February 1, 2021
The last post (Roving Bands of Pretend Capitalists), took a somewhat curt look at a couple of the issues surround the GameStop short squeeze and highlighted a couple of errors in regulations.
The next step is to draw a picture of liquidity and what happens when it goes away . . . what happens when some thing is abundant or scarce. Of course there are probably a thousand academic papers on the topic, but in the real world we already have a basic understanding of how this works.
If there were a universe with the capacity to produce one thousand gallons of water every day, and one thousand people lived there, who all needed one gallon of water per day, that world would be quite upset if there were one thousand and ten people. In that world everyone would have to do with less or there would be negative consequences for some portion of the population until the supply and demand were brought back into balance. If there were a way to purchase water in that circumstance, those with more disposable income would likely raise the amount that they wanted to pay for water.
In the same universe, there could be a culling of water consumers, whereby there was now a surplus of water. In that case, if there were a way to purchase water, the cost may decline. (Another option here is storing water for the future, in effect, savings, but we will assume the water disappears daily if it isn’t used).
One thing that is consistent here is that there is absolutely NO WAY to create more water, just changes in supply and demand.
If there were a drastic shortage of water, then those with disposable income may be willing to pay a LOT more for the price of water to protect themselves. This rise in prices in our world could be called inflation. If water were a share certificate in a company, it would be called capital appreciation.
If that drastic shortage showed up, there is a high probability that the water users on this make believe planet would begin scrambling for water, perhaps earlier in the day, or perhaps ensure they have enough resources to pay the premium for the water when they needed it. They may also speculate that the price would change before the end of the day to make it more or less expensive. In any case, their behaviour would adapt to their need for water.
Now what happens if that were shares in a company stock called GameStop? First off, there are technically a limited number of shares of the company available as mentioned previously. For a variety of reasons, some of those shares are not available for sale, so the number is even more limited.
At this point, things get pretty technical. First of all, a short seller sells shares that they don’t own into the marketplace. These are not real shares, these are virtual shares and they cause excess liquidity of shares (this is another significant regulation mistake – See item 1 below).
- Company float – 100 shares (issued and outstanding)
- ‘Closely held’ – 20 shares (can’t be easily sold)
- Free Floating – 80 shares (smaller, unregulated holders hold these shares)
- Short sale shares – 1 (a share borrowed and sold with a promise to return it later)
- Free Floating effectively – 81 (float plus short sale share)
Now a large group of people could decide to short a lot of shares, thereby flooding the market with virtual shares. In the case of GameStop, here are the numbers from January 15th of this year.
- Company float – 69.75 million shares
- Free floating – 46.89 million shares
- Short sale shares – 61.78 million shares
- Free floating effectively 108.67 million shares
So the short sellers have flooded the market with shares, shares that they proposed were seriously overvalued (that’s why they shorted the stock) and removing incentive for others to purchase the shares (if smart people are willing to short it, why should we buy it?) and you have created a ‘liquidity crisis’ of way, way too many shares. (This highlights one of the regulation problems mentioned in the prior post).
Selling shares short requires the use of margin, and sometimes ‘borrow fees’, which are essentially rental fees. (This is another regulation problem – see item 2 below).
There is another liquidity crisis when the opposite situation to that mentioned above occurs for the short seller. It is possible that a company’s shares rise in value triggering a forced purchase (covering) of the short sale. If short sellers hit certain margin limits, they are forced to cover their short, no matter what the price and incur heavy losses. This causes the shares to jump in value, often dramatically and without warning. This opposing situation is called a short squeeze.
The liquidity crisis in each case is, to go back to my example, a situation of too much water, or too little water, for those who need it. And as one would expect, prices adjust accordingly.
This afternoon, the GameStop short squeeze appears to be easing (it has appeared that way before though) and the price is down by 25% or so to $235. The number of shorts has been dropping quite rapidly (that data is hard to get and can be inaccurate) and the number of buyers who can be inspired to buy significantly overpriced shares has likely dried up as well. (I like to use this example . . . why would I buy a Big Mac for $100 when I can buy one for $3? In this case a fair value for GameStop is probably $10-20 per share if things go very well. Why pay $300, even if everyone is excited?)
So what about the regulatory stuff?
- Short sellers should not be allowed to sell massive numbers of shares on the market without making a filing ahead of time.
