GameStop and Compliance: Part 3 – The Squeeze

Thomas Fox
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Compliance Evangelist

I think the GameStop phenomenon portends a seismic shift in many areas. It may well be a turning point in markets and investments. Where it will be going, I do not think anyone knows right now but everyone needs to be watching and, more importantly, every Chief Compliance Officers (CCOs) and compliance professional needs to be paying attention. One of the most prescient observations about the Coronavirus health crisis and its impact on business came from Jed Gardner, Senior Vice President at Linedata Technology Services, who said, “we have moved from disaster recovery to business continuity to business as usual during the time of Coronavirus. He explained that risk managers, compliance professionals and business executives now have to plan for the unknown unknowns in their business plans and risk management strategies.”

Matt Kelly often says that social media is not the message; it amplifies the message. Moreover, it connects literally armies of like-minded folks into a community where they can have real power. The Wall Street investment community found that out in a very powerful way over the past couple of weeks regarding GameStop. Wall Street had always perceived itself as immune and protected from what they viewed as the whims of Joe Q. Public (or what Wall Street would derisively call ‘the great unwashed’). The reason was not social but economic, Wall Street viewed the barrier for entry to achieve a position which could impact the stock market as too high. Obviously, these same people were not watching television on January 6, when the US Capitol was attacked.

What does this mean for the compliance professional? It means that literally anything can come up and out of left field and end up as a high, hard one headed towards your corporate head. I know those are muddled baseball metaphors but a very muddled Spring Training will begin in two weeks so a tip of the baseball cap is in order. Special bonus question – Will the Astros make ALCS for the fourth straight year? This time cheating free? On to the Squeeze.

Roaring Kitty

How were so many main street traders able to impact the stock market in a way that may change it forever? Start at the beginning with the trader whose Reddit handle is Roaring Kitty. According to Nathaniel Popper and Kellen Browning, writing in the New York Times (NYT), “In mid-2019, a Reddit user — known as “Roaring Kitty” on some social media accounts — posted a picture on an online forum depicting a single $53,000 investment in the video-game retailer GameStop. The post attracted little attention, except from a few people who mocked the bet on the struggling company…Over the next year, he began tweeting frequently about GameStop and making YouTube and TikTok videos about his investment. He also started livestreaming his financial ideas. Other Reddit users with monikers like Ackilles and Bowlerguy92 began following his every move and piling into GameStop.”

Reddit 

Reddit is an online platform which provides chat rooms for like-minded folks. In the instance of GameStop, it was WallStreetBets, which has more than 2 million followers. According to Allison Morrow, writing in CNN Business, the site is “littered with posts cheering the stock gains and no small amount of righteous indignation.” The site not only provided information but, in many ways egged, investors on. One user said, “What I think is happening is that you guys are making such an impact that these fat cats are worried that they have to get up and put in work to earn a living,” a moderator in the group posted this week.” That fuzzy sensation you are feeling is called RESPECT and it is well earned. Wall Street no longer dismisses your presence anymore.”

This approach is antithetical to the way Wall Street typically does business. Morrow quoted tech investor Chamath Palihapitiya for the following, “Instead of having ‘idea dinners’ or quiet whispered conversations amongst hedge funds in the Hamptons, these kids have the courage to do it transparently in a forum,” he said. “What it proves is this retail [investor] phenomenon is here to stay.”

Matt Phillips, writing in the NYT, said, “The traders’ motivations vary widely. Some reason that GameStop’s shares are a good value. Others are just riding the wave. And others want to squeeze Melvin Capital, a hedge fund that was shorting GameStop. They’re the ones quoting Heath Ledger’s Joker character from “The Dark Knight”: “It’s not about money; it’s about sending a message.”

The Squeeze 

How did these main street investors, using such pedestrian tools as Robinhood and E*TRADE, potentially change the market forever? They did it through a maneuver called ‘the squeeze’. Phillips wrote, “many are placing their own options bets, on the opposite side of the shorts. [See yesterday’s blog on ‘the shorts’] These bets involve contracts that give them the option to buy a stock at a certain price in the future. If the price rises, the trader can buy the stock at a bargain and sell it for a profit. The brokers who sell the options contracts have to provide the shares if the trader wants to exercise the option. To mitigate their risk, they buy some of the shares they’d need. Normally, this small amount of demand doesn’t do much to the price. But if enough traders bet big, the demand can push the stock up. If it goes high enough, the brokers who would be on the hook have to buy more shares, lest they get stuck having to buy a lot of expensive shares all at once. That increases demand, which increases the stock’s price. Which means the brokers have to buy more shares, which means … you get the idea.”

Project Syndicate reported that “on January 27, investors that had taken short positions on GameStop lost $14.3 billion.” Phillips reported that Melvin Capital needed a $2.75 billion cash injection on January 25 because of the squeeze. Further, “the firm had closed out of its short position. Andrew Left of Citron Research, another short, said he had covered the majority of his short position “at a loss, 100 percent.””

Should the shorts have been ready for this? Isn’t shorting a stock an inherently risky position to start with? Afterall, Bill Ackerman had to close out his short position against Herbalife Nutrition eventually. Short seller legend Jim Chanos has been hurt by his short of Tesla. As late as December 2020, in a Barron’s interview, Chanos cited corporate governance concerns, particularly when Tesla merged with a solar energy company controlled by Elon Musk. Chanos also has criticized Tesla for its reliance on sales of EV car tax credits for a huge amount of its revenue.

It is all about risk management, seeing around corners and, as Jed Gardner reminds us, “Business as Usual” in the 2020s.

Join us tomorrow where we look at the regulatory response.

[View source.]

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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