February 4, 2021 | by izzat ismail
February 4, 2021 | BY Kaia Parv
The story captivating everyone last week was around Wallstreetbets (or WSB), a subgroup of Reddit social network, taking on large institutional traders. A tale of retail investors deciding to go against behemoths, and seemingly succeeding. Only until the brokers, such as Robinhood, stopped taking their orders, at the back of various speculations. While the rumors are alluring, the reality is much duller
WSB, a Reddit group, first came into spotlight in early 2020 when COVID-19 related global lockdowns were imposed. Hordes of retail investors, suddenly house-bound and receiving support from government in some countries, discovered financial markets. Using apps such as Robinhood, which effectively had gamified trading experience with zero fees imposed, they started trading. Robinhood offers a plethora of instruments, among them equities and options. Options are derivatives which allow to lever the position. Options offer unlimited upside, or downside, depending on the type of option and the strategy implemented. Options are also extremely sensitive to volatility with volatility being one of the inputs in the pricing model. One might ask – how does Robinhood and other zero fee brokers earn their revenue if there are zero fees imposed on clients? There are a few sources – firstly, they would earn on bid / ask spread. Also, they get paid by market marking giants who process their flows, a process called Payment for Order Flow. Lastly, Robinhood could engage in stock lending for the long positions they hold on the behalf of their clients.
Early in 2020, the WSB crowd seemed to implement erratic strategies which made no sense. Such as buying options on bankrupt names like Hertz. Or going long names in distressed sectors, such as Boeing, during times when these sectors were severely damaged by lockdowns. General public shrugged off the noise and deemed WSB crowd as ‘dumb money’. The term is contrasting ‘smart money’ used when referencing institutional investors, in particular large hedge funds.
Fast forward to January 2021, when investors were captivated by a sudden uptick in names that had seemingly weak fundamentals. Some due to lockdowns but some due to secular trends in place way before COVID-19 started spreading. Names such as Blackberry and Gamestop, but also AMC Entertainment.
Upon closer examination, it was revealed that the buying spree had been an organized effort by members of WSB. The analysis done around those securities was not based on fundamentals, although there were members who had modelled the potential future earnings, but rather based on market structure. Namely, the short interest (percentage of shares sold short of total shares) was often very high, to levels that did not make sense. Gamestop short interest was 140% for instance.
Also, the shorts were held by large hedge funds who are known for the predatory strategies. So, WSB traders did a counter move, targeting institutional investors in their own game and calling it a revolution. And they excelled – share price of Gamestop was up 400% last week, posting intraday moves from U$110 to U$483 on the 28th of January.
Hedge funds, such as Melvin Capital, that held short positions, were in trouble. Firstly, the cost of shorting to levels seen with Gamestop is extremely expensive. The margin requirement was around 200% for Gamestop, according to market participants. Secondly, once the price started to rise, it was nearly impossible to cover the shorts as the free float was so low. So, the smart money players started bleeding cash, reaching a point that required an intervention. The help came from connected hedge funds, such as Citadel and Point72, giants in the institutional space with AUM of U$ 35 billion and U$ 17 billion respectively. The bailout to Melvin Capital was U$2.8 billion. It was reported that Melvin Capital return was down 53% in January, at the back of covering Gamestop shorts.
During the rollercoaster of constant media updates, the White House shared comments last week that Janet Yellen and her team were monitoring the situation. Also, the CEO of Nasdaq told the investors that the exchange may put brakes to activity, on the premise that social media chatter may be considered manipulation and distorting prices. Once a number of brokers, including Robinhood, announced they were halting trading with certain names, all sorts of speculations started spreading.
One of the main rumors was that Citadel (Yes, the same corporation that bailed out Robinhood, albeit a different line of business) had told retail brokers to stop taking orders. Citadel, being a major market maker, pays Robinhood and other retail brokers for their order flow (Retail brokers, such as Robinhood -> Citadel -> Exchange) This means they settle the retail trades either via crossing internally, or on the exchange. Citadel commands 27% of US equity volume, and 43% of retail order flow, making them one of the largest players in that space. The controversy around Payment for Order Flow has gotten attention a number of times but no regulatory action has been taken so far. Also, Citadel has been fined for not offering the best execution for underlying clients. The amounts have been insignificant, given the amount of volume Citadel commands.
It was also speculated that perhaps Ken Griffin, the CEO of Citadel, called Janet Yellen, the newly appointed Secretary of Treasury, to get her to put brakes at the clearinghouses, such as DTCC. Namely, brokers, who had stopped taking retail orders for certain names, reported that the DTCC had increased the collateral requirement the brokers have to post, at the back of volatility spike. Last Friday market wide collateral requirement jumped from U$ 26 billion to U$ 33.5 billion. Brokers, who did not have enough liquidity to post the collateral had to stop taking orders, or face a regulatory fine. Collateral effectively protects clearinghouse from parties who are short and therefore may not be able to settle or cover, assuming trade goes against them.
Eventually it was established that it was indeed DTCC that had put the party to an end. Once retail brokers were re-capitalized (Robinhood raised U$3.4 billion of fresh capital in 4 days) the trading activity was allowed to continue to a certain extent. While this situation is still developing, it has been reported that short positions have been covered to about a half of what they were. Also, the share prices of those companies targeted have come down but not to 2020 levels.
What could be the potential outcome of this event? The important thing to note is that the event is still ongoing – short squeeze is still intact. Also, WSB members have started to target other companies and also silver derivatives were squeezed to a point when futures were up by 11% in a single day. Depending on how the situation develops, we may see further regulation of financial assets for retail investors. The main instruments retail had used to push the prices up were options. In essence, options are complex derivatives that may have unlimited upside or downside return. We could see a new regulation introduced that prohibits retail investors with little experience and knowledge transacting with options. We could-and should-see regulation around the leverage institutional investors use, given leverage is the key culprit Gamestop situation even took place. We could also see regulation around the use of social media for exchanging trading and investing ideas, albeit this would be extremely hard to monitor. What’s certain is that the sophistication and strategies of institutional and retail investors have changed. Previously, institutional players were benefitting from the market structure, access to information and execution. This dynamics has now changed – retail has access to the same tools and information, and they are not afraid to use it.
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