- If a company were to sell shares into the market, they must file a prospectus to do so, and then give regulators and investors time to consider it prior to selling the shares. Their claims, statements and projections are subject to review and must assure regulators that the information provided is an honest review of the business.
- Certainly small scale short sellers shouldn’t be impacted by heavy regulatory burdens. A typical investor wanting to short a small amount doesn’t need this hurdle/burden
- If a short seller wants to make claims about the company that is perfectly reasonable, but they should be forced to carry the same responsibility of being an honest review of the business.
- If a short seller wants to sell a significant portion of the shares outstanding (say 1%) they should have to file to do so, at least when they sell the shares (currently short sales are reported twice a month and the data is published 12 days later and the data for many markets is only available for a fee.)
- If short sales for any particular company are over 10% of the float (this is the level that is typically allowed for employee share purchase plans, where no additional reporting is required), then short sale reporting should be required on a daily basis by short sellers or their agents (brokers)
- When new rules were implemented in 2008 one of the arguments for the rules was the ‘burden’ of reporting short sales. This is a false argument and reflects the privilege of the moneyed class. Computers do all of the work and reporting for every financial trading house is done at least once per day.
- When new rules were implemented in 2008, one of the arguments for the rules was that shorts wanted to protect their trading secrets. There is no justification for keeping data about the sale of securities into the market a secret. Every company wishing to do so is forced, by the same body to explain and justify such sales.
- Another major issue is that brokerage houses are working against shareholders by loaning out their shares, earning fees for doing so, and not working to protect the interests of their clients.
- Shareholders today typically use a broker to buy and sell shares. As mentioned in a previous post, they don’t receive a certificate and store that in their safe, or under their pillow. They put it into safekeeping with a broker. That broker keeps all of the shares (its really just numbers on a computer nowadays, there are rare occasions when certificates are actually held) and can tell very quickly (usually instantly) how many shares they have in their client accounts.
- A broker will then lend shares to their clients for the purpose of shorting the shares. They may get trading fees, lending fees, margin fees and a variety of other business benefits for providing this service. This activity (lending for shorting) is in direct opposition to the shareholders who they are borrowing from (as it creates excess liquidity and pushes prices down).
- This shorting activity offers no opportunity for the owner of the share to prevent this activity (some brokers will allow a sell order to be placed at a very high price which effectively prevents those shares being available for short sale, but this requires active management and many brokers have policies in place to actually prevent this practice).
- The failure of regulations to prevent the GameStop surge is due to a breakdown in the rules that have been in place for 88 years, the SEC Acts of 1933 and 1934. Those acts prevented unqualified people from promoting securities to avoid misrepresentation and other negative outcomes.
- The use of message boards and news letters has proliferated in recent years without any negative consequences for most people.
- Enforcement of such rules against Reddit or other message boards such as Yahoo or Google would therefore, today, seem spurious and selective, when in fact it should have been enforced all along.
- Social platforms that have been given protection (free speech laws) means they can’t be held accountable for the information that is spread on the platform, and that includes recommending the purchase of securities by unlicensed participants.
These regulatory missteps lead us to the spectacular rise of GameStop and the view of a ‘big win’ for small investors over zealous short sellers. This is a very reasonable assessment, but it isn’t likely to continue, and today’s significant and dramatic decline in the share price for GameStop is likely to cause a lot of pain for smaller shareholders who don’t understand that there is no underlying value.
This post is quite abbreviated and I apologize for the terrible prose. There are very complex issues underlying these events that are not adequately explored here, but the overall view should be focused on the following details:
- the short selling that allowed short positions to reach 130% of a company’s float should never have happened and by any meaningful interpretation of securities laws is a serious crime for selling unregistered securities in public markets.
- the use of message boards to promote or recommend the purchasing of any investment is illegal and should not be allowed to happen.
- Investors who do not understand basic investment are bound to be hurt when the ‘pump’ part of this process is done and the ‘dump’ part gets underway with a similar frenzy.
Regulation new or old that favours the moneyed class will be poorly received by the small investors, and rightfully so. While the government’s regulations are designed to protect small investors, they have had a far more negative effect of providing excessive power and opportunity to large investors while absolving those same large investors from responsibility and consequences when their actions produce disastrous results. That must change to make the system fair.