My thoughts on the GameStop volatility

Update (February 8, 2021): Well, there you have it, GameStop is back closer to reality at around $60 as of today. It lost 80+% from the peak value. Who would have guessed that?!

January 30, 2021

Wow, what a week! I was reminded again why I prefer to be an index investor (for the most part). I don’t have to live through the wild price moves as we saw in GameStop (GME) and the other “meme stocks”. And I don’t have to worry about trading restrictions. But it was entertaining to watch the drama, stocks going up by 100+% in one day and seeing short-seller hedge funds being driven to the brink of ruin. The media certainly loved this story of David vs. Goliath; a mob of Reddit users in the “Wall Street Bets” (WSB) group vs. the powerful finance establishment! My blogging buddy Retire in Progress wrote a nice post about the GameStop Short Squeeze. But I also wanted to share some of my own thoughts. Let’s take a look…

What created the price spikes?

Before I get started, let me just briefly go through some of the basics of how we can generate such crazy price movements. What we observed here in the case of GME, AMC, and several other meme stocks is called a short-squeeze. Investors who short a stock can’t just sell out of thin air. They first have to “borrow” the stock from someone, normally a brokerage company that lends out the shares of some of their other brokerage customers – a process called securities lending. To return the borrowed stocks, the shorter will then have to buy the shares back at a later date.

Also, a quick side note: to borrow the shares, the shorter will have to pay a fee to the lender. So, if you ever wonder how brokerage companies can offer you free brokerage accounts, commission-free trades, etc. that’s part of where their revenue comes from!

A short-squeeze is essentially a self-fulfilling prophecy where due to a price hike in a stock with a lot of short interest, the shorters have to then scramble to buy back the shares they borrowed and this “panic buying” then puts even more upward pressure on the price. Of course, someone with infinitely deep pockets could theoretically just sit out the price spike but nobody I know has infinitely deep pockets. As the adage goes: the market can stay irrational longer than most investors can stay solvent. This has ruined many investors that would have been correct in the long-term, but got wiped out through margin calls in the short- and medium-term. LTCM, MF Global, are famous examples and also smaller players like OptionSellers (see my case study) and many more.

An additional factor in the price spike was that the WSB crowd got their bullish exposure to the underlying stocks not only through buying the stocks outright but primarily through buying call options on the stocks. A call option is a derivative that gives the buyer the option (not the duty) to buy an asset at a given price in a given time window or at a certain point in time. As in every derivatives transaction, it takes two to tango. For every buyer of a call option, there has to be a seller of that same option. Very few investors will sell a naked call because the loss potential is truly unlimited. Most will “delta hedge” the exposure of the short call option. So for example, if you sell one call option (100x multiplier) with a Delta of 0.2, you’d hold only 20 shares of the underlying to hedge the risk of (short-term) price movements in the underlying. That way, if the price of the stock goes up by $1, you lose 100×0.2=$20 and that loss is exactly offset by the $20 gain in the stock portfolio.

Unfortunately, delta hedging is not a one-time set-it-and-forget-it affair. As the price of the underlying changes so does the Delta (also called the Gamma effect), so the Delta-Hedging has to be readjusted, most often daily. And if the price keeps increasing, so does the Delta. It means that the investors with the short call option were forced to buy more of the underlying every time the stock went up to Delta-Hedge their short call risk. So, the price going up begets more buying pressure and thus the price will go up even more. It’s an upward momentum machine that exacerbated the  buying pressure from the short-squeezed funds even more.

Let’s move on to some of my thoughts…

The rumors of “Big Wall Street’s Demise” are greatly exaggerated!

Is Wall Street finished now? There were some lurid headlines like “GameStop Moves Show How Individual Investors Are Shifting the Wall Street Power Dynamic“; I had to laugh at such a dumb headline though it was sad seeing it in the normally reputable Wall Street Journal. Sorry to sound like a party pooper, but Wall Street is quite a bit bigger than the handful of short-bias hedge funds that faceplanted recently. Everybody, myself included, loves a David vs. Goliath story, so just to be sure, I couldn’t help but feel a bit of Schadenfreude myself. Especially because I can’t say I even know anyone personally who works in the space of short-bias hedge funds, despite being active in finance for 2+ decades. That alone shows me what a niche market this is in the grand scheme of the finance world. If these Reddit investors want to impress me and seriously take down Wall Street, why don’t they try to move the S&P 500? They probably couldn’t move the market by even 0.01%. The market cap and the daily volume in physicals, ETFs, futures, futures options, and index options is a bit too large for their budget consisting of a stimulus check and mommy’s allowance. So, I think the media got a bit too far ahead. In case you didn’t know already, Wall Street will survive this! ๐Ÿ™‚

Update (2/8/2021): Sure enough, the HFRI Index data shows that the overall performance of all hedge funds was positive (+0.92% equal-weighted, 3.38% asset-weighted). Equity-centric hedge funds were up 0.78%. Recall that the S&P 500 was down 1% in January. Market-neutral (where you’d likely find a lot of the shorters) was down 0.53%. But a far cry from what was portrayed as WSB sinking the entire Hedge Fund industry!

HRFI Jan 2021 Performance
Jan 2021 HFRI index performance. Source: HFR.com

Wall Street in general and Hedge Funds in particular might even be net beneficiaries of the market volatility!

If you thought that there’s a lot of animosity between the WSB crowd and hedge funds, keep in mind that the only group of people with even more intense hatred toward hedge funds are, you guessed it, other hedge funds and Wall Street players. If you remember the LTCM debacle in 1998, LTCM reached out for help to some of the Wall Street heavy hitters. As the rumors go, after seeing the LTCM positions, some of the firms apparently used that knowledge to bet against the LTCM book, accelerating the fund’s demise. So, I wouldn’t be surprised if other hedge funds jumped on the GameStop bandwagon some time ago and profited from the short squeeze after they saw some of their Hedge Fund “friends” get into hot water. So, all the talk about Reddit taking on the big Wall Street Goliath may look like a great narrative. But there are some brilliant and savvy people in finance, and I suspect that they already benefited from the short squeeze after sensing blood in the water, making more money than all the WSB folks combined. The same thing happened many times before: LTCM, Lehman Brothers, etc.

Furthermore, I wouldn’t be surprised if there are already some high-frequency fund algorithms monitoring the Reddit group to identify the next stock going to the moon for no fundamental reason.

In any case, we shall see how the hedge fund world performed in January; a company called Hedge Fund Research (HFR) publishes aggregate hedge fund return indexes regularly. I doubt you will even see a blip in the performance of the headline index when the numbers come out next week.

Other non-hedge-fund establishment finance players also made out like bandits. A private equity company holding AMC convertible bonds had a huge payday, see the WSJ article here: “Silver Lake Converts AMC Debt to Equity After Dazzling Stock Rally“. 

I would also suspect that some of the non-hedge-fund players on Wall Street might have done very well. More trading volume is generally good for Wall Street revenues. I wouldn’t be surprised if some of the Wall Street heavy hitters had a record January profit thanks to the Reddit folks and the useful idiots in the media.

