Gaming the System – What the Short-Squeeze of GameStop Stock Could Mean for Regulation

GameStop

Article by Brian McMahon, Regulatory Change Analyst at Vox Financial Partners

I’m sure you have heard the story, as it’s been all over the news, but in case you missed it, here’s a recap.  The share price of GameStop, an American video game, consumer electronics, and gaming merchandise retailer, soared by over 1700% last month. It was inspired by “investors” on the nihilistic Reddit forum WallStreetBets –  with one specific user targeting them months ago.

That Reddit user noticed that the stock was shorted over 100% by hedge funds (which implies naked short selling, which was banned by the US Securities and Exchange Commission (SEC) as part of Regulation SHO implemented in January 2005), but he also believed that the financial position of GameStop, combined with the business potential to sell new game consoles, didn’t warrant the extreme short position. He decided to buy positions in GameStop and frequently posted updates online. More and more people started paying attention, and the stock price began to rise as investors followed him.

As the price started to rise, this kicked the ‘short squeeze’ into motion. Investors who had previously shorted the stock saw the value of their positions being eroded, and losses started accruing. As investors scrambled to cover their positions and limit their losses, it sent the price rocketing even further as the fixed supply of shares in circulation, combined with the massive demand (from both retail investors following the Reddit hype and investors covering their short positions), resulted in the price rising over 400% in the last week of January.

The events led to brokers such as Robinhood preventing retail investors from purchasing stock – a move which was publicly condemned by US Representative Alexandria Ocasio-Cortez (AOC). 

AOC called for an investigation into the events and, as a member of the Financial Services Committee, supported the suggestion to hold a hearing. She also retweeted calls for a financial transaction tax on hedge fund shorting and SEC regulations on short-selling practices.

Other public figures such as Elon Musk, who has been known to cause the market to move due to some of his past comments, also publicly called for ‘shorting’ to be made illegal.

In September 2008, the SEC temporarily banned most short sales in nearly 1,000 financial stocks in response to the financial crisis that led to the collapse of Lehman Brothers. The bank blamed unrestricted short-selling for their ultimate demise, but there were certainly other factors at play.

Events like this have resulted in regulation changes in the past.

Regulations were introduced to limit the amounts of leverage that could be used within the commodity futures markets in 1980, after the Hunt brothers, the richest family in America at the time, had effectively cornered the Silver market.

In the energy markets, the Federal Energy Regulatory Commission (FERC) was pushed to restrict price hikes during the 2000-2001 California energy crisis following the revelation that Enron Corporation deliberately created real and imaginary power shortages to drive up prices and reap vast profits in the state’s newly deregulated energy market.

What’s next?

Public focus is now shifting to look at the future of regulations surrounding shorting selling. Will the practice become more regulated with specific short position limits? Will the practice be forbidden completely, or will everything remain unchanged after the events grow old and leave the headlines?

Regulation often has unintended consequences. Short selling provides market information that provides efficient pricing and liquidity for all investors, or so the argument goes. History has shown that banning short selling hasn’t been effective at slowing deep declines in stocks during a crisis. In the financial crisis of 2008, the ban on short sales failed to slow the decline in the price of financial stocks. In fact, prices fell substantially over the two weeks in which the ban was in effect and stabilized once it was lifted. Similarly, following the downgrade of the US sovereign credit rating in 2011—another notable period of market stress—stocks subject to short-selling restrictions performed worse than stocks free of such restraints.

It will be interesting to see how this plays out in the coming weeks or months. In a world of winners and losers, some hedge funds have definitely lost a lot of money, but they have now likely closed out their short positions. As GameStop stock falls back to something closer to its actual value, it is likely the small investors who are last to get out who will get burned.

Vox is a global consulting firm that specializes in navigating financial institutions through complex regulatory and business change.

To learn more, visit our website here.

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