“The risk-reward of being a short seller is not worth it; it’s not worth it for me or my family.”
Andrew Left, founder of Citron Research, The Wall Street Journal, January 29, 2021.
Volatility in the stock market is not new. We remember the October 1987 crash, the dot.com bust in the early 2000s, and the collapse following the Lehman bankruptcy in September 2008. If you invest to gain the long-run benefits of equity ownership, you need some way to shield yourself from the inevitable day-to-day carnage.
But, even if one takes such a broad perspective, recent experience with GameStop is extraordinary. As we write, the story is far from over, with several U.S. stocks—like GameStop, AMC Entertainment and Express—still on something of a wild ride. The Securities and Exchange Commission seems poised to investigate. And, members of Congress are planning to hold hearings. We don’t have any particular insights into how or when this will end. That is, except to say that history teaches us that episodes like this typically end badly.
Since this is an unusual post, we begin with a very clear disclaimer: nothing in this blog should be construed either as investment advice or legal advice.
In our view, we can already draw three big lessons from the equity market events of the past week. The first is about how narratives and the limits to arbitrage can lead to unsustainable asset price booms. Second, short sellers are important for the efficiency of asset pricing and the allocation of capital. Moreover, with the ongoing rise of passive index investing, their potential role in keeping the U.S. equity market efficient will become more, not less, salient. Third, to keep the financial system safe and resilient, it is essential that clearing firms maintain sufficiently stringent margin and collateral requirements even if, on occasion, it limits a broker’s ability to implement trades for its clients.
Before we get to the details, we start with a brief summary of the recent GameStop-related events. With its headquarters in Grapevine Texas, GameStop runs about 5,000 video game stores around the country. In 2020, a combination of the shift to downloading video games and the decline in mobility during the pandemic lowered revenues and turned profits into losses. At its trough in April 2020, GameStop’s market capitalization was about $200 million, roughly in line with the firm’s net worth.
Fast forward to Monday, January 11: the stock price neared $20 (more than seven times higher than nine months earlier), boosting the firm’s market capitalization to $1.4 billion. Over the course of that week, the price doubled to $40, but this jump is barely visible in the chart below. Then, from Thursday January 21, to Friday, January 29, GameStop traded in a range from $37 to $483! For each day, we show the trading range in the gray bars of the chart. We also show the market capitalization (dashed line), which surpassed $20 billion—about 100 times what it was in early 2020.
GameStop Stock Price and Market Capitalization, January 11 to 29, 2021
Source: Yahoo Finance and YCharts.
Being economists, our first instinct is to see if we can identify a compelling fundamental rationale for this extraordinary increase in firm value. In this case, however, the far more plausible explanation—as Robert Shiller has emphasized for years—is that widely-shared narratives or stories can drive stock prices to extreme values.
Shiller’s narrative analysis seems to fit the stories that users of Reddit’s r/wallstreetbets forum actively share. Such social media platforms make it easier for affinity groups to form, and for narratives to develop and spread. Combine the (currently) 7½ million members of the r/wallstreetbets community with the nearly 15 million users of the retail investor platform Robinhood app, and you have the potential for stories to drive individual stock prices far away from their warranted value, perhaps for an extended period.
Now, one of the things that is supposed to keep asset prices close to fundamentals is the presence of short sellers who put their own capital at risk when they think the price of a security is too high. To act on this belief, they borrow the security and sell it, hoping to gain by buying it back later at a lower price and returning it to the lender.
While it aims to profit from non-fundamental price misalignments, short selling is hardly riskless. As Keynes supposedly said, “[t]he market can stay irrational longer than you can stay solvent.” (Vishny and Shleifer provide a classic model of the “limits to arbitrage” phenomenon that can make a short position costly to hold.) It is easy to point to instances where such risks have caused traders seeking to profit from misaligned prices to fail. One leading example is the 1998 case of Long Term Capital Management, which was driven out of business when supposed arbitrage trades moved against them and they could not meet collateral calls (see, for example, here).
In the case of GameStop, presumably reflecting doubts about the firm’s business model, short selling has been rampant for some time. Throughout 2020, an average of about 90% of outstanding shares (62 out of 71 million) were sold short. That surely helped depress the share price. But then—when the price surged in January 2021—maintaining these short positions became very expensive.
To see why, we can do some quick calculations. The New York Stock Exchange (NYSE), where GameStop trades, requires that a short seller post a minimum 125% of the current market value of the securities borrowed. Looking at the GameStop example, imagine starting at the end of September 2020, when the share price was $10. An investor shorting 1 million shares would require collateral of $12.5 million. By January 29, at the closing price of $325, that margin requirement would have soared above $400 million! At some point along the way, the margin calls probably become so painful that the short seller abandons their position and takes the loss (see the opening citation from Andrew Left).
