Shares and shorts: the Reddit events in the stock market

Reddit; stocks

At the end of January, the international media started reporting that a group operating on the Reddit platform, r/wallstreetbets, coordinated a massive purchase of shares of companies including Nokia, BlackBerry, AMC Theatres and, the most notorious and relevant by volume and symbolism, GameStop. The result was vast speculative bubbles in their stock prices, registering rises of more than 450% in two days. These bubbles significantly hurt large hedge funds, which were short on the stocks. Obviously, the story appealed to the media: a “battle” between Reddit users and Wall Street.

stock; reddit

GameStop Corp. (GME) shares price evolution.  NYSE delayed price. Currency in USD. Source: Yahoo!finance

Shorting involves betting that the price of a stock will go down. It consists in borrowing shares to sell them at a price X and waiting for the price to fall. When the price drops to, say Y, the same number of shares are bought and returned to the original owners, and a profit of X – Y is pocketed. The payment of interest and provision of variable margin calls are required to maintain the short positions taken by investors. All this is automated through trading platforms (brokers), and the liberalization of the sector allows a stock to be shorted more than once.

Indeed, around 140% of GameStop shares were sold short before the Reddit purchases. This means that the hedge funds that were shorting the shares borrowed more than the entire stock of the company. Shares used for shorting are supposed to have the permission of their owners, but in reality overshooting is accepted in the terms and conditions of the trading platforms. Similarly, the owners are supposed to receive a payment for the “rent” of the platform, although this does not happen.

What happened when Reddit users purchased masses of shares? Juan Romero explains.

Theoretically, you can lose an infinite amount of money by going short, because the price of a share has no upward limit. So, when the bubbles started, the hedge funds were in a big trouble, losing many millions every day. The massive purchase of shares by Reddit users provoked a “short squeeze”: short sellers have to buy shares to cover their positions, contributing to the rise of prices itself. Money flowed from Wall Street to retail investors.

Trying to stop this flow, on January 28, the main brokers restricted the buying option from their digital platforms. Ironically, the best-known broker that restricted the sale of shares is called “Robinhood”, and curiously, the measures taken contradicts Wall Street’s own ideology. The alleged self-regulating market, previously the theoretical justification for the liberalization of finance, suddenly required regulation in order to rescue the hedge funds.

Melvin Capital was one of the hedge funds hardest hit by Reddit purchases. And to be able to meet the requirements of its short positions, Melvin Capital had to be bailed out by the hedge funds Point72 Assets Management and Citadel LCC to the tune of $2.75 billion. Citron Research is another hedge fund that was affected, tweeting on Friday 29 that, “after 20 years of publishing, Citron will no longer publish ‘short reports’”.

Elon Musk interviewed Robinhood’s CEO, Vlad Tenev, after he had introduced the restrictions, asking him “Why couldn’t people buy the GameStop shares?”. Tenev’s answer was that the clearinghouse demanded a deposit of $3 billion from Robinhood if it was to continue selling such shares, later reduced to $700 million. The clearinghouse is basically the National Securities Clearing Corporation (NSCC), a subsidiary of Depository Trust & Clearing Corporation (DTCC), a big company that provides clearing and settlement services to the financial markets, and whose owners are Wall Street‘s brokers, banks and insurers. Tenev said that NSCC requirement was “opaque”, but he did not really offer more by way of explanation.

In the financial markets, the clearinghouse has to settle operations at the end of the day. It takes all partners in transactions and matches their operations, putting money from its own funds in case they cannot be balanced that same day. In the event that a certain settlement involves some risk of non-settlement, the clearinghouse may require a reserve deposit from the brokers to settle their operations. This is really what Tenev was referring to.

In order to continue selling shares of GameStop and other companies purchased by Reddit users, brokers had to put up a huge deposit of their own funds, perhaps even 100%. This means that they had to put all the money from the shares that were bought that did not match the corresponding sales. So the brokers just blocked the “buy” options.

Another factor that contributed considerably to this decision is direct pressure from the hedge funds that were losing billions as the price increases. Robinhood is a commission-free broker, which means that its profitable clients are not retail investors, from whom they make no money, but big hedge funds like Citadel LCC. Obviously, this conflict of interests must have influenced Robinhood’s and other brokers’ decisions to block buying options, in the same way that it influenced the decision of the NSCC to increase dramatically the required reserve deposit.

The reason given by the supporters for the restrictions imposed on Reddit buyers is that you cannot collude to buy stock. The funny thing about this argument is that you can collude if you are a powerful institution that does so in a closed-door office, but not if you are thousands or millions of ordinary people who do so through social networks. The restrictions barely lasted a day and no regulatory agency intervened to defend financial liberalisation. In line with the rhetoric of hedge funds, the SEC also looked for signs of fraud occurring in Reddit’s forums.

Recently, hundreds of Reddit users purchased masses of shares in big companies like Gamestop and Nokia - but what effect did it have?

Still, a large part of public opinion was quick to criticise the manipulation of the market by the brokers. American politicians across the parliamentary spectrum, ranging from Alexandra Ocasio Cortez to Ted Cruz expressed their disagreement with refusal to intervene in the free market to defend the interests of the hedge funds.

The Reddit incident certainly does not have an anti-capitalist character, and nor does it mean that the financial system will come under control in the near future. But it does signal a rapid change in the economy. Finance appears to have become even more of a casino in which the most curious operations are possible, no matter how strange their relation to the productive economy.

Juan J. Duque Romero is a PhD Candidate at SOAS, Department of Economics.

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