GameStop: Wall Street short sellers are not villains but Reddit traders should be totally free to attack them

Arturo Bris, Professor of Finance, International Institute for Management Development (IMD)
·5-min read
<span class="caption">Let the games continue. </span> <span class="attribution"><a class="link rapid-noclick-resp" href="https://www.shutterstock.com/image-photo/portland-usa-jan-27-2021-mobile-1903528705" rel="nofollow noopener" target="_blank" data-ylk="slk:Tada Images">Tada Images</a></span>
Let the games continue. Tada Images

In the battle between the army of renegade Reddit retail traders and Wall Street’s hedge funds over unloved stocks like the Texan computer games retail chain GameStop, there has been a serious case of mistaken accusations on both sides. They are both being wrongly accused of manipulating the markets, but they are not.

Let me start with the hedge funds. The reason why they were targeted by the 5 million-plus traders who follow r/WallStreetBets (of which I am one, by the way) is because their strategy of short-selling stocks is seen as damaging.

Hedge funds and institutional traders sell a stock short when they have a negative view about a company. In essence, this involves borrowing the stock in the securities lending market and selling it, with the commitment to return the loaned stock later.

Such a strategy tends to be self-fulfilling: when the stock is sold, it puts downward pressure on the price (especially if many investors do the same). Then, when the time comes to return the borrowed stock, the hedge fund buys it back at a much lower price, thereby pocketing a hefty profit.

In the view of the angry retail traders who have driven up the price of GameStop and other stocks like Nokia in recent days, this is manipulation. Their attack, using cheap and easy trading apps like Robinhood, was based on the simple premise that if short sellers make prices go down, buyers make prices go up (assuming they have market power).

If buyers dominate, it creates what is known as a “short squeeze” as prices go up and the short sellers have to rush to buy fast in order to lose as little money as possible. In some cases, the rising prices will trigger “margin calls” by their lenders, which requires the short sellers to immediately cover their costs. This has inflicted billions of dollars of losses on hedge funds like Melvin Capital.

Meanwhile, the rush to buy stocks back pushes prices even higher, and some short sellers are pushed out of the market because the stock is too expensive for them to buy. In such cases, they are usually penalised by the exchange regulator for “failing to deliver” the stock back to the lenders that they borrowed it from.

In defence of short sellers

The debate about short sales and their impact on stock markets goes back to the beginning of the 20th century. It was highlighted during the 2008 financial crisis, and I was already among the few that advocated for short sales as a way to increase market efficiency, together with my colleagues professors William Goetzmann and Ning Zhu.

However, most saw the fall of Lehman Brothers, AIG and other financial institutions in 2008 as caused by short sellers artificially betting on their stocks plummeting. Many jurisdictions, from the US to Japan, implemented short sale restrictions and market halts.

In some European markets, it has actually been quite common for the market authorities to prohibit short sales for certain periods. Remember: regulators want stock prices to go up, not down. The extreme case is the Pakistani regulator, which in 2008 imposed a regulation that basically prohibited selling (not short selling but any selling).

In defence of renegade traders

As for the Reddit traders, Robinhood and certain other platforms suspended buying (but not selling) of targeted stocks like GameStop in the midst of the excitement. This earned them much vilification on social media, and one trader filed a lawsuit against Robinhood.

Shares in GameStop and other stocks quickly tumbled, but they rose again a few hours later when the platform signalled that the suspension would be temporary. Robinhood explained soon after that it had taken this “tough decision” to ensure that it could meet its capital obligations with US regulator the SEC.

It could presumably have breached these requirements if the prices of stocks had suddenly fallen because so many traders would have borrowed heavily to maximise what they could buy, and Robinhood would have had to pick up the tab if they couldn’t pay.

The platform quickly raised an additional US$1 billion from its backers to cover such eventualities, and then reopened trading a few hours later. The prices of the targeted stocks then shot up again, though it soon emerged that there were still heavy restrictions on how many shares traders could buy in GameStop and certain other companies.

Now the controversy is whether regulators should go after Robinhood on the basis that it has been facilitating stock manipulation. In my view, the retail traders are no more manipulators than the short sellers. Manipulation requires both false information and intent to profit. Neither side falls into this category.

Markets are to finance what democracy is to our political systems: we need to allow people to vote according with their preferences and information. In the case of GameStop, it is equally as acceptable that sophisticated investors use market mechanisms to benefit from pessimistic beliefs, and that uninformed, well organised investors push stock prices up in order to harm the Wall Street institutions.

It should be the role of market regulators to increase transparency of markets so that trading is not driven by misinformation. They should also educate potential investors about the risks involved in equity trading (in fact, the potential losses for Reddit members in the GameStop episode could yet end up being enormous).

Finally, it is a regulator’s responsibility to facilitate market entry to all, whether they are sophisticated or uninformed, whether they are rich or poor, whether they are tall or short. Markets are an amazing invention of humankind, but they are risky.

This article is republished from The Conversation under a Creative Commons license. Read the original article.

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Arturo Bris follows r/WallStreetBets.