Not only is your humble blogger not feeling well and in no mood to write, but due to the uninformed and misguided hyperventilating about Robinhood and the outrage about Reddit touts being deprived of their trading fix and possibly some gains, I nevertheless feel compelled to weigh in.
I can muster the teeniest bit of sympathy for media frenzy over this story. It’s a happy bit of nostalgia, a reminder of the innocent days of the flash crash, before Trump and Covid. Plus the financial press must be happy to be getting some attention again. First Leon Black, now wild stock gyrations and lots of finger-pointing. They might be on a roll.
But let’s put the atmospherics to the side. This episode, including the grotesquely disproportionate amount of attention it is getting, is an indictment of American capitalism.
First, the spectacle of the Senate wasting its time, in the middle of a pandemic, on some trading junkies maybe having not made as much money as they felt entitled to, is pathetic. It shows how warped the priorities of our putative elites are. This is secondary market trading in one bloody stock. Secondary market trading is societally unproductive (more on that shortly) and should be discouraged by increasing transaction costs (this is one of the big reasons to push for a financial transactions tax, not for revenue purposes, although that’s a nice side bennie, but to shrink the financial casinos).
The company is unimportant. The parties on both sides are competitors in a beauty contest between Cinderella’s ugly sisters: clueless new gen day traders versus clumsy shorts, many of whom look inept at the basic survival requirement of managing trading risk. And as we’ll address in due course, the real bad guy, the SEC for promoting such a socially unproductive market, has yet to receive the criticism it deserves. It’s simply bizarre that cheap market liquidity is being treated as some sort of right.
The focus has been the traders on Robinhood, a free trading platform, although some of the bigger low-cost services also had some trading halts in GameStop. These punters are surprised that a free service might not give them the best, or any execution in a bad market? Did they not work out that they were the product and having their order flow to Citadel might not be a great position to put themselves in?1 Or as Financial Times reader AM put it:
Providing zero commission retail investing is only viable with an inflexible and highly optimised execution model.
It’s no surprise that the execution model fails for small single name stocks when their market goes haywire.
Now in fairness, it appears that not all of the speculators involved in the short squeeze were plucky retail investors up against big bad Wall Street pros; some have suggested that there were hedge funds on both sides of this play. But the press is still running uncritically with the “little guys get the better of professional money” spin, no matter how well it actually fits what happened.
However, another wee problem with the little good guys versus big bad Wall Street narrative is that the retail traders might be deemed to have engaged in price collusion or market manipulation. Bloomberg’s Matt Levine walked very carefully around the issue and said he couldn’t conclude either way. But his arguments to try to exculpate the Reddit-maybe-colluding longs all hinged on the trades being one big lark. So why should Congresscritters come to their defense if it’s not clear that their activity was legal, and it is clear that they were speculating, not investing? You live by that sword, you can die by it too.
The shorts are depicted as hedgies, when short sellers are arguably the least pernicious financial speculators. They do the unloved and risky work of finding badly managed, overhyped, or even outright fraudulent companies, then betting on their views and trying to educate other investors that they are being had at current price levels.
However, the GameStop shorts look like an awfully inept bunch. Even though at a remove, they appear to be correct about their views of the company’s valuation, if you are a short, you never want to take a position that is so large you can’t get out of it pretty quickly, as in out of proportion to regular trading volumes. This is the same rookie’s mistake that brought down LTCM, which managed to make a outsized bet in the interest rate swaps market. From Ghostrider2014:
Firstly, contrary to what WSBers think, there is no sympathy in any corner (wall street or main street) for the HFs who in their infinite wisdom shorted over 100% of free float – that is just dumb and they deserve to lose in the squeeze.
Secondly, there is no way the long is driven solely by retail demand – there is over $15bn of trading every day for the past 4-5 days and that has to be institutional money. So this is HF vs HF most likely.
Finally, brokerages have no incentive to halt trading unless they have capital/margin requirements from the clearing houses. So this conspiracy theory of wall street banding together doesnt make sense.
Second, the reporting on the Robinhood and other trading halts in GameStop has been abysmal. Some of them were circuit-breaker-type interruptions due to the speed of the price moves. But that big uptick in price volatility in turn led the clearinghouses imposing higher margin requirement on brokers trading in GameStop, hitting Robinhood, proportionally most exposed, the hardest. Mind you, I’m not saying that Robinhood handled its customers very well when this happened, but the underlying cause isn’t nefarious. Robinhood is likely to be revealed as incompetent, which is still a very bad look someone handling other people’s money.
