By Omkar Ratnaparkhi
Shares of Gamestop stock (NYSE:GME) surged during the past few weeks due to an extremely short squeeze scenario causing the House Finance Committee to hold a televised hearing on market volatility on February 18. The key players invited to the hearing were Robinhood CEO Vlad Tenev, Melvin Capital CEO Gabe Plotkin, Citadel CEO Ken Griffin, Reddit CEO Steve Huffman, and famed retail investor Keith Gill (better known as u/DeepFuckingValue on Reddit and Roaring Kitty on Youtube).
Most investors thought that the GME short squeeze was a one-time event lasting from around January 11-29 when prices for the stock soared from under $20 to an all-time high of $483 despite no drastic fundamental changes in the balance sheet or business model of Gamestop. However, from February 26-29, a second squeeze seems to be taking place as the stock has soared from under $45 to above $180 during the week and closed Friday just under $100 in after-hours trading.
What is a Short Squeeze?
In order to understand a short squeeze, you need to understand short selling. Short selling is when an individual or fund bets a stock will go down in price by borrowing shares on margin (a loan used to trade stock) and immediately selling them with the hope of actually repurchasing them later at a lower price. A short squeeze is the rapid rise of a stock that causes short sellers to cover their shorts in order to cut losses. The covering of the short position causes the stock price to continue to rise due to an increase in demand rapidly. The increase in demand is caused by the short sellers being forced to buy back more and more stock at exorbitant prices to cut losses.
In January and December, members of the Reddit forum r/WallStreetBets found their new favorite meme stock: GME. Gamestop recently had some major changes to its board as pet e-commerce company Chewy’s founder Ryan Cohen acquired a 13% stake in Gamestop. Cohen believed the company was undervalued and could become an e-commerce gaming giant. On top of that, some members of the r/WallStreetBets subreddit realized that GME had an extremely high short interest that was above 100% and on some days was even above 140%, meaning that more shares were being shorted than actually existed. This is caused by the shares being loaned out over and over again to different short sellers, so instead of one hundred shares being shorted by one investor, you have two investors shorting the same one hundred shares because the transactions haven’t fully settled. As someone who has lurked on r/WallStreetBets for a long time, there has never been a time before when the subreddit rallied behind a stock in such force. The frenzy around GME overshadowed the other popular meme stocks such as Tesla (NASDAQ:TSLA) and Palantir (NYSE:PLTR), and other heavily shorted stocks road the coattails of GME such as AMC (NYSE:AMC) and Nokia (NYSE:NOK). The increased media attention also shot up the subreddit member count from under 2 million to 9.3 million and counting. Many individuals in the subreddit no longer cared about making money by taking profits on the stock. Instead, they wanted to send a message to the big financial institutions of Wall Street. The message to Wall Street was simple: your irresponsibility was rewarded by bailouts in 2008; now we’re gonna make you bleed by short squeezing hedge funds to the brink of bankruptcy. Multiple users on r/WallStreetBets posted open letters to Wall Street, the media, and the government telling their life stories about how the 2008 Financial Crisis affected their family and how they wanted to make wealthy Wall Street insiders, “the suits,” pay for their wrongdoings. The subreddit transformed from a place for gamblers and politically incorrect stock market memes to something bigger: a place for the little guy to stick it to the man.
Robinhood’s mantra ever since its inception in 2013 has been to “democratize finance” and give investors of all economic backgrounds the same opportunity to invest through commission-free trading. Although Robinhood built its reputation during the past seven years on standing up for the little guy, Robinhood lost all credibility on January 28. Robinhood and other brokerages restricted trading in many high volatility stocks, including banning buying of GME. The price of GME immediately plummeted because the demand side of the stock was killed, but the supply side still worked. Robinhood and other brokerages had artificially crashed Gamestop stock. Robinhood CEO Vlad Tenev is on a month-long PR campaign to explain his decision. Tenev’s PR campaign seems awfully disingenuous to most retail users of the app. For starters, in many interviews, he claimed Robinhood had no liquidity problem that could lead to bankruptcy. Still, he then proceeded to describe a liquidity crisis involving the firm’s inability to meet capital requirements set by regulators. Tenev even had the gall to claim that he was “protecting retail customers” by tanking the stock’s price. On top of that, the decision to stop trading could be even worse than just Robinhood going bankrupt, according to interviews with Interactive Brokers (NASDAQ:IBKR) founder Thomas Peterffy. IBKR is a trading platform that caters to both retail and institutional customers. Peterffy described that IBKR stopped trading because he was afraid that the short selling hedge funds would not be able to pay back the high margin rates to the brokerages like Robinhood and IBKR. This would cause both the hedge fund and the broker to go bankrupt. The bankruptcies could have caused a broader market collapse through a domino bankruptcy. So the brokerages did the only thing they could think of to save themselves and the market: force the little guy to lose money by causing the stock price to fall and allow the hedge funds to cover their short positions.
Robinhood was also caught in a large conflict of interest but denies that the conflict of interest influenced their decision. Short selling hedge funds lost over $20 billion to small retail investors. The hedge fund that was most detrimentally affected by the short squeeze was Melvin Capital. Melvin Capital received a $2.7 billion bailout, and the majority of the money came from the hedge fund Citadel. The sister company of Citadel is Citadel Securities. Citadel and Robinhood want each other to succeed because Robinhood allows Citadel Securities to front-run customers’ orders through a process called payment for order flow.
The House Finance Committee Doesn’t Understand Finance
Congress had the opportunity on February 18 to ask hard-hitting questions about the restrictions on trading and the unethical nature of payment for order flow. Instead, Congress members failed to understand the etiquette of video calls (failing to turn off mic when speaking, having decent background, decent camera angle, etc.) On top of that, some members of the committee seemed to fail to understand basic financial concepts. The entire hearing seemed reminiscent of the Mark Zuckerberg hearing in which one Congressman even asked, “how do you make money if Facebook is free?” In the Gamestop hearing, a Congressman asked, “is payment for order flow legal?” another asked, “can a Robinhood customer invest in Robinhood?” and those are just a few of the pointless questions asked. Almost 75% of the questions asked were easily answerable through a quick Google search or just seemed to lack knowledge of financial concepts.
Despite many House Finance Committee members not asking helpful questions, some members actually did their homework and came prepared to challenge the narratives that Robinhood, Citadel, and Melvin Capital were pushing. Rep. Alexandria Ocasio-Cortez (NY-14) asked whether Robinhood can really call themselves “commission free” when high-frequency trading firms like Citadel are Robinhood’s main revenue generators and front-run the orders of retail users. Tenev’s answer was that Robinhood is simply behaving like other brokerage firms. Citadel CEO Ken Griffin claimed that his services give retail users better order execution (many studies have disputed this claim.) Rep. Jim Himes (CT-4) asked Tenev what the rate of return is for the average Robinhood user and how it compares to an industry average or an index. Tenev was, as usual, very evasive and refused to give Rep. Himes a straightforward percentage about the rate of return of the average Robinhood account or the total AUM (assets under management) of the brokerage firm. The entire hearing was not a total waste of time, however. It was a wasted opportunity to explore greater options on regulating the amount of leverage hedge funds and financial institutions can take on, and the amount of short interest one stock can have.