Market integrity, disruptions, innovations and the fallout of Wall Street versus retail traders.

Finance & Fury Podcast

Welcome to Finance and Fury. In this episode, we are going to look at some of the potential fallouts from the GameStop saga – looking at market disruptions, market integrity and the ongoing implications of potential regulation changes

If you want an overview of this – check out last Mondays episode.

1. But in short - Gamers are good at playing games – when they know the rules
   1. The rules of the financial game are starting to be more understood by people online - Some people on reddit were paying attention to the Form 13F filings in the US for hedge funds – have to be lodged each quarter– saw that GME was heavily shorted by a few funds, The one firm that received the most attention, Melvin Capital had heavy short positions
   2. The price of GME has come back down a fair bit from its high point last week, was sitting at around $60 on Friday last week – but there was a gradual increase from around $18 at the start of Jan to around the last week of Jan – when the price started to sky rocket – went up over $400 – triggered a short squeeze where funds were trying to get out of their short positions by buying back the shares – but there either went enough shares, pushing prices up further or you had to accept a massive loss
      1. Even buying the shares back at $60 would still result in a big loss – most got into the short positions between $4 and $10
   3. There are some estimates – hard to get a total for all the funds that lost money – but Losses total losses were estimated to be around $70bn from short positions within the hedge fund community – Melvin Capital lost around $13bn of their capital – loss of around 53% in the fund
2. So in this episode – I want to go through the nature of this market disruption, and the greater implications of this – from the market integrity point of view as well as potential regulatory responses

To start with – discuss the nature of Market disruptions – through innovations

1. One view that I have about this whole saga is that the disruptions are due to innovations – both human and technological
   1. It is a bit of a paradigm shift – humans are adaptive creatures – if a group of online investors managed to push up the price of a company, where some made some decent money, while causing massive losses to institutions, what is to stop this from happening again?
   2. When looking at the evolution of humans and technology, it can help to paint a picture of what may happen next in financial markets – the basic trend occurs as follows:
      1. Disruptive companies or trends start- normally start small or at the low end of a market – these start out with a focused/niche group
         1. Existing powers that be (companies or groups in the social dynamic) ignore this new competition – mainly because it is small – so either poses no threat to the loss of customers or there aren’t enough people to affect change
      2. Over time successful trends or disruptor climb the value chain – with companies, they offering better products and services, with social groups, it also provides value – community or prestige

• Eventually – these disruptors grow to a point of being legitimate competition - the existing powers that be either fail or adopt the disruptor’s models, and the whole cycle starts over again

1. Much more to this cycle – but when viewing the recent rise in retail trading through this model – it is following a pretty classic disruption model
   1. The emerging disruptive trend in markets – coming from retail investors in combination with technology – have access to low/no cost trading platforms as well as chat sites/social media that binds them together – so they can move trades as one
   2. They have been overlooked by the powers that be – relatively small -but when taken at the aggregate level, especially now with stimulus checks coming in – they each have an additional $2k ($1,400 more coming on top of the initial $600)

• As a group – the common knowledge of gambling and gaming is relatively strong

1. Therefore, it is pretty easy to assume that this style of behaviour will grow and have further influence on financial markets

1. The big lesson about disruption – is that once the ball gets going, it rarely stops – unless diverted – which is where ‘market integrity’ will come into this -