See the discussion by the WeBull CEO starting at 1:20 on the big increase of DTCC margin requirements and how that affected brokers:
The simplified version from DSC at the pink paper:
RH has capital requirements for that activity and in extreme vollitality/elephant herd of orders it’s easy to see how that got smashed and how it might have been reasonable for RH to liquidate non margin but RH funded positions
Third, while this story has entertainment and perhaps even educational value, the fact that it’s getting any traction in DC is confirmation of how backwards our priorities are. Since the crisis, there have been boatloads of economic studies on secular stagnation and other ills of advanced economies. Despite the joke, “You can lay economists end to end and never reach a conclusion,”: a surprisingly large number depict overfinanicialization as a drag on growth. Even the IMF concluded that the country representing the optimal level of financial “deepening” was Poland circa 2015, and more financialziation was productive only if regulations were strict. Those conditions haven’t been operative in the US for quite a while.
On top of that, the most unproductive activity is secondary market trading and asset management. The US stock market has a very high level of secondary market activity compared to primary investment, as in companies selling stock to the public to raise new funds to expand their business. You don’t need anything approaching this level of liquidity for companies to be able to price and sell new shares, as the success of large (by the the standard of the day) IPOs and stock offerings of seasoned issuers back in the stone ages of high priced stock commissions attests. The fact that it’s twice as easy to become a billionaire in asset management as in tech shows the degree to which money manipulation is sucking activity and talent away from Main Street to Wall Street.
Fourth, and related to our third point above, is how the SEC has actively promoted speculation and poorly functioning markets. Since my childhood on Wall Street, the agency has relentlessly pushed for lower and lower stock trading costs, as if that were somehow a good in and of itself. In fact, it has largely fostered speculation and the worst sort of liquidity, the kind that is there when you don’t need it and goes poof when you do. It’s a complete disgrace that SEC hasn’t stopped high frequency trading, which is destabilizing in bad markets, which it could easily do by revoking Rule NMS, which on top of making the world safe for high frequency traders, dark pools, and also gave American the worst possible market structure. As recovering derivatives trader Craig Heimark and we explained in 2014:
Perversely, much of the regulation of the last twenty years has been nominally in the interest of “market efficiency” but has come at the expense of market integrity. Far too many of the arguments and studies saying the promotion of competition among exchanges (and dark pools) has led to greater efficiency look at the efficiency as measured by the bid ask spread (plus fees) only of trading in the top stocks (because if they are trade weighted so that is where all the volume is). But this greater efficiency comes at the expense of no reciprocal liquidity obligation (witness the flash crash) as well as reduced liquidity in less frequently traded stocks.
The societal benefit of trading is to reduce cost to raise capital for actual companies. Does anyone really think that narrowing the spread on Google by a penny or two makes any difference to its weighted average cost of capital? In contrast, incidents like the flash crash and the feeling the market is rigged keep many small investors away from the market. The penalty for reduced liquidity in small stocks may actually be material to small company capital formation.
And these small investors are right to be concerned. The old exchange system was a hub and spoke model, which was a stable system architecture. The internet was an outgrowth of a DARPA project to make a communication system so decentralized that it could not be taken out by a nuclear strike. Hub and spoke models are stable, but subject to an outage, say by a nuclear bomb or electrical failure. What chaos theorists have found is that highly decentralized networks are stable, as are single node networks (like exchanges), but that slightly decentralized networks are fragile. And that is what we have now thanks to the SEC’s misguided efforts to “modernize” the stock market via Regulation NMS.
So I am bracing myself for some particularly painful, as in misguided, Congressional hearings and follow on upset. It’s really disturbing to see the Congresscritter eagerness to score points on this nothingburger (in the larger scheme of things) on Twitter and in the press, when late 2019 House hearings on private equity abuses produced an embarrassing amount of Big Finance pom pom waving on both sides of the aisle.
And while I would be delighted to be proven wrong, the odds of anything good coming out of this controversy look vanishingly small.
1 Just to be clear, the order flow buying part of Citadel swears up and down it has a firewall between it and the hedge fund part of Citadel, which translates into, “Don’t you accuse us of front-running.”