Issue 98

GameStop and the battle of David vs Goliath

Delivered on 01 February 2021 by Justin Pyvis. About a 7 min read.

By now everyone should be familiar with the GameStop saga but if you're not, below is a recap. Feel free to skim down to the "The Outlook" if you're already up to speed.

The Recap

On Reddit - a social news aggregation and discussion website - there exists a 'subreddit' called wallstreetbets, which is essentially an echo chamber for retail investors looking to pile into relatively cheap, high risk stocks with the aim of turning a quick, large profit. It's basically the internet's home of pump and dumps where the more people they can convince to buy a stock, the higher the price goes, and the more money (some) people stand to make.

The users in wallstreetbets tend to be young, favouring the smartphone trading app Robinhood as it's easy to set up and is commission-free. The subreddit's mascot is a child wearing a suit and users regularly boast about being retarded or autistic... you get the idea.

/r/wallstreetbets logo

About a week ago users on wallstreetbets decided to take aim at GameStop, a floundering company (think the Blockbuster of video games) that, it turned out, had been heavily shorted by some very large and well connected hedge funds. One of those funds was Melvin Capital, which lost billions of dollars in days as the GameStop share price surged ('squeezing' their shorts). That led to the firm needing a multi-billion dollar bailout from its owners, Point72 and Citadel, allowing Melvin to reportedly close out its short positions at a huge loss.

But that didn't stop the members of wallstreetbets. They doubled down, buying not just GameStop but also other companies that had been heavily shorted such as AMC Theatres, Blockbuster and more recently silver, effectively squeezing any remaining shorts and wiping out at least $23.6 billion from various hedge funds in the process. Global markets lost a lot of value on Thursday, some of which may have been due to hedge funds - worried about wallstreetbets targeting their trades - closing out long positions to cover their shorts.

It's essentially a modern day David and Goliath story, with thousands of David's taking on some of the biggest Goliath's on Wall Street. What's not to like?

GameStop's volume has risen enormously
Source: WSJ

But as one might expect, those Goliath's are well connected. As mentioned earlier, a company called Citadel is a part owner of Melvin Capital, the hedge fund that levered heavily into GameStock short positions.

Citadel is also one of the biggest sources of revenue for the Robinhood app, which charges large investment firms such as Citadel - 'market makers' - fees to access real-time information about the stocks its users are buying and selling.

So it should come as no surprise that with billions being wiped out every day, the pressure to do something mounted. Sure enough, Robinhood soon restricted buying shares in GameStop and a few other companies that had also been pumped by wallstreetbets.

You heard that correctly: selling on Robinhood was still allowed, people just couldn't buy. It was a move that temporarily thwarted wallstreetbets, with only the big boys able to trade freely given they don't rely on middlemen brokerage apps like Robinhood to make their trades. Robinhood, if you didn't gather from its name, was an app supposedly designed to take from the rich and give to the poor, or "let the people trade".

Robinhood "let the people trade"

Robinhood is now subject to at least one class-action lawsuit accusing it of market manipulation, along with calls from politicians to investigate the company. In what is a rare sight these days in Washington, there was even bipartisan support!

Bipartisan support!

However, there was also a financial reason for Robinhood restricting buying other than its cosy relationship with Citadel. Robinhood, as mentioned earlier, charges zero commission on retail trades. But according to Webull CEO Anthony Denier, when you make a trade, brokerage firms:

...have to fund that trade with the clearing central house called DTC for two whole days. And because of the volatility of stocks, DTC has made the cost of the collateral of the two-day holding period extremely expensive.

And we just can't afford-- well, we're not a clearing firm, but our clearing firm simply cannot afford the cost to settle those trades. We cannot use customer funds to front that cost due to regulation. So the brokerages or the clearing firms have to go into their own pockets to do it. And they simply can't afford the cost of that trade clearance. That is the reason why these stocks are coming off. It has nothing to do with the decision or some sort of closed room cigar-- smoke-filled cigar room of Wall Street firms getting together to the dismay of the retail trader. This has to do with settlement mechanics of the market.