Update 1/31/2021: My blogging friend Retire in Progress provided the following interesting link: Nine Investors Instantly Make $16 Billion On GameStop Stock ‘Squeeze’ confirming some of my points. Among the nine largest (estimated!) GME stock holders are mostly the large fund companies (Fidelity, Blackrock, Vanguard, Dimensional) and a few professional investors. Apparently, passive index investors got the largest share of the gains followed by a few other establishment professional investors.

Update 2/3/2021: WSJ article about hedge funds that cahsed in on GameStop.

The smart short-sellers had probably cashed out of that trade already!

Let’s look at a chart with a long history. As recently as October 2015, GME was trading at about $47 before the company’s long demise started. If you are a smart short-seller who shorted GME at $47 and saw a quote of $3 in early 2020, why would you want to keep sitting on that short position after you made $44? You already made 90+% of the potential profit, why not get out at that time? You’d hope that the smart short-sellers did. And the late-comers and the greedy ones and the incompetent ones wanted to squeeze out the remaining $3 of potential profit by seeing the price go to zero. A bad idea! So, again, a few short sellers tried to pick up more nickels in front of the steamroller and got – well – steamrolled. But I don’t think that this will put a dent in the financial market in general or even the hedge fund market in particular.

GME chart02
GME close since 2013. Source: Yahoo!Finance

The success of the “Wall Street Bets” group is likely exaggerated!

I’m glad that some of the WSB traders got rich. So rich in fact, that they’ll be able to pay off their student loans, see here: “Redditor betting on GameStop claimed to use profits to pay off student loans” (from Yahoo!Finance). Congratulations, you’re now just as rich as I was when I finished college and the economics Ph.D. without any student loans! A little bit of sarcasm here, sorry! But seriously, I am elated that taxpayers (i.e., most of us here) don’t have to bail out a bunch of Gen Ys and Gen Zs now. And once they file their taxes next year and they see the big bite from paying the full tax rate on short-term gains (federal plus state) plus potentially Obamacare taxes, I sense that they will learn an important lesson. We should all celebrate that.

But I also wonder how many of their bets before GameStop, AMC, etc. have not panned out so well. If they have been playing this kind of game, i.e., buying deep out of the money call options on some dead-beat stocks and waiting for the recovery, I sense that they must have blown through a lot of cash before hitting the jackpot in late 2020/early 2021. That’s because if you buy a call option and the price of the underlying stays below the strike you get nothing. You lose the option premium. A 100% loss relative to the price of the option. So, you will obviously hear from some of the loud members of the WSB group holding up their bounty, but for every one of them, there are probably dozens of less successful traders. See Omar’s story in the recent CNN post.

Was there discrimination against retail investors?

Brokerage companies, especially Schwab and Robinhood, took a lot of heat for restricting trading in the “meme stocks”. Even my blogging colleague Paula Pant proclaimed that FIRE folks and the meme traders should now be “united under a common banner” to demand trading for the people. Though I hope Paula was a bit sarcastic about that one, because my support for WSB is certainly limited. The way I understand it, trading was restricted only for the handful of meme stocks and only in one direction (buying). On Wednesday, Thursday, and Friday, I traded CBOE S&P 500 index options in my Interactive Brokers (IB) account and single name stock options in my Fidelity IRA, all without any glitches. So, I don’t quite understand what the hubbub is about. 

The trading restrictions were construed as more evidence of the “us vs. them” and the “people vs. the powerful” narrative because it gave rise to rumors that individual investors were shut out to protect the rich and famous and the powerful hedge funds. I don’t quite follow that logic. If you had been a hedge fund trading with Robinhood you would have been restricted just like everyone else (yeah, I know, no hedge fund will ever trade with Robinhood). Likewise, if you had been a retail investor trading with a Prime Brokerage where hedge funds tend to hold their accounts then you would have faced the same restrictions (or lack thereof) as the hedge funds. You get what you pay for. And since you pay nothing for your Robinhood trades you occasionally get exactly that: nothing, i.e., no trading access. Get over it! In a few weeks, when the meme stocks have fallen back to a normal level again, you will all be happy you didn’t buy GME call options with a $500 strike!

Update 1/30/2021, 11:50 am: As some readers have pointed out, it looks like the trading restrictions were not even that intentional. They had to do with the fact that in light of the extreme volatility of some of the stocks, the clearinghouse (Apex Clearing) used by many of the brokerages was forced to put up more collateral to clear trades but was not able to. See the relevant WSJ article. It would explain that retail clients at other brokerage firms had not faced restrictions at all. Again, this doesn’t appear like a targeted attack on retail clients. If you’re a hedge fund and your broker had used Apex you’d have faced the same restrictions. If you’re retail client using the “right” broker you had no restrictions. 

Did the short-sellers manipulate the market?

Short-selling is an essential tool in finance. If you are a stock picker and you perform securities analysis you should have the right to short-sell the stocks you find overvalued, just like you have the right to buy the stocks that you feel are undervalued. In fact, the price-finding mechanism should normally function more efficiently if financial actors can short the stocks they find unattractive. Well, I say normally because the Reddit crowd has just established an exception to that rule, at least in this handful of instances out of a pool of thousands of stocks. In any case, unless the short-sellers spread false information about the stocks they just shorted (also called “short and distort” – essentially the inverse of “pump and dump”), then everything is perfectly legal. A lot of the short-squeezed stocks I studied do indeed look like corporations with extremely weak fundamentals and a very uncertain outlook, measured by very objective criteria, like EPS, EBIT, EBITDA, cash flow, etc.

Of course, where it gets a bit questionable is when the short-sellers’ analysis is blinded by their own economic incentives. And instead of just passively sitting back and waiting for the bad stocks to go under they go public and bash the stocks they short. Where does objective securities analysis turn to biased analysis and ultimately misrepresentation and securities fraud? Probably the funds that shorted GME never crossed the legal definition of fraud. As a general rule, I always ignore people pushing an agenda and that goes for both the shorters that are bashing stocks as well as the people with long positions trying to push the stocks higher.

Did WSB manipulate the market?

Likewise, the WSB people totally have the right to buy call options on whatever stock they like. We can’t even call this “pump and dump” because the Reddit group seems to be quite transparent in that they never claim that GME is a great stock worth $300+. They just want to squeeze the shorters. You can’t be more transparent and honest about your motives for being short-term bullish about a long-term pathetic stock. That doesn’t look like manipulation at all!

Which of the two sides is the smaller evil?

Politicians are getting involved now. Oh, my! And both congresswoman Alexandria Ocasio-Cortez and Senator Ted Cruz are agreeing on something and siding with the retail investors. We should all be worried now!

