Seeker of Truth

I already covered GameStop in my previous entry, but I feel there is enough I did not cover last time that warrants revisiting the phenomenon and dedicating an entire post to it. Moreover, upon reflection, I may have been a little too accepting of the narrative put out by mainstream media.

In case you somehow missed this major piece of news, back in late January a brick and mortar video game retailer called GameStop was the center of what the media has portrayed as a David and Goliath-esque battle in which an online community of retail traders on social media platform Reddit (David) and Wall Street hedge funds including Melvin Capital (Goliath) came head-to-head with David ultimately prevailing in the end.

The sequence of events based on the prevailing mainstream media narrative goes like this:

Melvin Capital, Citron Research, and a few other Wall Street players took short positions (betting that the stock will decrease in price) on GameStop.

Millions of members of a community interest group on Reddit called wallstreetbets organized themselves to take the opposite side of the bet and go long (buy shares in) GameStop.

This online community bought tens of millions of GameStop shares, which caused the stock to increase in price. Melvin Capital and others who were short the stock had to cover theirs shorts by buying shares at much higher prices, which put even more upward pressure on the stock’s price.

Melvin Capital, which previously had $12 billion in assets under management, lost over 50% of its money in the trade, resulting in Citadel and Point72 stepping in with an infusion of cash to the tune of $2.75 billion (essentially bailing out Melvin Capital). It seems like David (the small retail investor) has triumphed over Goliath (Wall Street)!

Not so fast! The people with a vested interest in Melvin Capital coming out on top convinced the government to act in their favor, resulting in Robinhood temporarily disabling the ability to buy GameStop shares on Jan 28 (it was still possible to sell) – resulting in a 44% crash in the price and allowing the short sellers a respite to get out of the trade at a lower price.

Politicians on both sides of the aisle jumped in with talk of regulating Robinhood, hedge funds, and social media platforms such as Reddit.

There are some nuances that I may be missing, but that is the gist of the narrative put forward by mainstream media. The problem is that there are some fundamental flaws with it.

The “army of retail investors” on Reddit were most definitely not the main driving force behind the massive short squeeze. Matt Levine of Bloomberg put out a piece that shows that “a lot of the move in GameStop’s price was not caused by retail traders on Robinhood and Reddit, but by professionals, hedge fund and proprietary trading firms and professional day-trading shops.”

Over 50% of trades that are placed through Robinhood are routed through Citadel Securities (which is the market-making subsidiary of Citadel). While Citadel does not process all retail trades, it claims to be responsible for nearly 40% of all US-listed retail volume.

Moreover, many of the trades were for blocks of 5,000 and 10,000 shares. Which, at $500k to $3-4 million a pop, is very unlikely to be trades made by retail.

The more likely explanation is that hedge funds and high-frequency / algorithmic traders took notice of the unusual activity coming from retail traders and entered the fray because they saw an opportunity to make money.

In short, retail traders served as a catalyst but not the driving force for the massive run up in GameStop’s share price.

Unsurprisingly, Robinhood’s CEO Vlad Tenev was grilled in the court of public opinion by various figures in business and the media over the controversial decision to suspend buying of GameStop and other stocks that were the focus of attention by the wallstreetbets group. The public outcry ultimately led to a congressional hearing by the US House Financial Services Committee that was largely a waste of time as the witnesses (including Tenev), who were under oath, did not provide meaningful, direct answers to the over five hours of questions put forward by the committee, but at least we were able to determine that the reddit trader with the username “RoaringKitty” is “not a cat.” (You can’t make this stuff up…)

The question people want to know is did Ken Griffin call up Janet Yellen (who, it should be noted, received more than $800,000 in compensation from Citadel for speaking engagements…) and ask for a favor to have a few strings pulled behind the scenes to halt the buying on Robinhood?

To what degree is Robinhood “beholden to Citadel” as Elon Musk asked earlier this month over an online broadcast on the new social audio app Clubhouse?

It’s an enticing theory – one which I admit even I latched onto in my previous post – but there are entirely logical explanations to restrict trading.

When individuals or institutions trade stocks, the actual exchange of money for stock does not actually happen instantaneously. There is a lag of two days (known as “T + 2”) before trades are settled by an entity known as a clearing house.

Before the settlement happens, the broker is just sending records.

We can illustrate this with a simplified example:

Buyer A buys 10 shares of GME for $3000

Seller B sells 5 shares of GME for $1450

For the purposes of this simplified example, suppose this was the entirety of trading activity for that day.

The broker would need to provide $1550 to the clearing firm and receive 5 shares of GME.

This transaction poses a credit risk.

What if the broker did not have the money on settlement? The clearing firm would be on the hook which is precisely the reason why the DTCC requires that brokers put up deposits in cash upfront (essentially collateral)

On January 28 when Robinhood and other brokers disabled the ability to buy, the DTCC raise its capital requirements, and Robinhood could not legally submit trades on GME stock until they could cover the corresponding amounts through deposits.

There is understandably quite a bit of anger directed towards Robinhood. The fact is that investors who were using Robinhood to buy and sell stocks were unable to buy GME and other reddit stocks and had to watch in horror as the stock came crashing down, but you cannot really pin the blame on Robinhood. Robinhood was simply following the law and regulations that it was compelled to do so.

If people want to remain angry at Robinhood, they should be directing their anger not towards the decision to halt buying and instead towards Robinhood’s business model and the actual way they make money. I already touched upon this in my previous post, but Robinhood makes money by selling “order flow” to market makers such as Citadel in a process known as “Payment For Order Flow.” This is not unique to Robinhood – virtually all brokerage firms engage in this practice.

Trading stocks on Robinhood’s app is ostensibly “free,” but one should really view it as a tradeoff between getting the best price possible in a trade (no pun intended) and paying nothing in commissions. Retail investors who used Robinhood’s app to trade securities are not Robinhood’s actual customers. That title goes to the market-makers such as Citadel that pay Robinhood tidy sums of money in exchange for its order flow. Always remember that if a product or service is “free” to use, that means you are the product! (not the customer!)

After these stocks touted on reddit inevitably came crashing down, it was almost exclusively the retail investors who were left holding the bag.

So who are the winners in this whole saga?

We can certainly count Citadel and its market-making arm among the biggest winners. Citadel made an absolute killing with the frenzy of trading activity. As a market-maker, Citadel does not make directional bets on securities and does not care if a given stock moves up or down. Market makers generate revenue via the bid-ask spread and commissions.

Another big winner was the tech-focused private equity firm Silver Lake Partners, which owned convertible bonds in the near bankrupt movie theater chain AMC. Thanks to the short squeeze that caused AMC’s stock to pop tenfold, Silver Lake was able to convert its bonds into equity which translated into a nice $713 million pay day.

Other capital allocators such as the Ontario Teachers’ Pension Plan also made close to $500 million selling stock in a shopping mall owner Macerich (ticker: MAC) following a similar short squeeze.

The narrative being pushed forward in the media of “David” (the army of reddit traders) triumphing over “Goliath” (hedge funds such as Melvin Capital), while enticing, simply does not mesh with reality.