I'm not sure why clearing firms have to hold collateral for two entire days. It sounds like a throwback from the old days where everything was done with paper and funds took days to clear. Outdated regulation perhaps? Whatever the reason, the requirement exists and the GameStop trade was getting very costly for Robinhood, which had to raise $1 billion due to all of the capital it had tied up at clearing houses.

But back to the story.

At the time of writing, wallstreetbets is still holding strong. GameStop shares closed at $325 on Friday, close to the all-time high of $347.5. But at the end of the day this is a plain old pump and dump, requiring a continual stream of 'greater fools' to keep the price elevated - GameStop is a firm teetering on the edge of bankruptcy - and the share price will, eventually, come back down to earth.

The Outlook

As with any negative-sum game, there will be winners and there will be losers. I have no problem with wallstreetbets users engaging in this kind of activity. If you're a 20 year old with idle hands (e.g. furloughed due to COVID-19 restrictions) and plenty of cash in the bank thanks to multiple rounds of government handouts, but nothing to spend it on - millennials look for experiences over possessions, remember - why wouldn't you have a punt on GameStop, especially if you could take a hedge fund down a peg or two in the process? It sure beats the casino!

I also have no problem with hedge funds shorting stocks in companies such as GameStop. It's an effective way to express a negative opinion about a company and helps the market price discovery process. However, shorts can be squeezed and that's perfectly fine.

The worst case scenario from here - and probably the most likely (that's the cynic in me) - would be if regulators eventually decide to further restrict short selling and put limits on retail traders' ability to buy, all in the name of 'protecting' people from themselves.

Apparently the the Treasury Department is monitoring the situation. Now on what side of this might Treasury fall, you ask? Just follow the money. Treasury is now headed by none other than former Federal Reserve Chairperson Janet Yellen, herself the recipient of... wait for it... $337,500 in October 2020, $292,500 in October 2019, and $180,000 in December 2019 from, you guessed it: Citadel!

Why did Citadel pay Yellen close to a million dollars over the course of a year? For three speeches, where she offered them "her perspective and advice".


Maybe Yellen will prove me wrong. I just can't get past the fact that a million dollars in a single year for very little work buys a lot of influence, so my default position is that Treasury will end up supporting some kind of regulation that helps companies such as Citadel, or at least does them no harm. Sorry, wallstreetbets.

But crony capitalist revolving-door moral hazard issues aside, what this whole saga really highlights is how incredibly frothy markets are at the moment (see Issue 96). Everyone from 'recent law school students' to 'Atlanta residents' have seemingly become day traders, and the prevailing wisdom among that group is that "fundamentals do not apply to retail traders. It’s all about sentiment. The only reason why Tesla is worth what it is is because people believe in that company".

The pandemic lit the financial fire, with governments and central banks turning it into a roaring inferno by mistakenly stimulating demand during what has been mostly a supply side shock. This will end badly for many.

In other news, Google doesn't make money from... news

I've been writing for a while about the Australian government's foolish attempt to subsidise legacy media companies by stealth taxing Big Tech (see Issue 97). It turns out Google doesn’t even make money from news media:

It's also important for me to point out that news-seeking queries do not generate revenue for Google. It's very unlikely that an advertiser would like to appear next to news content on search, as opposed to a query with high commercial intent. News queries are about 1.25 per cent of the queries that we see on our search engine. So to the extent that this code is requiring us to pay for links and snippets in search to a small group of people who participate in our search results, where it's always been the publisher's choice to appear in those results and they are the beneficiaries of valuable traffic, that is the model of search. The advertising business is very targeted.

Richard Holden, Professor of economics at UNSW, had a good article on the subject in the AFR last week:

[Google leaving Australia] is neither an idle threat, nor an unreasonable one. The media bargaining code is hopelessly flawed. It misunderstands the cause of the decline in media revenues, seeks to extract money from unrelated activities of technology companies like Google and Facebook, has requirements that threaten the core business of those companies, and has a bargaining system that could most politely be described as "rigged". It is the public policy equivalent of Stalinist show trial.

I no longer expect the media code to get through Parliament. It's just too contrived and gets the facts completely backward. Even politicians - or at the very least their advisors - should eventually realise that this legislation is rotten to the core.

Issue 98: GameStop and the battle of David vs Goliath was compiled by Justin Pyvis and delivered on 01 February 2021.