Yahoo headline Cruz agrees with AOC
Yahoo!Finance headline on 1/28/2021

Just to be sure, I don’t particularly care for either side, neither the short-sellers nor the WSB group. If I had to side with one of them, though, I’d probably still go with the short-sellers as the slightly smaller crooks. So, a (temporary) restriction to buying the impacted stocks, as troublesome as it may have been, was probably for the greater good. There are (at least) two reasons why I think the hype and the price surge about WME and some of the other short-squeezed stocks is actually very counter-productive:

First, one could argue that some of the short-squeezed stocks became so unlikable because of past management mistakes. For example, in the gaming world, everything has been moving toward downloads and games on handheld devices. The demise of GameStop is likely due to past and current management sleeping at the wheel and not recognizing this trend (anybody noticing parallels with Blockbuster Video?).  What kind of signal are we sending when potentially ineffective and incompetent managers get rewarded and see their own call options skyrocket? In other words, if you think that the retail investors in general and the WSB group, in particular, are the biggest beneficiaries of this price surge, think again. Management of the impacted companies, past and current, will likely hold a much bigger chunk of the long call options than a few Reddit kids who gambled their stimulus checks. The Wall Street Journal reported about this issue: “Insiders at GameStop, BlackBerry, LaCroix Maker Are Suddenly Sitting on Big Stock Gains“. WSB might have just shoveled millions of dollars to the incompetent managers that drove some of these companies against the wall. Great job, everybody! It’s like Robin Hood (and I mean the guy in Sherwood Forest, not the broker) taking from the rich and giving the loot to some other rich person, only a completely incompetent and less deserving one. Not fair!

Second, pushing the share price higher is counter-productive because for some of the “zombie companies” that are potentially unsustainable in the long-run, being taken over might have been the only route for long-term survival, at least for part of the business. Well, I guess at a market cap of $20b we will not find a buyer for GameStop anytime soon. In the worst case, we might even see some of the “zombies” raise some fresh capital now and they’d take over a healthy company. Good luck with the new management! Turning capitalism on its head! 

Conclusions

There you have it. As I said in the beginning, as a (mostly) index investor I don’t have a horse in the race here. Except for the integrity and stability of financial markets at large. Restricting retail investors from buying the impacted stocks was troublesome in one sense but defensible in another. It was certainly a PR disaster for brokers and potentially the green light for politicians to come up with more cockamamie financial regulation. Not happy about that!

So, in any case, I just wanted to point out some of the not so comfortable and not very popular viewpoints you might not have heard elsewhere. With the general public, the media, and politicians (both parties!) and even personal finance bloggers, all ganging up on the finance industry it almost feels like the latter is now the David fighting Goliath. How ironic is that?

Thanks for stopping by today. Looking forward to your comments and suggestions below!

106 thoughts on “My thoughts on the GameStop volatility

  1. Love the point about this being like “taking from the rich and giving the loot to some other rich incompetent person”. Uncle Sam probably won’t complain about the extra tax revenue.

    On a slightly different but related topic, given the increase in Signal Advance’s share price was “sure” to crash back down as its meteoric rise was due to a case of misidentity with the Signal Messenger Service in Elon Musk’s twitter post, would some have benefited a lot from shorting that stock? As a fellow index investor, I obviously didn’t take the risk of the chance of unlimited loss. However, as it turns out, people did realise pretty quickly and the price dropped back down. Who (if anyone) would have benefited?

    1. I doubt that there were many shorters getting in at the top. Once the stock starts deflating again one could argue there are mostly losers, the suckers that bought at the top. Even the initial shorter that stayed through the episode only gained relative to the peak price, but might be still underwater relative to their entry.

  2. I am usually a huge fan of your work but this post demonstrates a fundamental lack of understanding about the GME situation. Gamestop recently had major changes in ownership and its board, most notably bringing in Chewy founder Ryan Cohen. The turnaround story here is quite compelling and the plans for the future promising. I bought in at $20 as a long term hold on that basis. Many others also were buying on that basis and some solid, well researched material was placed on WSB by a user who it turns out is a financial advisor. By the way, he has made tens of millions on this play now.
    The lack of research and understanding in this post is made all the worse by the sardonic and dismissive attitude.
    You do some great work that I deeply appreciate, so I donโ€™t say this lightly: you should be embarrassed by this post.

    1. Are you seriously implying that as you bought at $20, you are holding at 250 because of long term outlook?

      1. I sold 90% of my shares and LEAPS this week in the midst of the frenzy. I intend to buy back in if/when it drops below 40.
        The current valuation is clearly a product of the short squeeze, but the squeeze was caused in no small part by a meaningful change in the business that warranted a price higher than the 100% of the float and a very large percent of the total shares in the market, which means more squeeze and more price appreciation may be coming. I think that’s risky for a bunch of reasons, which I’ll detail if people really want to know, but I am willing to continue holding a very small stake (0.1% of my portfolio) to see where it goes.

        1. Yeah, I like the idea. A barbell streategy where you take high risk with a small part of the portfolio.
          So, you’re very different from the WSB guys who buy only one stock and gamble with the entire portfolio…

          1. YOLOs are for folks younger than I with less to lose and more time to recover. But reading their posts, their desperation with an economy that left them behind and a financial system that seems to have concern for them is compelling. For those who aren’t willing to actually do their own due diligence or even sift through the reports and articles by others, it’s even more risky.
            But I have to feel for a young person making $9/hr after getting a college degree and seeing no prospects in the current economy and business climate. There’s a reason why most lottery tickets are sold to people who see little hope of achieving financial security any other way.

    2. No, he shouldn’t be embarrassed because he isn’t wrong LOL.

      A financial advisor is a glorified sales job, they do maybe 5-10% actual investment advising, most of it is spent cold-calling potential whales.

      And it’s great that the turnaround story is compelling but it isn’t $20 billion compelling.

      1. Yeah, I noticed that too. Keith Gill – I’m glad he did so well – but he’s not a securities analyst. He used to be an insurance salesman:
        https://www.wsj.com/articles/keith-gill-drove-the-gamestop-reddit-mania-he-talked-to-the-journal-11611931696
        “Mr. Gill […] until recently worked in marketing for Massachusetts Mutual Life Insurance Co.”

        It’s like calling used car salesman an engineer… ๐Ÿ™‚

        Update 1/31/2021: Walking a little bit back from that nasty comment. His case for upside potential based on the 2020 GME prices was certainly legit. But he’d have a hard time that GME is a deep value at more than $100.
        Also, someone even claimed Gill is a CFA charter holder. If confirmed, that would give him credibility.

