On the 27 January 2021, a David and Goliath battle played out on Wall Street, which captivated the markets’ and regulators’ attention.
A bunch of day traders on Reddit and other social media networks threw down the gauntlet to hedge funds that had been short selling the stock of gaming company GameStop, buying the ‘meme stock’ up in such significant numbers that its share price inflated by 12,500%, which resulted in some retail brokerages temporarily prohibiting certain trading activity. Some funds also incurred significant losses as they were forced to close out their short positions in meme stocks.
Now, 10 months after the momentous event, a 45-page Securities and Exchange Commission (SEC) report has concluded that the extreme volatility of meme stocks like GameStop tested the capacity and resiliency of the markets. While a short squeeze or “buy to cover” trades were not the primary driver of the sharp price increases in GameStop’s stock price, the report raises questions about market efficiency as it relates to short selling.
The Staff Report on Equity and Options Market Structure Conditions in early 2021, which was published by the SEC on 18 October, identified a number of areas for further study and additional consideration:
- Forces that may cause a brokerage to restrict trading;
- Digital engagement practices and payment for order flow;
- Trading in dark pools and wholesalers;
- The market dynamics of short selling.
“January’s events gave us an opportunity to consider how we can further our efforts to make the equity markets as fair, orderly, and efficient as possible,” SEC chair Gary Gensler stated. “Making markets work for everyday investors gets to the heart of the SEC’s mission. I would like to thank the staff for bringing their expertise to this important report, and for their ongoing work on to address the issues that January’s events raised.”
The report found that in January 2021, more than 100 mostly consumer-facing stocks familiar to the public, experienced large price moves or increased trading volume, which “significantly exceeded broader market movements.” The amount of “short interest,” in some stocks based on the number of shares sold short as a portion of the total shares outstanding, exceeded the market average.
The SEC Staff Report concludes that “buy to cover” or short squeeze volumes may have placed additional upward price pressure on GameStop’s share price, forcing other short sellers to exit their positions, adding even further upward pricing pressure.
As short sellers are out of the market, at least temporarily, the report says a stock’s price can continue to rise unchecked. “Further, because short sellers could lose more than the capital they have invested, the extreme risk could deter further short selling in the stock. While the price of GameStop did eventually fall, one could ask to what extent a short squeeze lay behind its price increase dynamics?”
However, GameStop’s share price remained high even after the direct effects of covering short positions had waned, says the SEC’s report. “The underlying motivation of such buy volume cannot be determined; perhaps it was motivated by the desire to maintain a short squeeze. Whether driven by a desire to squeeze short sellers and thus to profit from the resultant rise in price, or by belief in the fundamentals of GameStop, it was the positive sentiment, not the buying-to-cover, that sustained the weeks-long price appreciation of GameStop stock.”
GameStop’s price surge also raises questions of market efficiency relating to short selling, the report states, with SEC staff observing that it was “unusually costly” to borrow GameStop shares. “To the extent that GameStop was costly and risky to short, the reluctance to sell short could have contributed to the run-up in prices and the subsequent steep decline,” the report states. Improved reporting of short sales, says the SEC, would allow regulators to better track pricing dynamics in the market
The SEC highlights the important role played by the clearing agencies such as the National Securities Clearing Corporation (NSCC) during the events of January 2021. “The risk management mechanisms of these clearing agencies effectively led others in the transaction chain—such as retail broker-dealers—to pause and manage the risk exposure that arose as the rate of transactions accelerated,” the report states.
It says some of the trading restrictions imposed by broker-dealers during the highly volatile trading conditions back in January, were a reaction to margin calls and capital charges imposed by the NSCC in response to the extraordinary volatility. Other broker-dealers restricted trading due to capacity issues.
“This raises questions,” said the SEC, “about the possible effects of acute margin calls on more thinly-capitalized broker-dealers. One method to mitigate such risks, the report added, would be to shorten the settlement cycle.
The SEC also said consideration should be given to whether dark pools and wholesalers, where much of the retail flow in GameStop stock occurred back in January, should be subject to the same levels of transparency and resiliency compared with exchanges and ATSs (Automated Trading Systems).