Behind the Curtains of Wall Street Bets

Justin Najmy – One of the many positive outcomes of the digital age has been the increased accessibility for people to invest in capital markets. Given free trading applications like Robinhood, the friction for people to purchase and sell shares has not only lessened, but also the friction for the ability of these same people to make sophisticated bets, such as options and futures trading, has lessened. This enabled WallStreetBets (“WSB”), a group of individuals that congregate on Reddit to discuss stock picks and momentum trades, to play with the legacy financial giants. WSB’s strategy was simple, force a short squeeze on the stocks that legacy hedge funds and financial management companies were heavily shorting. Accordingly, a perfect storm for a hyperbolic price increase was created.

One part of the dynamic was that market makers—the middlemen between buyers and sellers—are forced to hedge certain risks and outcomes. Meaning, if traders are buying call options, which is a leveraged bet that the stock will go up in the future, then the market maker must buy that stock to negate any potential profit for the call option traders. This sequence will continue to playout if price of the shares continues to go up, which can start to create scarcity in these shares. And because call options were the preferred exposure for WSB followers, and because of the enormous size of WSB, this trend became magnified and thus catapulted the price of stocks like GameStop (“GME”).

The other part of the dynamic which exacerbated the price increase of these WSB stocks was that in an era of historical low interest rates and the ability for exchanges to rehypothecate shares, billion-dollar hedge funds and financial management companies were utilizing large amounts of cheap leverage to short more shares of these companies than there were outstanding. Moreover, at one point, hedge funds and financial management companies were shorting 136% of the GME shares outstanding. And in order to close out of a short position, one must eventually buy the shares of the stock being shorted. So, technically, there were not enough shares to buy in order to close out the entire position, therefore creating immense demand. And not only were WSB purchasing large swaths of GME shares, but WSB were also not selling the shares, thus denying the ability for these hedge funds and financial management companies to close out their position. Consequently, in attempt to buy shares to close out their positions and mitigate losses, the price of these stocks experienced massive gap ups as the financial management companies were in a bidding war against WSB hoping they would budge.

For a moment, WSB almost caused an investment management firm—Melvin Capital—to become insolvent, however, Citadel, a multinational hedge fund, provided Melvin Capital a lifeline of money to help stave off Melvin Capital’s almost epic collapse. In addition, free trading applications like Robinhood suspended users from buying WSB stocks on January 28, consequently helping short sellers like Melvin Capital by causing a collapse in price of WSB stocks and allowing the chance for Melvin Capital to rearrange its exposure. Because Citadel is one of Robinhood’s biggest customers, individuals have speculated that Robinhood’s trading halt of WSB stocks was because Citadel, having provided money to Melvin Capital, would have been negatively impacted as the price appreciation of the WSB stocks continued to cause the demise of the already crushed short sellers like Melvin Capital.

Preventing users from purchasing WSB stocks on trading apps like Robinhood, and thus leading to the inevitable price collapse of those stocks, prompted stark criticism from outspoken individuals like Dave Portnoy, Chamath Palihapitiya, and Mark Cuban. These popular figures labeled Robinhood’s actions as “unfair.” Nonetheless, as unfair as it may seem, such halts are allowed per SEC rules. In January, the SEC announced that broker-dealers like Robinhood “may determine not to accept orders where a transaction presents certain associated compliance or legal risks.” Further, the SEC announced that trading platforms can limit trading via Limit Up-Limit Down rules promulgated by the Financial Industry Regulatory Authority (FINRA) which are “designed to prevent trades in these stocks from occurring outside a specified price band.”

Consequently, on February 18, Robinhood Co-Founder and Co-CEO, Vladimir Tenev, testified to the House Committee of Financial Services that Robinhood halted trading because it did not have enough collateral, per an SEC rule, for all the trades on stocks like GME by its users.  Robinhood’s collateral positions grew immensely from $700 million to $3.7 billion during the GME craze, leaving a sudden need for $3 billion dollars of collateral deposited with the clearinghouse—a body that ensures buyers and sellers receive their equities and cash, respectively—to cover the value of the sudden rise in the stock. Therefore, even though accessibility to capital markets through apps like Robinhood incrementally leveled out the playing field between institutional and retail investors, rules still exist that give institutional incumbents advantages over retail players like WSB.

A cryptocurrency frenzy has coincided with the WSB frenzy, thus the halting of trading on applications like Robinhood has presented a perfect opportunity for the vociferous leaders in the crypto space to advocate for decentralized exchanges, a drum that crypto leaders have been beating for years now. Centralized exchanges like Robinhood using their own servers to manage trades, coupled with users accepting the terms and conditions when signing up, has allowed free trading applications like Robinhood to halt trading for certain stocks if it is pressured to do so. In lieu of centralized servers, decentralized exchanges would allow the trades to run on multiple servers and computers. By combining atomic swaps and smart contracts, trustless trades between different parties becomes possible. Accordingly, a decentralized exchange mitigates the risk of downtime and the halting of trades like what occurred with WSB and Robinhood. However, uncertainty and regulatory risk still remains as legislators are starting to look into the space.

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