        1. I’d encourage you to look at some of his early analysis of Gamestop, from like July and August. It’s better than 99% of what’s on Seeking Alpha and grounded in a really solid analysis of the fundamentals as well as the short squeeze. He may not have a PhD or exactly the right title for some folks, but the work is solid. There’s (almost) always disagreement in stock analysis, but he’s clearly done serious due diligence.
          Here’s his July 2020 analysis: https://www.youtube.com/watch?v=GZTr1-Gp74U&t=1s
          It’s easy to dismiss him as a YouTuber / insurance salesman / whatever, but his work speaks for itself (and he was making it all public back in July).
          He handles some of the overall market trends from about 12′-20′ and then dives into fundamentals from about 20′. He discusses the technical analysis bear case starting around 46′. He saw this as a sound value play at $4 before Ryan Cohen and the Chewy team came in with an overhaul and revamp.
          Oh, and remember that Michael Burry likewise saw the sound value play in Gamestop in the first half of 2020.
          I think one of the biggest errors in reporting on this is blaming WSB for the short squeeze. The shorts were horribly wrong from day one, didn’t get out when they should have (at least when Ryan Cohen came on board), doubled-down on the short positions, and got squeezed hard. Now they are whining when the bill has come due. At one point shares short was something like 140% of the entire shares in the market. There were something like 95 million shares shorted and only 69 million shares in the market. Any responsible investor should know that is an incredibly dangerous position to be in, highly vulnerable to a short squeeze. Those who were short are simply reaping what they have sown and now have to pay the share holders enough to convince them to sell. And given the supply-demand imbalance created by those who went short, they can’t complain much if the shareholders decide to hold them hostage for outrageous prices.
          All of this is being missed in the reporting and blog posts focused on Reddit and retail investors. The biggest holders of Gamestop are actually index funds (Russell 2000, total market, etc.). The rise of those funds is in some ways exacerbating the short squeeze because they cannot sell shares when the price becomes irrational. Those shares only return to the market if someone sells the whole index.
          And all the terrible reporting that has depicted this as “stick it to the hedge fund” and “revenge for 2008” and “class warfare” has probably made the situation a thousand times worse. Wall Street Bets encourages that narrative, to be sure, but literally millions of people have flooded into Wall Street Bets since the media made this story all about them. And that also means that likely many thousands and perhaps even millions of people who identify with the David vs. Goliath story came in and invested money at a much riskier and much higher price.
          Interestingly, some of them say they don’t care if they lose it all, as this is not about money but a social/political statement against Wall Street. I find that foolish and counterproductive since the biggest winners will still be folks like insiders and institutional investors, but it’s a part of what’s now driving the irrational behavior around Gamestop.
          Like you said in another comment, if you have some high-risk money to barbell, shares might still 2x or even 3x, but I personally doubt it. The highest I have seen it go was about $514 in the premarket. And there’s not a great way to gauge the status of the current shorts (especially how many of those are new shorts from the obscene highs this week, who will no longer be in a squeeze).
          I’m looking at puts with expiration dates 4-6 months out, but the volatility has driven options prices through the roof.
          Ok, enough from me on this. I just seriously wish people reporting on this across the spectrum would do a little more research and report & comment more accurately on the situation. The narrative most people are getting is a gross distortion of reality.

          1. “He may not have a PhD or exactly the right title for some folks” – if some of the articles I’ve read are true then he’s actually a CFA charterholder (I believe ERN has the same designation).

            1. That would be a surprise. I don’t know many CFA holders that work in “marketing for insurance”. The insurance industry has a lot of its own 3-letter designations, so maybe someone mixed it up? But it’s certainly possible he holds the CFA.

              Either way, I’m moving more toward conceding that the work of Keith Gill is certainly 100% legit because he made a good point in 2020 that there is some upside potential, especially at the 2020 prices.
              But even Keith Gill, CFA would have to admit that there is no deep value rationale for GME at a price north of $100.

          2. I think we’re on the same page here then. His initial analysis sounds solid. You can make a case that at the 2020 GME prices, there was upside potential (especially with the pandemic and more demand for gaming).
            Also in agreement that the irresponsible shorters should be penalized.
            Also in agreement that WSB are not alone to blame for the squeeze. As I wrote in the post, probably other HFs piled into this to shoot down their competitor. (think Ackman vs. Icahn).

            “The narrative most people are getting is a gross distortion of reality.”
            Agree with that too.

    3. Thanks Pat. I’d be shocked that any reader will agree 100% of the time.
      A few points here:
      I kept the post short (well already at 3,000+ words) and didn’t even get into much of the details of the security valuation. Others have done that.
      I totally concede that GME might have some reason to go from $3 to $20 as it did in 2020. The pandemic created some demand for games again and after the malls opened again I can see that GME has some potential. New management sometimes helps. Hence my comment about the dumb/greedy shorters that wanted to make those last $3 on the bet.
      But all of that was priced in as of late 2020. And everything above 20, certainly everything above 40 is hype and bubble.
      But I’m certainly happy that the trade worked out for you.

  3. I would like to understand why Robinhood took the actions they did and why they needed a cash injection. What if they hadn’t been able to find the cash? What if the hedge funds had gone bust?

    1. From what I understand Robin Hood, WeBull and several other trading apps where using Apex Clearing as their Broker for DTC, which clears and settles Equities. Due to the price surge DTC required more capital to be held in order to support the clearing and settling of these equity securities. When Apex did not commit more capital, that was the cause of the temporary restriction.

    2. I can’t speak for Robinhood. It’s probably a combination of a) protecting retail investors from themselves. b) restrictions that clearinghouses imposed on Robinhood, c) potentially pressure from Citadell, which would be a scandal

      I was surprised that RH needed a $1b in cash. I’m not familiar with the inner workings of an online brokerage. I suspect that they didn’t actually lose $1b but they simply want to have a cash reserve to be able to handle large sudden net outflows. Keep in mind that what you hold as a cash balance at a brokerage is not kept in cash at that company but likely invested on their side. And they hold only a fraction of that cash themselves, hoping not everybody wants to invest or withdraw that cash balance all at once. Well, that idea might have changed this week… ๐Ÿ™‚

      Hedge funds go out of business all the time. In fact, I would guess that up to 90% of all hedge fund startups disappear.
      For the more mature funds there is often workout plan where some additional cash comes from other hedge funds, but of course they want to take over that fund and the intellectual property and strategies. Melvin Capital was a very successful fund before WME.
      But again, if they had gone under, hey would have gone under. It’s an LLC or LP and the owners and investor would have lost their equity. ๐Ÿ™‚

    3. TDAmeritrade ToS App also had issues on Friday, and I could not see SPX options in normal way. Luckily, the workaround was to “roll” a current position and then edit the trade.

        1. Desktop ToS worked fine, and I could place trade on mobile with work around.

          A little salty that I couldn’t sell a covered call on NOK shares, but all for the best to get out of share even.

  4. Greetings from Germany (small investor here, index funds only). I really enjoyed reading this. I’d like to ask two questions:
    – Don’t you see any risk of contagion on Wall St., i.e. aren’t these hedge funds “too interconnected to fail”?
    – Some people claim being long $GME was a rather safe bet, kind of “once in a lifetime” (due to factors like the enormous short interest and low market cap), you just had to do your DD. Could you comment on this?
    Thank you.

    1. Thanks!

      I don’t quite see contagion risk. As I said: short-bias HFs are a tiny fraction of the financial system and other HFs and Private Equity companies probably had great profits.
      Banks, Investment Banks, etc. are very interconnected. There was a risk that after Lehman failed in 2008, they would all go bust one after the other. The interconnections like that don’t exist in the hedge fund space. In fact, quite the opposite and as I wrote above, one HFs decline is another’s gain.

