stock back and re-shorts it simultaneously. Or, often they will have another friendly fund short for them and the position can be flipped back to them within 24-48 hours. None of this is or has been legal, but has continued with regularity for decades on Wall Street as larger players have preyed upon the smaller retail investors. Once in a while, the funds become so greedy and short such large positions that a threshold is met and a clearing firm begins to act forcefully. This is created by relentless buying pressure from retail and funds are forced to cover some of their short at much higher prices, a squeeze. This is how a short squeeze is created. If the major short players in GameStop were major Fed banks, we can assure you that there would be no short squeeze. Hedge funds are at the bottom of the financial food chain now and do not receive the treatment larger Fed members do. There is a small chance the SEC, which takes its marching orders from the Fed, would allow a major bank to implode from a short squeeze such as this. So when analyzing potential short squeeze candidates, it is always import to know who is short, how much, and at what price.
So how does this end? If past history is any indicator, GameStop will sell a block of stock to a group of funds well below market and in turn allow the funds to exit from this war, and, in the process, capitalize their company to rebuild and grow their brand. The GameStop model is dying and the company was on the verge of bankruptcy which is why it drew the ire of short sellers. With this new influx of capital, they can grow in a different direction and management will rationalize helping long term share holder growth as the share price eventually crashes lower on this news. The million dollar question is at what price and when does the company act? They have certainly been offered private placement deals already to acquire large blocks of their stock in a financing but have resisted. The SEC wants to see a peaceful resolution to this war in the end. Companies like Robinhood, whose clients own a ton of GME, restrict the buying from their retail investors to avoid massive margin calls that get triggered from the huge swings. Most retail investors utilize leverage and margin, especially at Robinhood. Once GME dips a sizable percentage, many people get margin calls triggered and they must be met within 3 days even if the stock bounces back. So if you paid $380 for GameStop on Wednesday (on margin) and Thursday it hit $130, you are going to generate a large margin call which must be met with cash or a sale of securities. Robinhood is responsible to its clearing agent and to its regulatory requirements. So in essence, your margin call can inevitably be their margin call if you fail to deliver stock or cash. This can be the trigger for a firm to go out of business. We do not see this as likely for Robinhood, but the scenario is on the table. If we had anything in a Robinhood account, we would begin to withdraw funds to a stronger brokerage immediately. In a perfect world, the firm should immediately allow purchases and sales in a stock like GME, but restrict the use of margin. This can ultimately mitigate a large percentage of risk. However, other forces seem to be at-large here, and there is a good chance Robinhood is taking marching orders from these hedge funds to subdue the squeeze. These hedge funds in particular make up a significant portion of Robinhood’s revenue – coincidence?
In closing, retail online trading firms have restricted buying in many securities over the last two decades due to large short positions, this is not a new practice. The restrictions have always been triggered for two reasons: self preservation and industry pressure from banks/funds to aid them in their trades. Why all the attention now? Social media and the amount of new investors currently trading since the pandemic are at all-time highs and have created a loud voice for the long-time abused little guy. Take profits relentlessly if you are in one of these trades as we expect history to repeat itself. When the music stops, the drop will be sharp and fast. However, there could be plenty more room to run.