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The GameStop Short Squeeze Explained:

Christopher J. Gan

Like many of you, I have been caught up with the newest reality TV show of 2021, Gamestop. The cause of this drama is a financial anomaly called a short squeeze, resulting in the price of Gamestop stocks to soar into the stratosphere. This has led some individuals making millions of dollars, and hedge funds like Melvin Capital to lose billions of dollars in the process.

The questionable actions of brokerages like Robinhood removing the buy button on Gamestop stocks has placed them under scrutiny for blatant market manipulation by the retail crowd. This is countered by giant media networks like CNBC pushing the narrative that retail traders are at fault, despite uncovering an obvious flaw in the financial system.

There are a lot of confusing sensationalist headlines floating around, where everyone is putting their own agenda on it. Being a former Wall Street trader with an inside view into the situation, I have the responsibility to to try my best in explaining the situation objectively. I had previously spent time trading equity options at a top market maker not named Citadel.

For most of you, the situation is likely to run deeper than what you have imagined. I will be explaining why a situation like this was allowed to happen, and how it may affect investors moving forward.

Background

For those of you that are oblivious to what has been going on with Gamestop, here is a quick explanation. Gamestop is the world’s largest retail gaming store selling physical game copies. They have been slowly declining in value over the recent years, as more and more people are resorting to shopping online.

Hedge funds on Wall Street began noticing this retail apocalypse, which saw the decline of prominent brick and mortar brands such as Toys R Us and J. C. Penny filing for bankruptcy. They thought Gamestop would meet a similar fate, and so they decided to short the stock or bet that its stock price would go down.

However in recent months Gamestop has had a series of positive news, driving its stock price up. This included the founder of Chewy securing a 13% stake in Gamestop for $76 million (who has since seen 1700% return on investment), a partnership from Microsoft on the XBox, and a 519% increase in sales during the pandemic shutdown. Furthermore Michael Burry, the individual behind the Big Short, had also established a sizable position back in 2019.

How Shorting Works

It is commonly misunderstood that shorting is simply like selling a stock. Shorting relies on an entirely different concept, and here is how it works.


In this scenario, person A owns a share of GME stock. Person B, who is a short seller, decides to borrow the stock from person A - this is in effect an IOU that needs to be returned. Person B proceeds to sell his borrowed GME stock to person C for some cash.

If the stock price drops, then person B can then purchase back the stock at a lower price. He then pockets the difference, before returning the stock back to person A.

On the flip side, if the stock price rises, then person B will need to purchase back the stock at a loss. He can choose to keep holding on, but will be required to offer up collateral incase he is unable to pay back the losses. At some point in time, the broker will deem his position to be too risky, and will forcibly close out the position by purchasing back the borrowed GME stock.

What is fascinating about this system, is that one individual GME stock can be borrowed multiple times. In rare instances, it is possible for there to be more stocks shorted, than there are available stock. In the case of Gamestop, the short interest was over 130% the total publicly traded stock float.

In the event that the stock price rises, it will trigger some short sellers to purchase back GME stock to close out their position. This demand causes an upward pressure on the stock price, driving it up, resulting in further buying back of GME stock - thus creating a positive feedback loop that sends the stock price to Mars.

When more than 100% of the float is being shorted in the instance of GME, there is more demand for GME than there is supply. This creates a temporary scenario where the owners of GME stock can effectively name any price they wish. The buyers effectively are forced to oblige, otherwise they face risk of failure to deliver on contractually obligated shares.

In the event of a failure to deliver, a buyer of GME stock would not be able to receive the stock upon settlement. This results in serious repercussions of a forced buy-in by the court, where someone will need to take the liability.

The Unravelling of the Financial System

Robinhood has faced tremendous amounts of scrutiny after deleting the buy order on several tickers that were undergoing short squeezes, including GME and AMC, without proper explanation. Robinhood and other brokers have been accused of market manipulation by removing the demand for GME, in an attempt to halt the short squeeze.

It is likely that Robinhood was experiencing extreme liquidity constraints, given that they raised $1 billion of emergency funds from investors. Brokers are required by regulators to hold a percentage of cash tied to their user’s trading activity, so that they are able to pay them out if they choose to withdraw their money.

While it is easy to point blame at Robinhood, it is likely that what had surfaced into popular media is just the tip of the iceberg. By piecing together interviews from prominent figures such as Webull’s CEO and my experience as a market maker, here is what likely happened.

When a trade is executed on a brokerage platform, a buyer agrees to purchase the stock at a given price by a seller. Here, a broker like Robinhood simply acts as the middle-man between the investor and the exchange. While this transaction may seem automatic on one’s brokerage account, many things occur behind the scenes to ensure that the ownership of the stock is physically exchanged.

Robinhood then sells its order flow to a market maker like Citadel, who will then be able to execute the trade. Market makers act to always provide liquidity in an exchange, and is compensated by doing so by profiting off the bid-ask spread. While it may appear that Robinhood has no transaction fees, you are implicitly paying it through a wider bid-ask spread.

After Citadel executes the trade, they rely on clearing houses like Apex to settle the trade. Initially in the early infancy of the stock market, this settlement would be done through the swapping of physical stock certificates. Nowadays this is all digitalised, and it usually takes the clearing house two days on most exchanges to process this.

At the settlement date, the seller’s broker must deliver the stock being sold, and the buyer’s broker must provide the cash. There is obvious counterparty risk where the stock is unable to be delivered, resulting in the buyer to never receive their stock. To regulate this, special clearing houses like DTCC act as central counterparties that are responsible for taking on liabilities in the event of a failure in settlement.

Under normal circumstances, the clearing houses are only required to post up a small collateral of 1-10% when needing to deliver or purchase the stock. According to Webull’s CEO, the DTCC increased the collateral amount to 100% amidst the Gamestop short squeeze. This is most likely due to the realisation that there simply was not sufficient stocks to meet contractual obligations.

Unfortunately, the clearing houses are not well capitalised enough to collateralise billions of dollars for two day periods. The clearing house didn’t want to be caught with brokers not having the funds needed to settle, so they restricted Robinhood and others until they had enough cash to pay the collateral. We can see this in action after Robinhood’s emergency $1 billion raise from investors after having drawn down its credit lines at several banks.

Had DTCC not done this, Robinhood would not have been able to settle, resulting in either the clearing houses or the retail investors being on hook for billions of dollars. While Robinhood has certainly done a poor job in its public communications regarding the situation, it is clear that the financial system is broken. There needs to be regulations to prevent the shorting of over 100% of the float, as well as more stringent requirements for institutional investors to declare their short positions to instill confidence back into investors.