      In hindsight, every winning position is always a safe bet. But among the myriad of other equally positioned companies that looked alike initially but then failed (JC Penney, Blockbuster, Sears, etc.) how do you know which one’s the one?
      Also, we’ll talk again in 5 years and see where GME is then. ๐Ÿ™‚

      1. Quick note on contagion risk: When Robinhood and some clearinghouses started blocking transactions it was because (according to them) they lacked the liquidity to guarantee the transactions. Robinhood had to tap its lines of credit and pull in a billion from its investors, but it’s unclear whether that’s just to ensure liquidity or they had some additional costs or were short the positions. Fidelity had no trouble maintaining open trading on GME and related shares throughout.
        The highest total estimated loss to shorts I have seen is 70 billion. I think that’s around 0.08% of the total US stock market.

  5. Good & thoughtful post. Given all the volatility this week leaves/prompts me w/ one thought – reversion to mean.

      1. The online group participating in this has their own language. I learned some of it yesterday watching their thread. Some of the comments actually had me laughing out loud. They use “Diamond Hands” to mean buy and never sell. “Paper hands” means you are weak and sell. I am just an entertained observer.

  6. You missed the point. Why should hedge funds be allowed to short a stock 140%, but retail investors can’t take advantage and run up the price? Your comment about Robinhood restrictions makes no sense. No one cares about the 500 index trades you are doing, this was targeted specifically at new buys for GME and other meme stocks. Why are hedge funds allowed to cover but others can’t buy? This only helps hedge funds and shorts. If you really don’t see the one sided nature of this decision I question other posts of yours.

    If you want to reduce volatility in the market, don’t punish retail investors. Punish hedge funds for shorting a stock 140% in the first place.

    1. Also, how would you like it if someone sold shares in your brokerage account on your behalf, without your consent? That’s exactly what happened to one Robinhood user who had 4,500 shares of GME

      1. That’s what happens when you buy shares with high margin requirements. If you get margin called at a decent brokerage they will automatically start liquidating your positions.

        And the reason retail wasn’t able to buy in the poo brokers is because of high capital requirements imposed on volatilite positions.

      2. Oh, wow, that’s not right. If he bought them on margin on Wedensday and got a margin call on Thursday during the drop, it would be legit, though. If there’s some other reason for the sale, he should complain at FINRA.

        1. Yeah, from what I have seen of screenshots people posted of the forced sales, they were not margin calls. They appear to be executed mid-day with messages about risk and volatility. To make matters worse, they were executed and nearly the low for that day in more than one case. Robinhood has had issues with regulators in the past. This might be the end for them.

                1. I use Fidelity for my Fidelity mutual funds. So that kind of settles it.
                  If you like to trade mutual funds on IB they charge you an insane $14.90 transaction fee. But if you trade ETFs you may get it commission-free or for a small commission ($1.00 or $0.005 a share, whichever is bigger).

    2. From another commenter:

      “From what I understand Robin Hood, WeBull and several other trading apps were using Apex Clearing as their Broker for DTC, which clears and settles Equities. Due to the price surge DTC required more capital to be held in order to support the clearing and settling of these equity securities. When Apex did not commit more capital, that was the cause of the temporary restriction.”

      And you missed the point too. It’s not a hedge fund vs. retail investor issue. If you’re a retail investor banking with a brokerage that doesn’t use Apex Clearing you could have traded. And if a hedge fund has a broker that uses Apex, then the hedge fund would have been restricted, just like the WSB crowd.

      1. This should be a warning to anyone whose brokerage doesn’t clear through a large firm. Usually the disclosures at the bottom of the broker’s website will name the clearing firm. Apex is basically the remnants of a company that went bankrupt, and they are a very small shop now. The central clearing facility has no sympathy if you run out of dough. It’s possible and does happen to large firms (all the time). But larger firms will jump into action can wire in capital within minutes. Takes longer for smaller firms to pass the hat, and that’s only after they realize they’re dry. Sometimes it takes hours to get ahold of someone up the chain to get them to wire.

        –former settlements guy

      2. I think it may be worth noting that, at least in my understanding, Robinhood has not used Apex for a couple of years. They are their own clearinghouse.

        I don’t know much about this plumbing either, but I believe that this is why Robinhood’s PR was such a disaster. They couldn’t go around like WeBull’s CEO did with this excuse, and it isn’t clear to me why WeBull’s CEO tried to imply Robinhood did. When regulations changed that GameStop trades needed more money for coverage, Robinhood (not Apex) needed the cash directly to continue covering the trades.

        It isn’t clear to me if that means there could have been a direct conflict of interest between Robinhood and its retail investors, even outside of a relationship with a hedge fund, and if it may have had an incentive for the price to drop.

        1. Yes, true! There is another hierarchy of clearinghouse above APEX/RH that you cannot escape. RH didn’t have the cash or didn’t want to “waste” the cash sitting around as margin just to trade a few GME shares.
          It’s like Walmart runs out of toilet paper. Could they bring it in by helicopter? Sure. But it’s too expensive for them. It’s not a conflict of interest. It’s just a cost-benefit analysis.

          By the way: all the morons that wanted to buy GME at $300 should thank RH that the trades didn’t go through!

  7. The real story is likely more complex than the news articles, and I think ERN captured both sides well.

    The systemic risk only exists, if these HF are over leveraged and not protected from loss. Once the short % goes over 100%, that creates real risk for a squeeze, and I didn’t think that could happen.

    These HF need to have skin in the game, so they personally take losses and don’t just hurt the client.

    I think HFs now realize they can take losses at times, so they will not put on as much risk. Seems good that people fear losses.

    My guess us that GME total flow (price x volume) is a blip on the total market flow, so not going to crash the system.

    The SPX put sales were great this week due to the extra Volatility, and I made double my normal amount.

    1. Very true, great summary.
      And you make a great point about the systemic risk of some hedge funds. LTCM posed more risk and more counterparty risk because they had notional exposures in the triple-digit billions. Melvin Capital looks tame against that.

  8. For learning purposes, I tried getting a small horse into this race by selling a naked short of 3 GME shares. This scenario is too entertaining to pass up and I wanted in. I figured if the price goes back down to a reasonable level (maybe $20/sh), I can pocket about $1k, which can buy a few celebratory dinners. Sure, my losses are unlimited but YOLO right? A couple of things I learned already. The margin rates for this particular security is much higher than normal at 24% per annum. And it’s subject to the broker’s ability to find shares to borrow, even if my strike price hits. Like ERN said, the only obvious real winners here are the brokers.

  9. Your takes on Robinhood limiting trades on the basis of โ€œyou get what you pay forโ€ (when in fact all brokerages are now offering free trades) as well as your โ€œglad we donโ€™t have to bail out your student loans nowโ€ takes in this article range from bizarre to old man yells at clouds level analysis.

    Disagreement is one thing, but laziness and poorly thought out points are another. And in my opinion this article too often strays into the latter. Just not your best here.

    1. Agreed. I’m a long time reader first time commenter and this post really makes ern sound like a jerk. It’s fine for people to be wrong and for ern to tell people why, but belittling someone paying off their student loans, referring to us “taxpayers” (elbow nudge) not having to bail them out and rejoicing in them being caught out by future tax implications is just mean spirited and in poor taste.

