Broker Check

GameStop

February 03, 2021
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“Speculators may do no harm as bubbles on a steady stream of enterprise. But the position is serious when  enterprise becomes the bubble on a whirlpool of speculation. When the capital development of a country  becomes a byproduct of the activities of a casino, the job is likely to be ill-done.”  

 - John Maynard Keynes  

We don’t normally weigh in on day-to-day financial news at PIM. Generally, the most popular topics are  inconsequential or an idea that we’ve been working on for months before the general public takes notice. The  topic of Reddit/GameStop traders vs the hedge fund industry is one that deserves some attention due to the  incomplete or inaccurate information in circulation.  

What’s Going On?  

GameStop is a brick-and-mortar retail store that sells new and used videogames and consoles. The company  has been targeted by short sellers (those who sell borrowed shares in the hopes of buying those shares back in  the future at a lower price, earning a profit) due to the firm’s declining financial position and perceived lack of  long-term viability. Recently a group of traders loosely organized on an internet forum called “Wall Street  bets” have argued that regular investors should buy as many shares as possible to drive the price higher and  force the short sellers into buying their shares back at a much (much) higher price. This has generated billions  of dollars in losses for the hedge fund industry. In the past twelve months, GameStop shares have traded  between $2.57 - $483.00, with most of that gain coming last week.  

Is This Market Manipulation?  

Yes, it is. Last week GameStop briefly had a market cap of $40 billion, roughly the same size as eBay, Kraft Heinz and Public Storage, (respectively, not collectively). It seems very unlikely that a video game retailer (not  named Amazon or Microsoft) will ever grow to a level that justifies such a valuation. The interest in GameStop  seems to be primarily due to small investors sharing ideas and strategies on an internet forum and not based  on the prospects of the business.  

Investors using whatever platform they have available to talk-up stocks for their own financial gain is nothing  new. This has been going on since people settled trades under the Buttonwood tree in the 1700s. Usually, it is  a small group of wealthy investors doing so quietly. This time it is the opposite, with many small investors  being as loud as possible and making the issue about social equality. It is still market manipulation, even if  their other point is valid.  

Is Short Selling Bad?  

No, not really. Short selling is a tool with many different uses. At its most extreme it can be used to drive  failing firms out of business so that their capital can be more efficiently allocated elsewhere. This is “creative  

destruction”, an unpleasant but necessary requirement of financial capitalism. This type of short selling is very  risky and rarely used as a stand-alone investment strategy. Technically, short selling has infinite risk because  the stock must be purchased to repay the stock loan at any price. This is the squeeze in “short squeeze”.  

Short selling is more commonly used as a hedging tool, to mitigate risk. Hedge funds identify and establish  short positions in companies that they think have poor prospects. These short positions, it is hoped, will profit  from a general market decline that may lower the share prices of good companies they own outright (have  long positions). Further, the sale of borrowed shares generates cash that can be used to buy more shares of  companies that the hedge fund believes have a bright future.  

James Chanos is an elder statesman of the hedge fund industry who was instrumental in discovering the Enron  fraud. In an interview last summer, he said that over his career he has rarely made money off his short  positions.  

Small Traders vs. the “System”  

Brokerage firms and regulators are not working against small traders, though this has been a popular  conclusion in the press and with politicians. Last week Robinhood, the most popular broker for the Reddit  crowd, limited the number of shares of GameStop that investors could purchase. This was due to regulatory  requirements to maintain an orderly market, not an effort to stop trading in GameStop. Modern trading  appears relatively instantaneous. But behind the scenes exists a daisy chain of credit agreements and  contracts between the parties to the transaction. This process of providing cash or securities to the  buyer/seller is called settlement.  

The DTCC (Depository Trust and Clearing Corporation) settles most trades in America, somewhere around  $2.15 quadrillion (15 zeros) worth. In 2019, some 650 million transactions went through DTCC. Robinhood,  Schwab, Fidelity and all other broker-dealers are DTCC members and are subject its rules. These rules ensure  that trades can be processed quickly and without risk of failure. Every investor, including you, our valued PIM  clients, benefits from the DTCC system. It guarantees that a completed trade results in either cash or shares  on settlement date. Without it, all transactions would be at risk, and securities would become less liquid and  therefore less valuable.  

Member firms post collateral (cash) at the DTCC to pay for any failed trades. The amount that member firms  need on deposit depends, in part, on what the firm’s clients own. If a firm’s clients collectively own a large  amount of highly volatile GameStop shares, the possibility of failed trades increases and so, therefore, does  the DTCC collateral requirement. An individual account holder may not feel like paying for shares of GameStop  he/she bought at $400 when it is trading at $200 the next day. But their broker-dealer is on the hook for the  trade through their collateral account at the DTCC.  

The problem exacerbates itself with each additional share of GameStop traded, which is the reason that  Robinhood limited trading on that security. It is rumored that Robinhood raised $3-4 billion to meet their  collateral requirements over the past two weeks. Failure to meet collateral requirements at the DTCC puts a  member firm into receivership immediately. Literally the next day the firm is closed, and their clients are  forced to move their accounts elsewhere. The trading restriction on GameStop, and a few other securities  with similar characteristics, is done by broker-dealers wanting to stay in business not hedge funds conspiring  against the public.  

Is There Anything Interesting Here?  

Yes, thanks for asking. Two things come to mind. The largest hedge fund caught up the GameStop saga is  Melvin Capital. The firm needed $2.7 billion to stay in business last week, after losing $18 billion in a short  squeeze. Remarkably, two other hedge funds came to their rescue. This is not normal. Generally, hedge 

funds enjoy watching their competition fail. They wait for the losing firm to close, then buy their assets at  pennies on the dollar and hire away their best talent. They only help when there is a chance of systemic risk  that could harm their own businesses. It appears that at least some hedge funds felt that what happened with  GameStop was bad for the industry at large. Second, and this is the reason for the quote from Keynes, the  Reddit crowd is now looking at manipulating industrial metals markets (platinum, palladium, rhodium and  silver). Silver has a long history of market manipulation, making it a natural target. Unlike GameStop, these  metals are used in real world applications, and therefore their manipulation could cause the prices of  consumer goods to increase.  

Conclusion  

Short selling is the act of borrowing then selling shares of a publicly traded company, in the hope that the  shares can be repurchased at a low price, at a later date, and returned to the lender. The spread between the  initial sale proceeds and the later purchase price is profit. Short selling is a legitimate investment strategy,  more frequently used as a hedging tool than for wealth-building. There is, theoretically, unlimited risk, as the  price of the shorted shares may go to infinity rather than down. As the price of the shorted shares continues  to rise, losses mount creating a “short squeeze” that must eventually be covered at potentially considerable  cost. This is what some hedge funds recently experienced.  

Limiting trading on a stock during a period of extraordinary volume and high volatility is sometimes required to  maintain the collateral requirements of the Depository Trust and Clearing Corporation, and ultimately to  maintain secure and orderly markets. This should be thought of as a circuit breaker, a risk-management tool  that benefits all investors and has nothing to do with punishing retail, social media market manipulators.  

The extent to which the GameStop story has impacted PIM clients is very limited and temporary. We do not  pursue the types of strategies that would bring a company like GameStop into the portfolio, nor do we short  sell. There was increased uncertainty in the market last week as hedge funds were forced to re-assess their  

portfolios and trading strategies, causing the worst weekly decline since October. Most of that lost ground has  since been recovered as strong earnings from corporate America come to the forefront.

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