If this does continue – what are the risks of short squeeze

1. a large credit shock can traverse through the market - how can last few weeks squeeze activity affects the rest of the (institutional) market? It all comes down to the leveraged nature of trades
2. Aside from a broker/hedge fund not being able to meet margins calls or close out a position - most of the hedge fund industry is financed – in doing so, its beta is close to 1 from their net exposure x leverage
   1. In other works - if your (long-short) exposure is just 10% of gross values but you are levered 10x then your ultimate NAV beta is still about 1
   2. Trouble is - even the largest brokers will only allocate so much 'regulatory capital' towards Prime Brokerage; after which they will raise the cost of financing
   3. Morgan Stanley and Goldman (the two largest shops in the space) are in a much, much better position than in 2008 - but when more stocks get squeezed, they will raise financing costs to allocate precious capital - they will cap risk to the hedge fund and new trades will become impossible to put on if gross positions exposure exceeds risk adjusted limit
   4. If this were to cascade – hedge funds need to cover their position – through selling up long positions to cover the short ones - the first thing sold is the highest P/E (likely highest beta / momentum factor risk) exposure
   5. Now – Melvin was a pretty small fund in the scheme of things – but if a fund 10x the size of Melvin was to find themselves in this position – things could become worse – losing 53% of their capital in one trade, then follows the redemptions from existing investors - If these were to cascade, then the Fed will have to step in, and call the prime brokers and relax regulatory standards
3. Things are heating up - the most heavily-shorted stocks have risen by 98% in the past three months, outstripping major short squeezes in 2000 and 2009
   1. US equity long/short fund returned -7% this week and has returned -6% YTD.
      1. Over the past few decades there have been a number of short squeezes in the US equity market – what is different this time is that it has been an extreme case in a few specific companies
      2. In the last three months – when looking at a basket of top 50 shares with market caps above $1 billion and the largest short interest as a share of float in the Russell 3000 index – these companies have rallied by 98% - This week the basket’s trailing 5-, 10-, and 21-day returns registered as the largest on record.
   2. most shorted stocks took place even though aggregate short interest was near a record low – this is different as well because historically, "major short squeezes have typically taken place as aggregate short interest declined from elevated levels
      1. In contrast, the recent short squeeze has been driven by concentrated short positions in smaller companies, many of which had lagged dramatically and were perceived by most investors to be in secular decline"
   3. Bankers at Goldman sacs believe this could be an issue – one stated "this week demonstrated that unsustainable excess in one small part of the market has the potential to tip a row of dominoes and create broader turmoil." They went on to say "the retail trading boom can continue" as "an abundance of US household cash should continue to fuel the trading boom" with more than 50% of the $5 trillion in money market mutual funds owned by households and is $1 trillion greater than before the pandemic, what happens in the coming week - i.e., if the short squeeze persists - could have profound implications for the future of capital markets

This is where we come back to the concept of market integrity and systemic risks– which regulators are meant to be responsible for

1. What is market integrity? Well, it is one of the main objectives of securities regulators – in the US, the SEC, in Australia, ASIC - a rough definition it to protect the integrity or fairness of the markets
   1. This, together with protecting investors, improving the efficiency of markets, and protecting the markets from systemic risk, form the four fundamental goals of securities regulation
2. Such narrow definitions of market integrity conceptually link it to market efficiency - in that a market of high integrity should also be efficient because prices will reflect their fundamental value – there are a few definitions
   1. Michael Aitken has defined market integrity, in part, as “the extent to which market participants engage in prohibited trading behaviours.”
   2. Hersh Shefrin and Meir Statman (1) freedom from coercion (people enter transactions voluntarily and are not coerced into or prevented from entering transactions); (2) freedom from misrepresentation (people are entitled to rely on information which is disclosed); (3) information (people are entitled to equal access to a particular set of information); (5) freedom from impulse (people are protected from possible imperfect decisions); (6) efficient prices (people are entitled to prices that they perceive to be efficient in that intervention is permitted to correct imbalances); and (7) equal bargaining power (people have equal power in negotiations leading to transactions).
3. Here is where things can get murky – who defines what fair/efficient prices should be? What is an efficient price? Sure, GME at over $400 isn’t an efficient price, but are Afterpay or Tesla trading at their efficient price?
   1. What about freedom from impulse? To implement this, this could be what Robinhood did, limit/restrict buys – not letting people buy companies based around what is determined impulse
   2. The next element is regulators protecting the market from Systemic risk is the possibility that an event at the company level could trigger severe instability or collapse an entire industry or economy
4. These definitions, or rules are contradictory – regulators have four major functions - protecting market integrity, protecting investors, improving the efficiency of markets, and protecting the markets from systemic risk
   1. Based around protecting investors, this could mean the limitation of investors rights
   2. – the banning of the trades in a company should be something that the SEC should look into – reduces the integrity and efficiency and competitiveness of a market – stacks everything on one side
5. The issue with the regulations is that it is based on projections from one side – the financial systems – i.e. hedge funds and politicians – to help protect from this happening again, they may restrict the free market
   1. When looking at the options for Regulations – it may be as simple as tech censorship – discord banned WSB for a short time – may see the pressure of the Government on either trading firms or social media sites to reduce the coordination of traders
   2. One of the more likely outcomes will be that there will be some Scapegoats to scare the public from doing this again – already found one or two – similar to what happened in the US back in 2010 – what can get them is that some of these people on reddit trading have securities licences in the US
   3. they will once again find a small-time trader to scapegoat, regardless of whether their actions actually had a major impact on the market volatility in question
   4. Still an ongoing issue – but time will tell how this plays out – it may turn out that nothing may come from this – at the very least, the US/SEC/Regulators and committee members like Maxine Walters may just get a few scape goats from this movement fined/banned from trading or jailed –
   5. But if the trend continues of retail traders buying shares and shorting – further action may be deemed necessary by governments/regulators – to protect market integrity as they see it

Whatever the governmental response is – it will take a while to legislate – maybe a few years – but if a market crash occurs out of this – the blame will be placed on redditors – not the short sellers or the people betting against a share with other peoples money – just those going long with their own money

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