      1. Welcome to the personal finance blogging world. You have to mix finance with a little bit of entertainment otherwise nobody will read your stuff. Feelings might get hurt sometimes. I’m sure you you left a lot of comments in the WSB forum where you condemn the hate and vitriol that’s spread over there, probably 1000x worse than what I wrote here.

    2. Thanks for your comment. I stand by my “you get what you pay for” point. Fidelity still has a lot of revenue sources, from mutual funds, upsells to for-fee services, etc. so Fidelity can afford to a) have a stable trading platform and b) hire a clearinghouse with fewer issues.
      The fact that Fidelity now also offers free equity/ETF trades makes the situation for the WSB crowd even more embarrassing: you didn’t even save any money on commissions by trading on such a crummy brokerage platform.

      The “old man yelling at clouds” meme actually applies more to the WSB, AOCs and Ted Cruz’s of the world, claiming there is a grand conspiracy against retail investors.

  10. Amazing post, and thanks for the mention ๐Ÿ™‚
    I’d like to add a couple of links:

    This one shows how 9 investors made 16 Billions (vs ~1B of GME GANG), showing how in fact the “retarded” from WSB are just the front line, while real money is being made by professionals (Ryan Cowen above all):
    https://www.investors.com/etfs-and-funds/sectors/gme-stock-gamestop-investors-instantly-make-16-billion-gamestop-stock-squeeze/

    This other one is the latest Animal Spirit podcast where Ben and Michael discuss how actually, part of Wall Street is following the YOLO traders – so I wouldn’t call that “such a dumb headline” ๐Ÿ˜‰

  11. Big ERN I enjoyed reading the post and the related comments on GME. One question I do have is if there should be some limits on shorts beyond 100%. While I agree that shorting is an essential part of price discovery having short interest beyond 100% seems somewhat unnatural

    1. That would help, but I don’t know how this would work in practice. Suppose you’re at the limit and nobody can short. Then some of the shorted stocks are returned again. Who decides who gets to initiate the new short capacity? Is there a waitlist?

  12. I think ERN got the balanced points. It’s not about small investors vs evil rich people (I am actually poor and a populist). What’s happening is classic pump and dump in very large scale, it doesn’t really benefit anyone in the long run. I am surprised that this pump and dump is so glorified because “evil rich people are manipulating market all the time to leech the poor” narratives. No wonder some politicians jump into this.
    I understand big firms frequently manipulate the system but this is not the right way to “revenge” or “help the poor” etc. And it’s always boil down to wanting “snow white, perfect system that is for 100% clean for everyone”. It doesn’t exist, exterminating mosquitos may destroy the entire house. It should be controlled better way, and some parasites, you can’t eliminate completely because it doesn’t exist in nature.

    1. Thanks! Very well said! That’s the tragic issue here: long-term this will only make most of us worse off, except for maybe a few super rich hedge fund boys, a few of the early WSB members and (most annoying) the senior management at some of the corporations.

  13. Hi Karsten – You missed few major points:

    1. “they actually pulled this off”
    2. Shorting as appropriate as it is, is not going to be the same.
    3. Gamification of the system – we all know how this party ends.
    4. Risk Management – did absolutely horrible job causing even more price push up. This party would have been over with on Friday.

    Here is little funny point: Cramer will finally go away -:) after destroying naive individuals life’s for few decades now. There is video out there that Cramer explains how he rigged the system all the time.

  14. Great article and I agree with all points. The most ironic aspect is that Silver Lake was sweating out a default with AMC just in December, yet they were able to unload all their debt after the conversion and even make a profit. Those guys must be high fiving each other over the trade. Long-term even if AMC gets funding, producers refuse to gamble a $200 million film on a weak release. James Bond specifically has been pushed back multiple times now. Summertime is when usually the big blockbuster films release and kids are on vacation. If there’s another halting of films in the summer, AMC will be in the same situation by Fall again. I don’t think they can afford another year again of delayed blockbuster films.

  15. If you listen to Malcom Gladwell and his analysis of David and Goliath, it is actually very accurate. David was a clear favorite wielding a highly deadly sling against a mostly blind and immobile giant. The story is really about the favorite destroying the underdog and reframing it as the opposite.

  16. So if the short sellers were forced to buy during the short squeeze, and the WSB crowd were buying because of the frenzy, who was selling?

    Also, I’m curious about who started the narrative around the short-selling and the new ownership of Gamestop – seems fantastic timing. It seems like if you had a good PR engine you could potentially be an activist long investor on formerly hated shares and use the common folks to create a mob. Uncancel culture?

      1. Ryan Cohen (of Chewy fame) became the single biggest shareholder in Q3 of last year and began taking an activist stance on turning around the company. That started the share rise far more than Reddit/WSB. He has since increased his stake and joined the board.
        Article from September laying out the beginning of all this: https://www.bloomberg.com/news/articles/2020-09-21/top-gamestop-investor-wants-to-turn-retailer-into-amazon-rival
        GME also had a pretty solid Q3 earnings report. Their revenue was solid (esp. during a pandemic), costs going down, same store sales up, etc.
        These events are what drove GME to about $40 on Jan 14, not an internet army.
        That price increase then triggered the short squeeze.
        This was a slow motion and entirely obvious event (especially in hindsight I suppose) and the short sellers just did a terrible job of exiting their shorts when the whole landscape changed. They could have taken their losses at $35 on January 15 and saved themselves a lot of pain, money, and bad press.

        1. Again, we’re in agreement. There might have been some reasons for the stock to go above $20. The pandemic might have also helped with game sales.
          Though, I still have trouble reading too much positive into a stock that beat the earnings estimates in Q3, but BY LOSING LESS not earning more. All of that with the tailwind of the pandemic. But hopefully, they will post a profit again for Q4. To be released March 24. We shall see.

  17. ah so we’re a MOB? Let me tell my Reddit friends about that and we’ll target your blog with a DDoS attack ! Wait a bit !

    1. shaking in my boots here
      Oh, and by the way, don’t tell your friends that I’m heavily shorting the S&P 500. Just like all my evil hedge fund friends. We’d be really afraid if WSB started piling into SPX and drove that up. It would totally ruin me financially! ๐Ÿ˜‰

  18. Hi Ern, thank you for your thoughts, this is awesome article as usual. Sorry for off-topic but I am just curious… how long does it take you to write such an article like this one? I am also fin blogger and it usually takes me 8+ hours to write 1500 words well researched artlice so I am curious if it is just me or other bloggers have it the same.

  19. I don’t agree with your argument that the WSB crowd made insiders rich despite their incompetence. Insiders who are made temporarily rich can’t even sell unless they are inside their trading window. Can you imagine being an insider watching this unfold? Do you quit your job just so you can sell?

    1. You will likely be right, because the collapse was too fast most of the insiders to cash in – remember I wrote this on Jan 30! ๐Ÿ™‚
      I cross my fingers and hope that past ineffective management will not walk away with millions or even billions.

