Thursday, January 28, 2021
If you haven't been living under a rock, you probably know about the rally in GameStop's stock price now causing losses for hedge funds and dominating the news cycle. Today, major retail brokerages began to restrict trading activity in the stock, limiting their customers ability to place additional buy orders for the stock.
The increase in GameStop's stock's trading price from about $4 a share in July 2020 to a brief high of $492 today seems plainly disconnected from any fundamental value thesis. Many retail investors may have been simply buying the stock on the theory that because other people are buying the stock they'll be able to sell at a profit amid the continuing rise. Of course, it's impossible to know with certainty when this obvious bubble will pop.
A variety of reasons may explain the decision to no longer execute buy orders into the expanding GameStop bubble. Some of it may be simple paternalism. Regulators might ask why brokerages are letting retail investors commit possible financial suicide by buying into the bubble. Of course, this makes unknowable assumptions about the sources of capital being used to fuel the rally. We don't know how many people are actually putting everything they have behind this trade. It may just be a vast crowd of people throwing some cash at GameStop because they think it's funny.
Brokerages might also stop facilitating buy orders simply to protect themselves. In particular, retail brokerages may have also restricted trading in these stocks because of their own, or their clearing firms', concerns about risk. As this obvious bubble grows, the potential for the bubble to burst and GameStop's price to collapse may create real risk for market makers and clearing firms. They may not be able to manage their inventory with the rapid price changes. Many brokerages operate as introducing firms and use clearing firms on the back end to actually execute the trades their customers place. If a clearing firm tells an introducing firm that they don't feel comfortable taking any more buy orders on GameStop, the introducing firm won't be able to offer that option to its customers. Self-clearing firms like Robinhood may make this decision on their own. Some news reports now indicate that Robinhood has tapped capital recently, borrowing hundreds of millions. It's probably doing this because it thinks it may need it as the dust settles from this.
Update Bloomberg's Matt Levine explains how clearing difficulties likely led to the stoppage:
You don’t think about it much, but every stock trade involves an extension of credit. You see a price on the stock exchange and push a button and instantaneously get back a confirmation that you bought some shares of stock, but you actually get the shares, and pay the money for them, two business days later. This is called “T+2 settlement,” and it might seem a little silly in an age when a “share of stock” is an entry in an electronic database and “money” is also an entry in an electronic database. Why not just update the databases when you push the button? T+2 settlement feels like a vestige of the olden days, when traders agreed to trades on the stock exchange but then had to go back to their vaults to dig up stock certificates to hand over in exchange for sacks of cash. Back when I worked on Wall Street it was T+3. These days it is not hard to find people who want to talk to you about moving to instantaneous settlement on the blockchain. Bitcoin trades settle immediately. But U.S. stocks, for now, settle T+2.
This means that the seller takes two days of credit risk to the buyer. I see a stock trading at $400 on Monday, I push the button to buy it, I buy it from you at $400. On Tuesday the stock drops to $20. On Wednesday you show up with the stock that I bought on Monday, and you ask me for my $400. I am no longer super jazzed to give it to you. I might find a reason not to pay you. The reason might be that I’m bankrupt, from buying all that stock for $400 on Monday.
The way that stock markets mostly deal with this risk is a system of clearinghouses. The stock trades are processed through a clearinghouse. The members of the clearinghouse are big brokerage firms—“clearing brokers”—who send trades to the clearinghouses and guarantee them. The clearing brokers post collateral with the clearinghouses: They put up some money to guarantee that they’ll show up to pay off all their settlement obligations. The clearing brokers have customers—institutional investors, smaller brokers—who post collateral with the clearing brokers to guarantee their obligations. The smaller brokers, in turn, have customers of their own—retail traders, etc.—and also have to make sure that, if a customer buys stock on a Monday, she’ll have the cash to pay for it on Wednesday.
This is not stuff most people worry about most of the time. Generally if you buy a stock on Monday you still want it on Wednesday; even if you don’t, we live in a society, and you’ll probably cough up the money anyway because that’s what you’re supposed to do. But at some level of volatility things break down. If a stock is really worth $400 on Monday and $20 on Wednesday, there is a risk that a lot of the people who bought it on Monday won’t show up with cash on Wednesday. Something very bad happened to them between Monday and Wednesday; some of them might not have made it. You need to make sure the collateral is sufficient to cover that risk. The more likely it is that a stock will go from $400 to $20, or $20 to $400 for that matter, the more collateral you need.
Some investors may have bought the stock or call options on the stock in hopes of forcing market makers and others to buy the stock and drive the price up. This seems as though it might run afoul of the Securities & Exchange Act's prohibition on market manipulation. Section 9(a)(2) of the Securities and Exchange Act makes it unlawful to "effect . . . a series of transactions in any security registered on a national securities exchange . . . for the purpose of inducing the purchase or sale of such security by others." As James Fallows Tierney has explained, "regulators have tools beyond "fraud" at their disposal to get at other objectionable market practices," including Section 9(a)(2).
If brokerages take the view that most of the increase has been driven by market manipulation, they may decide not to facilitate these trades and become knowingly complicit in the short squeeze. To be sure, many of the posts on WallStreetBets, the Reddit message board behind the rally, seem fixated on forcing short sellers to close their positions and drive the price up. Whether the SEC will take action against the posters remains to be seen.
There have also been news reports about Robinhood and others selling out retail investors and closing their positions. This seems unsurprising. Many retail investors likely bought GameStop on margin--that is to say by borrowing funds from Robinhood. In these arrangements, the customer's stock portfolio provides collateral for the loan. Robinhood and other retail brokers likely legitimately fear that margin collateral -- GameStop Stock will decline rapidly in value. They're likely to sell these positions in order to prevent themselves from taking a loss as the bubble collapses.
How will this all shake out? I don't know. With more news breaking, it looks as though the brokerage firm trading stops were predominantly related to clearing requirements.
But I do have a few thoughts on where it's going to shake out. Brokerage firms must all join FINRA in order to operate. FINRA maintains its own arbitration forum for individual claims. It does not allow brokerage firms to include class action waivers in their account agreements. This means that the customer actions against brokerages will happen in two places, FINRA arbitration for individual actions and public courts for the class actions. When it comes to the arbitrations, investors will likely struggle to win any claim so long as they don't actually have any net losses on the trade. As a practical matter, FINRA arbitrators only rarely award damages if the investor made money. Showing that they should receive even more money usually requires showing much more than these traders will be able to manage.