Debunking the Myth surrounding GameStop: A summary of the SEC investigation
Now that the GameStop and meme stock hype train has died down, we can analyze the aftermath of the meme stock saga with detail from the newly released SEC report. On October 18, 2021, the SEC released their GameStop and meme stock Report. However, they did not call it that, they called it the Staff Report on Equity and Options Market Structure Conditions in Early 2021 — because the SEC doesn't do clickbait. It’s quite a good read, but it is also 45 pages long, so I’ll summarize what I learned from reading and what myths they have debunked. Some of the misinformation the report debunks include topics such as gamma squeeze, Robinhood trading halts, and alleged naked shorting. I’ll leave a link to the full report at the end.
As this is quite a long and extensive report, the two biggest things that stood out to me were the extent to which the price rise was unrelated to the hedge funds short covering. In addition, it is interesting that a lot of hedge funds’ participated on the long side — which was the opposite of what was being reported by the media at the time. With that out of the way, let’s get into the juicy details!
How did the SEC define meme stocks in the report?
Well, they define them as stocks that experienced large price moves or increased trading volume that significantly exceeded broader market movements. Many of the stocks were consumer-focused companies that are familiar names to the public. They say that some of these stocks had a high short interest, while others just had frequent mentions on social media, including Reddit and YouTube. They point out that online discussions about GameStop picked up pace in 2019 (pre-pandemic) and that people were posting valuation reports and discussing the short interest at that time.
Who are the Retail investors
The scale of retail participation in the GameStop rally is quite impressive. The number of individual accounts trading GameStop rose from about 10,000 people per day at the start of the year to nearly 900,000 different accounts trading GameStop at the peak on January 27th. The median Robinhood account balance according to the report is $240. There was a huge surge of new brokerage accounts opened during the pandemic — according to Robinhood’s documents, 6 million new accounts opened in 2020 which was a 137% increase from the year before, and one million of those new accounts belong to investors with an average age of 19.
Was the GameStop rally caused because of a short squeeze?
The answer is yes and no.
The report shows that short sellers were squeezed — but they were only a small percentage of overall volume, and they mostly got out early in the big run in the last week of January. According to the report, GME had sharp price increases as major short sellers covered their short positions after incurring significant losses, and this short covering likely contributed to increases in the stock price.
The chart above shows that buy volume in GameStop, including buy volume from those with large short positions, increased significantly beginning around January 22 and remained high for several days, corresponding to the beginning of the most dramatic phase of the run-up in GME’s price. But, the chart also shows that this short covering volume was a small fraction of overall buy volume and that GameStop continued to rally after the direct effects of covering short positions waned. The underlying motivation of such buy volume can’t be determined — according to the report but perhaps it was motivated by the desire to maintain a short squeeze. Whether driven by a desire to squeeze short sellers, or by belief in the fundamentals of GameStop, it was traders buying to get long the stock, not the buying-to-cover, that sustained the weeks-long price rise of GameStop.
You can see that when the stock price rallies hard, the short-covering which is the red bars in the chart flatten out. This is a bit different from the story we heard in the news at the time, which was that retail investors, bid up the price, forcing the short sellers to cover their positions in a massive short squeeze. What we see in this chart is that the retail investors bid up the price, the short sellers covered pushing the price up a bit more, and then the retail investors — believing that hedge funds were being squeezed — pushed the price up even further. By that point, the short sellers had either covered, or were waiting to cover during dips, but they were not buying the highs.
Interestingly, the SEC argue towards the end of the report that the price was allowed to get so far away from its fundamentals because there were not enough people willing to sell the stock short.
The price surge in GME raises questions of market efficiency that relate to short selling.
Staff have observed that it was unusually costly to borrow shares in GME.
Academic research implicates constraints on short selling as a possible contributor to bubbles where stock prices rise above what may be justified by fundamentals. Such constraints on short selling could arise from cost or risk aversion. To the extent that GameStop was costly and risky to short, the reluctance to sell short could have contributed to the run-up in prices and the subsequent steep decline. So, this can be seen as a rally that started as a short squeeze which then just continued as a bubble — due partially to a lack of willing short sellers.
Another interesting point in the report is that the SEC identified that some hedge funds were involved in the GameStop rally — not through a short squeeze, but as traders who bought stock to be long. The report says that by the end of January, some funds had closed out their short positions in meme stocks, realizing significant losses. Others, including quantitative and high-frequency hedge funds, joined the market rally to trade profitably. Staff believes that hedge funds broadly were not significantly affected by investments in GME and other meme stocks.
Did a Gamma squeeze cause GameStop’s rally?
Quick answer, no.