  20. What I struggle to understand is the depository requirement aspect. I think Robinhood would have been totally justified in liquidating any client positions purchased on margin; after doing so, all of the positions they were brokering would have been fully capitalized and hence they should not have had any issue meeting clearinghouse depository requirements (right? If not, why not?).

    The exception, of course, are uncovered shorts or short calls. Those positions have unlimited potential downside and hence there’s no finite amount of margin one can post/demand to completely eliminate a negative-equity scenario. It seems more likely to me that Robinhood inherited short exposure from deadbeat clients who were actually *short* GME and couldn’t meet margin requirements, forcing Robinhood to cover those positions itself. This supports an “evil conspiracy” explanation in a sense but has nothing to do with Citadel or outside interference.

    I’m not super-familiar with the internal nuts-and-bolts of the interactions between the clearinghouses but I bring this up because so far the extremely “hand-wavy” explanations (including yours; no disrespect intended) of depository requirements just don’t add up. They’re completely nebulous/vague and don’t answer the obvious question: if Robinhood liquidated all client positions purchased on margin, how is it possible that they would not have been able to meet depository requirements? And if this is not possible, why were people prevented from buying with fully-capitalized accounts rather than just margin accounts being liquidated? This seems an obvious solution since my understanding is that Robinhood clears its own trades and hence could have simply “moved” shares from a margin account to a fully-capitalized account as long as the transaction was done at a price consistent with current exchange trading.

    All this aside, I find it curious that anyone would establish a completely uncovered short position (and even more curious that a third party would be willing to broker such a position!). If I was a brokerage I would require short positions/calls to be hedged with (further) OTM long calls so that I could at least put a number on the maximum possible loss associated with a position. I might not necessarily require the client to post 100% of that capped loss value but it would sure help me in determining the worst-case scenario from an actuarial / risk management standpoint.

    1. Don’t quote me on this, as I’m not an expert in the back-office financial dealings. But here is an attempt at an explanation. There are two completely separate margin issues.

      1: Robinhood (RH) clients have to have enough assets in their account for margin transactions. If they fall below a certain level, RH has not just the right but the obligation to liquidate positions to bring the account above minimum margin again.

      2: RH does not have to post margin at the clearinghouse for the EXISTING positions of RH clients. The margin posted at the clearinghouse is purely for transactions not for holdings. Apparently, the clearinghouse would not accept buy orders from RH unless they post more margin. It might have been possible for RH to post that money but prohibitively expensive to come up with that kinda cash within a day. But they raised a big amount eventually (>$3b) and things are a go again.

      The whole margin issue was a PR disaster for RH. When Vlad was asked whether RH has a liquidity problem, the correct answer would have been “hell yeah, we have a liquidity problem” but that’s not the kind of statement you can make as a CEO in the financial sector. You have to beat around the bush and that looks almost as bad.

      Hope this helps! ๐Ÿ™‚

      1. Thanks, but how could they possibly have depository requirements that exceed the transacted value? What I’m getting at is that any new transactions could not have increased the depository burden on RH more than the value of the transactions (right?), and for fully capitalized accounts RH certainly (by definition!) has access to the capital associated with those transactions. So how is that consistent with RH’s claims that they didn’t have enough capital to broker the transactions?

        I work in nerd-finance far removed from this stuff, so I’m open to being corrected/educated if I misunderstand.

        1. Again: these are two completely separate margin issues. RH must post their own margin for access to the clearinghouse. They cannot use costumer funds for this, that would be illegal.

          This is my own, fellow-nerd-finance (haha, love that expression) explanation. ๐Ÿ™‚

          1. Got it. So what you’re saying is that the issue wasn’t the actual settlement funds but rather whatever funds the depository corporation required from RH to secure/insure the already-placed, but as-yet-unsettled trades? That actually makes some sense. Thanks.

            Now, what I’m left wondering if the following. If RH ran out of internal capital to secure unsettled trades during the settlement period (basically it sounds like they would have needed to “float” billions of dollars at least for a few days until the trades settled), wouldn’t they have had the option of liquidating shares purchased on margin by other clients so that fully capitalized clients could purchase said shares, with no net impact on their depository requirements? And if that’s so, and since RH runs its own clearinghouse, couldn’t they have done these transactions completely internally, essentially just “relocating” shares from one account to another as long as the sale/purchase price were consistent with the order book for that security at that time?

            Assuming they had the foregoing course of action available to them, it seems reasonable to ask why they did not do this (assuming, again, that they didn’t), as it would be more equitable (in my opinion, anyway) to liquidate positions purchased on margin in order to allow fully-capitalized clients to trade (I’ve never traded on margin personally but I would assume that part of the agreement with the margin lender is that your position can be liquidated at any time). The obvious answer is that it was not in their interest financially because of course RH collects interest on those margin loans.

            Pardon my nitpicking, it’s just that the finance journalists (and journalists in general) I’ve seen interviewing the impressively-reptilian Vlad Tenev don’t seem to have any sense of what specific questions to ask him (let alone any knowledge of what would constitute reasonable answers).

            1. RH indeed no longer uses APEX. But there’s the hierarchy above APEX (the clearinghouse of clearinghouse) where all trades are settled. By just cutting out the middleman APEX, RH still faced the margin requirements at that location.
              RH might have theoretically cleared trades between RH buyers and RH sellers, ideally even the forced selling due to margin constraints. But how do you identify in the order book of the exchange whether the counterparty is a RH seller or someone else. Itโ€™s impossible. Hence, RH had to shut down GME buying.
              And again: I feel uncomfortable defending RH. Never used them, never liked them, Vlad is a buffoon in my eyes, so if anyone has suggestions how RH could have done this better, please direct your suggestions to RH/Vlad! ๐Ÿ™‚

              1. I’m not sure if this would be prohibited from a regulatory standpoint, but in principle I don’t think there’s any reason that such an order would need to be routed through the exchange at all. My understanding is that, like other brokerages, RH has a fiduciary responsibility to its clients and hence has to ensure “best execution.” But I don’t see why that necessarily means placing an order through the exchange if there’s an internal client who wants (or needs, in the case of margin accounts that are to be liquidated) to take the opposite side of the trade. If a fully-capitalized client places a market buy order for GME (limit orders would make this more complicated so we’ll conveniently ignore that case), they are willing to cross the bid/ask spread, and hence if RH were to internally move those shares from the margin account to the fully capitalized account with a transaction price matching the L1 ask price in the order book at the time the order was placed, then they’d be fulfilling their fiduciary obligations to the clients without having to go outside their internal clearinghouse and hence would not need to post any margin to secure any unsettled trades (because there wouldn’t be one, at least outside of their own infrastructure). Again, in principle, I don’t see what would stop this from happening since the exchange is really just there to provide pre-trade transparency but I’m fairly certain folks can do whatever OTC deals they want as long as both parties agree to the terms.

