r/wallstreetbets, the GME Short Squeeze, and Misinformation

By Kevin M. ’21

Note: I am not an investment professional. This is not investment advice.

With the sudden mainstream popularity of r/wallstreetbets, millions of new retail investors with no investing experience or knowledge have begun stock and derivatives trading. Recent news of popular retail brokerage limitations on GME, AMC, and other short-squeezed stocks has created a flood of misinformation on how brokerages work and who is to blame for the staggering retail losses today.

1.       What is r/wallstreetbets Doing?

As a very basic overview, GME is the stock for the retailer Gamestop. A large number of institutional investors (hedge funds, banks, etc.) believed GME was going to decrease in price. These investors opened “short” positions on GME, in which they bet that the stock would go down. This was mainly done by selling the right to buy shares at a certain price at some point in the future (aka writing naked calls). 

Imagine if you sell to another person, Bob, the right to buy 100 shares of a stock one month later at $50 each. The stock price is currently $50, so Bob is betting that the stock price will increase one month later, at which point he can buy the shares for cheaper than the market price ($50) and can make a profit by selling them. One month later, the stock price is $0. Bob will almost certainly choose not to exercise his right to buy the shares at $50 a piece. You have pocketed the money from selling the right to buy the shares. 

However, imagine if these shares had increased in value significantly. A big problem has occurred. Your losses are potentially infinite, because there is unlimited potential for the stock to grow in value. If the stock grows in price, you may want to buy the stock before the buyer can even exercise the right to buy them from you, because as it grows higher, your losses will continue to increase, because you will be forced to buy a share for more than $50 and sell it at $50. So in this case, if you buy the stock at $70 you are locking in your losses at $20 per share, instead of having them potentially exceed $20. 

r/wallstreetbets noticed the high short interest (large amount of short positions) by institutional investors, and saw the possibility for a “short squeeze.” If the price of GME went up significantly, the institutional investors would most likely want to cut their losses and just purchase the stock before it went up even higher. However, this also has the effect of pushing the stock price up even more, as the institutional investors enter the market to buy the stock. This leads to the “short squeeze,” in which the stock price increases in a loop as short sellers cut their losses by buying the stock and the price increases even more, leading to more short sellers cutting their losses. So, r/wallstreetbets members bought GME shares and calls (betting that a stock will go up), pushing the price up and creating a short squeeze. This is the premise of what occurred over the last week up until today, when market conditions changed.

2.       How Stock and Derivatives Trading Works

When an individual or institution opens or closes a position in the market, there are multiple parties involved. Let’s take the relevant case of a retail investor buying a call on the New York Stock Exchange via WeBull. WeBull the brokerage, is simply an intermediary between the investor and the actual securities exchange. They must send the order to an options clearing house, which is the party that actually has control over the investor’s securities (the stocks in the options order). The clearing house also serves a guarantor for the transaction, ensuring that it is fulfilled. The clearing broker sends this order to DTC, which is the clearing corporation that functions as the central securities depository for all US equities markets. This means that they are the middleman between all transactions on equities markets. So when an investor purchases an options contract, the clearing house will send it to DTC, which will then facilitate the transaction through an automated system that will transfer the securities, record the transaction, etc.

An order may be fulfilled immediately, but behind the scenes there is a two day settlement period before the transaction is actually finalized by DTC. DTC, the clearing corporation for this options contract, has a margin requirement that the clearing firm must pay to cover the balance of the transactions in the settlement period. I won’t go into detail about the specifics (and because I’m not very knowledgeable in this), but the DTC takes on risk and thus must charge the clearing house, which charges the brokerage.

3.       Recent Events and Why Some Brokerages Limited Trading

With the huge volatility in GME and AMC stock price, the DTC raised their collateral requirements significantly for any purchases of these stocks. This is because a large amount of risk was introduced for the DTC which would have to settle transactions in 2 days, at which point the stock could have gone massively up or down. This was the primary reason why retail-focused brokerages were forced to limit trading. The majority of the massive influx in new investors over the last week has gone to a few simple no or low-fee brokerages, such as Robinhood. As millions of investors began to buy calls and GME/AMC stock, Robinhood sent these orders to their clearing department (Robinhood is both an introductory and clearing broker), which then had to send the orders to DTC and cover DTC’s margin requirements. This however was financially impossible for Robinhood, which did not have the capital on hand to serve as the collateral for the millions of orders they were bombarded with. This is most likely the reason why Robinhood is drawing on its bank credit lines right now. Other brokerages serving more traditional investors had capital on hand that could cover their more appropriately sized userbases, who also weren’t buying as much GME or AMC stocks or options. So ultimately, some retail-focused brokerages were forced to shut down trading of these volatile stocks because they were unable to cover the margin requirements charged by their clearing house, which was charged by the DTC.

4.       Conspiracy?

By blocking the ability to open a position in GME or AMC, the brokerages have effectively artificially deflated the stock price. This primarily hurts the many retail investors who have participated in its rise. These retail investors are understandably angry, and many are calling out their introducing broker (Robinhood, WeBull, etc.) for market manipulation in the favor of the hedge funds who were losing their short positions. However, this is unlikely.

In the case of the brokerages that halted trading, they were either forced to just straight up halt trading by their options clearing house or because they were unable to pay the fees charged by their options clearing house. Additionally, the introductory brokers were taking on large amounts of margin loans and the risk of their investors’ uncovered options getting margin called, which is why brokers like Robinhood have raised margin requirements on GME to 300% or sometimes more. It is of my opinion that the brokerages are not to blame in this situation.

Warning: At this point, I am just making relatively uniformed hypotheses.

If there was a conspiracy by the banks to limit retail purchases of their shorted stocks, it would probably have occurred at the options clearing house level or at DTC. It could be that the options clearing house halted trading for retail brokerages intentionally even though their costs and risk were not high enough to warrant it. However, since we know that Robinhood is both an introductory broker and clearing broker, it is unlikely that they would shut down opening GME positions, which they did, if this was the case. Some say that hypothetically Robinhood could have been pressured by their financiers and banking partners to halt trading, and were inclined to do so because of their plans to go public. I am not informed enough about Robinhood and their specifics to give an opinion on this. But for every other introductory broker that halted trading, it is of my opinion that it was not their willing decision.The other level at which market manipulation could have occurred is at DTC. Hypothetically, DTC could have increased margin requirements and fees for opening GME or AMC positions to an unnecessarily high level, knowing that this would force retail brokerages to halt trading. Both of these hypotheses could be easily disproved if it was shown that mathematically DTC had appropriate margin requirements and fees, and options clearing houses were taking on too much risk and fees. Somebody more knowledgeable and experienced than me may be able to do that using the DTC’s fee schedule and the fee schedules for the relevant clearing houses.

5.       TL:DR – Who’s to Blame?

Robinhood, WeBull, and the rest of your introductory brokers are almost definitely not to blame. If there is a conspiracy by the hedge funds and Wall Street Bankers to manipulate the market, it was done at a clearing house or the DTC, but this is unlikely. My simple explanation is that institutional investors most likely realized after the short squeeze that this chain of events leading to trading stoppages was going to occur, and because of that they increased their short positions and were able to cover many of their shorts today without the need for any nefarious meddling.

Have I gotten something wrong? Please let me know by emailing me at kma21@csus.org.

1 Comment

  1. If hedge funds can have fair game manipulating the market behind the scenes, I don’t think we can victimize Reddit and retail investors. Look at the Archegos blow up, that severely impacted almost all major banks…the most harm that Redditors have caused is shorting Gamestop and getting more people educated about the stock market….I say they’re doing more good for the general public than big banks!

    Like

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