The gamma squeeze argument was that retail traders bought a ton of out of the money call options, forcing options market makers to hedge by buying the underlying stock and then buy more as the stock price went up.
The SEC found that this was not a significant contributor to the rally. The report says that by mid-January, 91% of non-market maker options volume came from individual investors, and two-thirds of this retail option flow came through Robinhood, ETrade and, TD Ameritrade.
The report also says that there is no evidence of a gamma squeeze in GameStop during January 2021. While options trading volume from individual customers increased substantially, this increase was mostly driven by an increase in the buying of put, rather than call options and market-makers were buying, rather than writing, call options. Thus, the gamma squeeze argument holds no water.
That is the four weeks of daily data from January, and you can see a big step up in options volume and that more of the volume was buying put options than calls.
The fact that retail investors were mostly buying puts during the big rally is pretty interesting, they were possibly hedging their gains using options or betting that the price would fall. One way or another, retail traders piling into short-dated out-of-the-money call options and squeezing market makers back in January is more of a myth than reality.
Did Citadel Securities request Robinhood to restrict trading of GameStop?
Once again, no. The SEC gives a pretty good explanation in their report as to how margin requirements and stock clearing works and explains why we saw certain undercapitalized brokers stopping their customers from buying. There is also a good breakdown of the trading halts that occurred in the report.
The way clearing works is that brokers are required to keep cash (their own cash — not customer money) at the clearinghouse to guarantee trade settlement which occurs two days later. The more trades a broker does, and the riskier the positions are, the more cash the broker needs to keep at the clearinghouse. When there’s a ton of trading in very volatile stocks — which we saw back in January, the clearinghouses call the brokers to post more margin. The report gives a breakdown of how much additional capital the brokerages were asked for.
“ On January 27th NSCC made intraday margin calls to 36 clearing members totaling $6.9 billion, bringing the total required margin across all members to $25.5 billion.”
These members’ ratios of excess risk versus capital were not driven by individual clearing member actions, but by extreme volatility in individual cleared equities, NSCC (the clearinghouse) exercised its rules-based discretion to waive the ECP charge for all members on January 28, 2021. Absent this waiver, one retail broker-dealer would have had an additional ECP charge of more than double its margin requirement of $1.4 billion on January 28, 2021. They don’t say which broker this was, but it is not too hard to guess. What’s is interesting here is that the clearing house decided to actually waive certain charges– thus making it easier on brokerages and their customers. While a lot of people at the time felt that the clearing houses unreasonably restricted their ability to buy more stock, we can see that the clearinghouse gave these app-based brokers a break by not hitting them with the ECP charge.
I think a lot of equity traders at the time, including myself were not aware that clearing was even a thing in the stock market. This led to a lot of conspiracy theories back in January.
The stock market is rigged by pausing trading of GameStop on the New York Stock Exchange
As extreme intraday volatility in GME occurred, exchanges’ Limit-Up, Limit-Down trading pauses were triggered on six trading days in late January.
Limit-Up-Down (LULD) trading is a trading mechanism that attempts to address extraordinary volatility in stocks. If either the National Best Bid equals the stock’s upper bound or the National Best Offer equals the stock’s lower bound for fifteen seconds, the stock’s trading will be paused for five minutes. Significant price movement in GME during January 2021 triggered 40 LULD pauses, compared with only one in all of 2020. On January 28 alone, 19 LULD pauses were triggered in GameStop. Anyone who traded during volatile times such as the credit crunch is aware of these exchange rules, but we’ve had a long period of very calm markets and a lot of new investors had never seen stocks being halted like this before.
What about Naked Shorting?
The unusually high percentage of short interest of the total stock float raised a lot of questions of whether some of the short sales were “naked”. When a naked short sale occurs, the seller fails to deliver the securities to the buyer and staff did observe spikes in fails to deliver in GME. However, fails to deliver can occur either with short or long sales, making them an imperfect measure of naked short selling. Based on the SEC’s review of the data using NSCC, GameStop did not experience persistent fails to deliver at the individual clearing member level and most clearing members were able to clear any fails relatively quickly. For the most part clearing members did not experience failures to deliver across multiple days. So, there is basically no evidence of the widespread naked short selling, which many people were claiming was happening. One way or another the conspiracy theories about naked short-sellers are untrue.
Not included in the report is the explanation of how GameStop’s short interest rose to over 140% at one point. According to Dan Caplinger from The Motley Fool, even without a naked short sale, it’s theoretically possible for short interest to exceed 100%. The reason has to do with the nature of the short-sale transaction itself.