                As for Vlad, I agree completely, although I’d probably be lying if I said I wouldn’t give up a bit of my moral high ground for his billions (or just a singular “billion” — okay, fine, I’ll settle for $10M). I think his claim that RH “democratizes finance” is complete garbage and implies the very sort of “David and Goliath” falsehood on which they now find themselves on the disfavored end (poetic justice?). We live in a world where anyone can open up a free brokerage account and leverage their own capital to tap into the productivity of the global workforce from a computer or cell phone and pay essentially nothing (expense ratio on VOO is what, 0.04 or something?). His idea of “democratizing finance” is that every financially illiterate moron can now lever up into equity options without any understanding of basic finance/economics, let alone PDEs and boundary conditions and so forth. I am a proponent of personal responsibility so giving people access to the tools that will sow their own demise doesn’t really bother me, but claiming that you’re doing so to better the human condition while making billions personally is a huge load of crap.

                1. You make a great point: cross trades within the brokerage would be beneficial for the clients. But there are a few obstacles:
                  1: with continuous trading, what are the odds that the offsetting internal ask is also the best execution price for the bid? You’d still have to reference the prevailing prices at all exchanges to determine if the internal orders are the best execution price. And route to the exchange if it’s not.
                  2: with non-continuous trading like M1 where you have only 1 (apparently now 2) trading window(s) and all trades are just pushed as market orders. They could and should definitely cross the offsetting trades internally. But they’d still have to use the prices from the exchange to determine the “fair” price.
                  3: I doubt that M1 does the internal crossing because they don’t necessarily view you as a client. The hedge funds paying for the order flow are their clients. The brokerage customers and their order flow are the product. So M1 indeed has an incentive to route everything to the exchanges because they make money off the order flow. Internal crossing would reduce their own profit.

                2. [I apologize in advance for the long comment below!]

                  I believe multilateral netting occurs anyway (such that every clearinghouse clears as many trades internally as possible in order to minimize the amount of cross-clearinghouse traffic); I think this addresses (2) and (3). In all cases they would definitely have to use the exchange quoted prices for all transactions to meet their fiduciary obligations.

                  As for (1), yes, if they were essentially running an internal “RH exchange” or “RH darkpool” they would have to do this***, but what I’m suggesting is a very limited set of actions that would be taken only when they are running up against depository requirements at the higher-echelon clearing entity (DTC or whoever? Not sure). In a scenario in which a cash account places a market buy order and RH has determined that they can’t meet depository requirements for additional unsettled positions, they could “move” the shares from a margin account(s) to the cash account and mark the transaction price at the current exchange L1 ask price. There would be no issue of timing because RH itself would simply take these actions as those market buy orders came in; hence there wouldn’t be a need for the timelines of two independent trading entities to line up because the second entity, RH itself, is essentially selling passively on behalf of the margin client.

                  I don’t think multilateral netting solves the above issue entirely for the following reason. Imagine a scenario where RH decides it cannot meet depository requirements for additional unsettled positions of stock XYZ which is trading at a bid of $1000 and an ask of $1001 with an L1 size of ~1E4 on both sides and the minimum tick size is $1.00. They have a client with a cash account who places a market buy order for 100 shares of XYZ and they have another client that has 100 shares purchased on margin, so they decide to liquidate the margin account’s 100 shares to allow the cash account to purchase them. The only way to have any hope of these trades matching up with the exact same share price for the entire order would be to first place a limit sell order for the 100 margin shares with a price of $1001 and then immediately place the market buy order. The problem of course is that the matching algorithm probably prioritizes order arrival time right after price so it’s almost guaranteed that the market buy order will be matched to another participant (since there was already visible L1 ask at $1001, their just-placed limit order will have the lowest priority of all the folks in line at the L1 ask). Now, if that limit sell order later executes (i.e. does not have to be withdrawn and re-sent with a different price), then due to multilateral netting RH will be off the hook because at the end of the trading session those two trades (or an equivalent pair of trades) will be netted out and they will not have any unsettled trades with respect to any outside entities/clearinhouses (I think!).

                  BUT, if the exchange price moves through the limit sell price level before the sell order executes and they aren’t able to execute at the exact same price as the market buy order through the rest of the trading day, those trades can’t be netted and they’ll have to post margin for the unsettled buy order. So there would be real value associated with routing these trades internally and never touching the exchange because it allows the clearing broker to prioritize its own participants.

                  Also it could get a lot more squirrelly than that because of course a market order could potentially wind up eating through multiple levels of the order book and hence consist of two (or more, at least in principle) “lots” of shares with different execution prices / cost bases.

                  ***I think they actually do this anyway; in practice isn’t this how “payment for order flow” is conducted with the HFT firms quoting the bid and ask prices/sizes and thus serving as the liquidity providers / market makers?

                3. Wow, thanks for the explanation. I never dived this deep into the plumbing of trading. But it sounds like RH would have had a tough time doing the internal netting correctly and in a way consistent with its fiduciary duty.
                  Another issue was probably that a lot of buy orders came in, while the forced liquidation due to margin calls would have been too small to satisfy the demand.

                4. In my previous comment I said,

                  “The only way to have any hope of these trades matching up with the exact same share price for the entire order would be to first place a limit sell order for the 100 margin shares with a price of $1001 and then immediately place the market buy order. ”

                  But I guess they could also place the limit order and then count trade ticks until all the higher-priority limit sell orders at $1001 were filled and then place the market buy order as soon as their limit sell order was first in the chute. There are two issues with this:

                  1) It’s not clear that waiting to place a market buy order is acceptable from a regulatory standpoint since it does not guarantee “best execution.” But they could probably get around this by crediting the client with the cash difference between the actually executed price and the price they would have “likely achieved” by crossing the spread at the time when the order was placed, with the benefit being the guaranteed internal netting of trades. Not sure about this.

                  2) This kind of thing would be extremely latency sensitive/dependent. But I imagine RH has (or could develop) this capability since they’re routing through HFT firms anyway, who probably have the ability to place orders this delicately. Would probably require some very heavy duty C++/C/FPGA development though…and none of that is cheap.

                5. Yeah all very good points. And again, let’s all keep in mind that RH doesn’t view their brokerage clients as customers but as their product. RH will do what maximizes their revenue with their HFT clients. So, they would never implement this. ๐Ÿ™‚

          2. Let me clarify something about my suggestion that RH could have liquidated shares purchased on margin in order to lessen their depository requirements. I understand (or assume?) that settled trades do not put any kind of depository burden on the brokerage, so liquidating settled positions would not reduce a burden imposed by new unsettled trades. But since they run their own clearinghouse they could simply liquidate positions purchased on margin by other clients as new orders (from fully capitalized accounts) came in and fill these orders without going outside their own clearing infrastructure (i.e., moving the shares from one account to another). Now if they actually liquidated all of those margin accounts (I think some people reported their shares of GME having been sold by RH and I’m assuming these folks were trading on margin) then they would have had to restrict trading, but it’s not clear that they did — and financially, they have an incentive to keep those margin positions because they collect interest on the margin loans.

  21. As someone observing quietly on the sidelines, this thing was quite entertaining. I believe it was blown out of proportion by media because well, it makes for a great news story. If anything, again, it reinforces to me the importance of maintaining a low cost of living, and diversified investments into *boring* old ETF and LICs. Slow and steady wins the race – I am not gambling my early retirement on some YOLO stock or Doge coin

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