This brings us to the second challenge arising from the GameStop episode: the potential disappearance of short sellers. Many people seem to vilify short sellers because their efforts appear to lead to firm failures. Yet, were they to exit for good, the equity market would lose an important disciplining mechanism that helps keep share values in line with fundamentals, and helps limit the financing of zombie firms. Indeed, with the ongoing increase in passive index investors (see the chart below), the absence of short sellers could become increasingly problematic over time.
Actively and passively managed domestic U.S. equity mutual funds and exchange-traded funds (Percent of total equity outstanding), 2000-19
Source: 2018 Investment Company Fact Book, Figure 2.8, pg. 43; and 2020 Investment Company Fact Book, Figure 2.9, pg. 40.
Why? For capital markets to promote an efficient allocation of resources in the economy, equity and bond prices should reflect all the public information available about the issuers. But, getting those prices right means having people who collect and process this information and use it to allocate their portfolios. This is not what index investors do. They ignore relative values within each asset class. While short sellers are not alone in performing this distinguishing role (securities analysts and active managers do as well), short sellers often put their own capital at risk. As a result, driving them out of the market likely would degrade the quality of market price signals, reducing the efficiency of the system.
The third lesson from the GameStop episode thus far is about the importance of margin and collateral requirements for clearing firms. This one is a bit technical. When two people agree to trade a stock, exchanging cash for shares, that contract is just the start of a complicated set of transactions. The most critical part is the final settlement—the actual exchange of the securities and the cash—that occurs two days later. This is called t+2 settlement. In normal market conditions, a two-day delay for final settlement has little consequence. But, in periods of market volatility, two days can be a very long time.
To see why, consider that the seller faces credit risk in the interval before settlement if the buyer goes bankrupt before the transaction is complete. To limit such counterparty risk, an enormous entity called a clearinghouse processes these transactions. The clearinghouse acts as the buyer to every seller and the seller to every buyer in the market. In the case of U.S. equity trading, it is the National Securities Clearing Corporation, a subsidiary of the Depository Trust and Clearing Corporation (DTCC), that settles trades.
Such clearinghouses are arguably the most critical, most interconnected components of the global financial network. In the short run, they are virtually without any ready substitute, making them vital for the system as a whole. They also concentrate risk in a single, central node of the network. As a consequence, clearinghouses must set the very highest standards of resilience. Were one to become insolvent, any resolution plan would start with maintaining continuity of its vital services to avoid a financial crisis. (See our earlier posts here and here.)
Now, to guard against failure, DTCC requires that brokers guarantee transactions by posting collateral. That is, to make sure that in two days the promised cash will be there to complete the purchase, the broker for the buyer must have sufficient funds in an account at DTCC. The clearinghouse determines the overall amount of collateral required depending on a combination of the broker’s transaction volume, the volatility of prices, and other factors (such as lopsided buy or sell activity by the broker). The bigger each of these, the more risk that a transaction will not go through after two days, so the more collateral.
On Thursday, January 28, DTCC announced that trading in stocks like GameStop “generated substantial risk exposures at firms that clear these trades,” so they were raising collateral requirements by 30% from $26 billion to $33.5 billion. The collateral hike compelled a number of brokers to restrict trading, at least until they raised the funds (see here). In response, retail customers of some brokers complained that they could not trade, and public officials issued calls for investigations (see here and here).
But the hue and cry about obstacles to trading completely misses a key point: policymakers who wish to ensure financial stability must encourage institutions like DTCC to be super-resilient. So, when extraordinary volatility materializes—as one can see in the first chart of GameStop’s share price—the clearinghouses must raise collateral buffers to ensure confidence in the continuity of their operations. The alternative could be a catastrophic run on the clearing institutions themselves. Put differently, we should be pleased, not perturbed, that DTCC acted quickly to ensure broad market functionality, even if it means that trading in a few extraordinary shares is temporarily disrupted.
The bottom line: if brokers are not prepared to meet clearinghouse collateral obligations, they simply should not be trading.
To go back to where we started, we suspect that this episode will end badly for many small investors. Sophisticated asset managers profit from volatility by selling assets when prices rise far above a sustainable level. As a result, asset price booms can result in a transfer of wealth from retail to professional investors. We already see stories about private equity firms cashing out what were money-losing positions before this episode began. Presumably, they are not selling to other seasoned asset managers.
Experience teaches us that no one can reliably beat the market average over time. But, there is at least one exception: the presence of a large number of unsophisticated small investors makes it possible for professionals to outperform. We fear that the GameStop episode will provide yet another instance of this exception.