As an example, take a situation involving four investors. Annie owns shares of GameStop, and Annie and her broker have an agreement that allows the broker to lend Annie’s shares to short-sellers. It lends them to Bob, who subsequently sells those borrowed shares short in hopes that GameStop’s share price will fall.
An investor named Chris ends up buying those borrowed shares from Bob. However, Chris has no way of knowing that those shares have been borrowed from Annie. To Chris, they’re just like any other shares.
More importantly, if Chris has the same kind of agreement, then Chris’s broker can lend out those shares to yet another investor. Diane, another GameStop bear, can borrow those shares and sell them short.
In this example, the same shares end up getting borrowed and sold twice. The short interest volume these transactions add to the total is twice the number of shares actually involved. You can therefore see that if this happened throughout the market, total short interest would eventually exceed the number of shares outstanding and approach 200%.
This still might seem impossible, and in a sense, it is. But part of the answer lies in the fact that there are investors that don’t currently possess actual shares of GameStop. This is called a synthetic long position. Investors lending the shares have the right to get back the shares at any time. So, when you add together the actual shares plus these “synthetic” positions in the stock, the short interest can’t exceed 100% of that larger total. This is why many calculations on Yahoo Finance and other sources show 100%+ as they do not include synthetic positions.
Payment for order flow
The GameStop saga drew a lot of attention to the fact that retail brokers like Robinhood sell a lot of their customers’ orders to “off-exchange market makers” like Citadel Securities. The SEC goes through the mechanics of how payment for order flow works in their report and once again there doesn’t seem to have been anything particularly unusual going on there. There were a lot of conspiracy theories at the time where retail traders questioned why their trades were being executed off exchange, and they were concerned that the stock was possibly trading at different prices in different venues. Interestingly during the January squeeze wholesalers — like Citadel — sent more and more retail order flow to exchanges to be executed as the volatility increased. On January 28th over 67% of retail order flow was routed by market makers to exchanges.
Green and Orange show the volume of GameStop traded on lit exchanges (green being the NYSE and Orange being Other National Exchanges). The blue portion is the orders that were internalized by market makers — or traded off exchange.
As you can see — as the volatility increased, the firms paying for order flow actually pushed more and more of the trades to exchanges rather than crossing them internally. Wholesalers doing this indicates that they were trying to avoid internalizing customer orders, possibly because it is harder to match buys and sells up internally when all you are getting are buy orders, but this also shows an unwillingness to take risks in a fast moving market.
The chart shows the quoted and effective spreads in GameStop for the month of January. As you can see bid ask spreads widened significantly towards the end of January. Nominal quoted spreads for the stock were nearly 50 times larger than the 2020 daily average according to the report.
In addition, market makers reduced the number of shares they were willing to trade at the posted prices. It is probably a good guess based on this data that market makers were profitable during the squeeze as they will have traded a lot of volume, with wide spreads, and pushed the flow that they couldn’t cross to the exchanges. The report ends with some discussion of market reforms that Gary Gensler — the chairman of the SEC wants to do anyway: things like reducing settlement times to reduce clearinghouse risk, improved reporting of short sales, more transparency for off-exchange trading. There is even a paragraph on how new trading apps encourage their customers to trade with confetti animations and other game like features. None of these things have much to do with what happened to GameStop that last week in January however.
How creditable is this report?
The report is really interesting as the SEC has more of a birds eve view of market dynamics and how events unfolded back in January than anyone else could possibly have. They use data from the Consolidated Audit Trail — where they can track each individual order throughout its life cycle identifying the customer, the broker-dealers handling the trade, and the venue where the trade is executed.
The fact that they collect this data and used it to assemble this report means that the report has a lot of detailed information on how different types of investors positioned themselves at the start of the year. The report includes information on the short interest in GameStop going back until 2007. As you can see it has been a popular short position for a while, and this is because the business was not exactly booming pre pandemic — mall based retailers have been struggling for a while.
While the report is mostly on GameStop and the events of January 2021, they have clearly looked at a bunch of meme stocks (the report refers to more than 100 stocks with unusual trading activity) and they analyzed the market dynamics that led to the various squeezes that we have seen over the last year.
Conclusion
The report rules out most of the conspiracy theories that were popular online.
The real story is that GameStop went up 2700% back in January because a bunch of small retail traders decided to buy it. They possibly bought because they didn’t like the guy at Melvin Capital or it was an Occupy Wall Street 2.0 protest to show their dislike towards hedge funds and wanted them to lose money by being the “Robin Hoods”. But basically, they bought a lot of GameStop because they like the stock.
The SEC full report on GameStop: https://www.sec.gov/files/staff-report-equity-options-market-struction-conditions-early-2021.pdf
