By Roy Zimmerhansl, practice lead at Pierpoint Financial Consulting

This is the second of a three-part blog post covering the GameStop story.

Different kinds of short sellers

The events of the past couple of months have publicised the disagreements between different classes of short sellers. Most short selling activity and volume support technical trading and market-making activity – it is this aspect of short selling regulators the world over recognise as adding liquidity and narrower spreads to markets. These generate higher volumes of trading on both the long and short side, keep indices in line with the underlying assets and keep markets trading through market makers.

The GameStop story started with short sellers who look at public companies on a valuation basis.

These are the investors that initially looked at GameStop, saw an outdated business model, declining revenues, mounting losses and a poor outlook and decided that the future stock price was likely to be lower. The debate even amongst hedge funds is that some funds – with people pointing at Melvin Capital – is that they took a huge bet that it didn't appropriately reflect the liquidity risk, and they have been proven right (at least so far). I'm not an investing professional, but over the many years I have been speaking with them and reading about them, it seems that it is as essential to know how you will be able to exit a position as it is on how you enter the position. There is no suggestion that there is any fraud or fakery on GameStop, so these positions had to be closed out at some point. Even without WallStreetBets (WSB), I wonder how such substantial positions would have been covered without a detrimental price impact (which, in the case of the short seller, would mean a price rise).

Finally, there are short sellers as investigators.

The extra scrutiny on short sellers in general has made it more difficult for those short sellers that work long, hard, and diligently to uncover the fakes and frauds. While the public and media are concentrating on greed, David vs Goliath, questions on how you can have more than 100% of the free float sold short (a topic for the future for me), etc., the sweeping anti-short selling lobby has made life more difficult and less profitable for those doing a genuine public service – with a clear profit motive. These are short sellers that have uncovered dozens of stocks over the years, exposing illegal and immoral activity that has not been discovered by long investors – active or passive, regulators, or auditors. Investigative journalists and short sellers seem to be the only dependable policemen/policewomen, investing huge time and effort and often informed by whistleblowers ignored by others. There is no question their work has been made more difficult by all of this. While the impact on lending supply has been negligible, it is early days yet, and a reduction in supply for a stock in future that is a fraud doesn’t serve any of us well.

Platforms and Clearing

The issue that concerned me the most throughout the frenzy was the decision by several platforms including Robinhood to limit client trading to only sell orders for up to thirteen meme stocks. This allowed investors to close positions but not open positions, even if the clients had sufficient funds. At first, I was aghast and added to the Twitter frenzy with my own comments and questions. When it emerged from Robinhood CEO Vlad Tenev that the arrangement to cease taking buy orders from customers, it both started to make sense as well as providing a warning sign.

Why did it start to make sense? Tenev advised that NSCC (the central counterparty subsidiary of DTCC) made a collateral call on Robinhood of $3 billion at 3 am. According to Tenev, that was an order of magnitude greater than had previously been their experience, with a Guardian article I read producing a figure of $124 million for Robinhood from NSCC just a few days earlier. For those not familiar with central counterparties, they are responsible for guaranteeing transactions to buyers and sellers of given products, in this case US equities. Another way of looking at this issue is if one of the CCP members defaults, the CCP is responsible for meeting the purchases and sales made by the defaulting entity and its clients. CCPs mitigate the risk by taking collateral from their members. The collateral amount is dependent on several factors beyond the simple buying/selling activity. The CCP also looks at the security-by-security activity and the proportion of the overall activity of each member. Why the security-level analysis? Robinhood and GameStop provide a perfect scenario so let’s have a look. 

1. Volatility rise. According to John Marshall, head of derivatives research for Goldman Sachs Research: “Over the past year, the equity market has been unusually volatile”.   As you can see from the VIX Index chart below, the 2021 volatility peak occurred on 27 January (the VIX measures expected stock market volatility). So, the CCP will have increased its collateral requirements generally as if any of their members had defaulted default, it is likely that prices would have been quite different than they were at the previous day’s close of business. I have seen information that said the total collateral that DTCC’s collateral requirements for all its broker clients were $33.5 billion on Thursday 28 Jan, up from $26 billion the day before.
2. Rise of Online Platforms. Again, according to Goldman’s Marshall: “For the largest online brokers, the number of daily trades has tripled since 2019” so many of the most recent platforms the volumes they are seeing are at record levels, possibly well beyond their operational capacity and/or expectations. I saw some speculation that Robinhood’s client base might be as high as 20 million, but even at the 13 million figure that Tenev used in his written testimony to Congress, it is still huge. Consider that Robinhood achieved that figure in 6 years and compare that to TD Ameritrade building a client base of 11 million (starting in 1975) and E-Trade (5.2 million customers at the time of Morgan Stanley acquisition announcement in Feb 2020). Unlike the larger broker-dealers and banks, these monoline retail platform apps don’t have the size, capacity, capital, broad range of businesses and historical experience of market ebbs and flow dealing with and absorbing spikes. If volumes have indeed tripled, customers should be asking if the newer platforms kept up with their ability to deal with all of the implications of dramatically rising business – like posting more collateral to CCPs. Tenev mentions that there was an element of discretion in the NSCC collateral call. Could part of that requirement include extra collateral due to concerns over the capacity of some of the online platforms (including Robinhood) to meet their obligations, given the frenzied trading throughout January? We may never know.
3. Concentration of activity. Imagine if there was a single stock that had an inordinately large amount of trading volumes in a particularly volatile stock. Then imagine that a CCP member defaults, and the CCP has to cover the member’s activity in this volatile stock.The potential for a significant price move in this stock is higher than the rest of the market (volatility includes price moves up or down - a divergence from the base price). Accordingly, you would expect the CCP to take extra collateral from the firms most active in the most volatile stocks.  Most stocks tend to have a relative balance of buy and sell orders, with the skew on any given stock determining whether the price is generally rising or falling. However, market squeezes, as with GameStop are overwhelmingly oriented towards buying. Thus, the CCP needs to take even more collateral from members with predominantly rising stocks because if that member defaults, the CCP may have to put up the cash to the sellers on behalf of the defaulting entity.

In summary, the NSCC’s collateral call was dramatically larger, because of a combination of the following factors:

• More overall market volatility.
• Discretionary factors were possibly disadvantaging newer retail platforms disproportionately.
• Concentration of activity in meme stocks that were rising in volatile markets, particularly GameStop.

The decision by various brokers to stop purchases changed the member default risk dynamic for NSCC, and for this reason, on the face of it, I can understand it, even if I think that it must have been incredibly frustrating for customers. Again, Carson Block of Muddy Waters said in one interview that they also were blocked from buying. By definition, that must have been for long investments as all customers could buy to close positions (as this reduced the risk at the individual customer level).

Also, it is important to note that CCPs seldom (if ever) release detailed information on the full collateral calculations that they make.

Now, Tenev also said that the original collateral call was renegotiated down from $3 billion to $1.4 billion. I'm not sure how, but I assume that the only negotiable aspect was the discretionary factor. To me, this collateral reduction is one key area that needs further investigation and discussion. 

• How and under what terms did NSCC decide that Robinhood risk had more than halved over the course of hours when the market was closed?
• Who made the decision to stop customer buying?
• What can the platforms do to ensure they have the ability to deal with collateral spikes, and should platforms be limited in size without having in place regulator approved plans for dealing with such spikes?

The immediate issue that I am hearing more about now are failures to deliver. If that is the case and shares aren’t mobilised, this will eventually lead to buy-ins, driving higher prices.