GameStop, Robinhood, and Short Selling: Not a Free Market

COMMENTARY Markets and Finance

GameStop, Robinhood, and Short Selling: Not a Free Market

Feb 6th, 2021 7 min read

Commentary By

Norbert J. Michel, Ph.D. @norbertjmichel

Director, Center for Data Analysis

David R. Burton

Senior Fellow in Economic Policy

The GameStop controversy represents a small fraction of the overall market—the highly regulated market—and it should be kept in proper perspective. NurPhoto / Contributor / Getty Images

Key Takeaways

All stock trading in the U.S. takes place in a highly regulated market. It is, therefore, impossible to blame the problems...on the failure of the free market.

FINRA itself is in need of reform, particularly with respect to its arbitration process and regulation of small broker-dealers.

None of these reforms should include giving regulators more authority to judge the quality of individual investments.

For many years, researchers at The Heritage Foundation have pointed out that U.S. financial markets have been highly regulated for more than a century, especially after the 1930s.

Regulatory intrusion in the capital markets has increased steadily, with major new legislation imposing ever more rules about every decade.

That fact is critically important in understanding the recent controversy surrounding GameStop’s stock.

All of the details have yet to be sorted out, and anyone guilty of fraudulent behavior should be held liable. However, some of the facts are evident.

First, some major hedge funds were “short selling” GameStop’s stock because they were betting that its price would fall.

To make this bet, those funds borrowed shares of GameStop, then sold the borrowed shares with the objective of buying them back later at a lower price to return the borrowed shares. For the funds to earn a profit, the price had to fall.

For example, a short seller might borrow 10,000 shares of GameStop from a broker and then sell the shares on the market for $20.

If the share price falls and the short seller buys the shares for $10 on the market, the short seller earns a $100,000 profit because he had to pay only $10 per share to return the borrowed shares he sold for $20 per share. In this example, the hedge fund spends $100,000 ($10 x 10,000 shares) and receives $200,000 ($20 x 10,000 shares).

Of course, if the price rises instead, the seller loses—possibly an enormous amount because a stock price can rise (in theory) to any number.

Part of the GameStop controversy is because the price rose.

In particular, the price rose because many individual retail investors, organizing via the Reddit forum wallstreetbets and trading using the low-cost trading app Robinhood, sparked a price rally.

Ultimately, this rally caused what is known as a “short squeeze,” where the rising price causes short sellers to buy the stock immediately, before the price gets too high, in an effort to limit their future losses.

This action is often forced on them because their broker-dealers force them to deposit additional funds to cover their losses. Otherwise, their broker-dealer will “close” the short position to stem the losses, whether or not the customer wants to do so.

That’s because, in principle, the losses are unlimited and can be very large, and the broker-dealers do not want to be liable for customer losses.

The catch, though, is that all of this buying tends to make the price go even higher, thus “squeezing” the short sellers.

While hedge funds regularly employ this tactic on other hedge funds, the GameStop incident is one of the first times—possibly the very first—that retail investors sparked such an event.

It is also perfectly clear that all stock trading in the U.S. takes place in a highly regulated market.

It is, therefore, impossible to blame the problems surrounding these trades on the failure of the free market, as some have done.

For instance, the online financial services company Robinhood is under attack because it halted trading in GameStop stock last week and limited purchases in margin accounts (where customers borrow to buy stock). Robinhood was one of many broker-dealers that took those steps.

Aside from the fact that Robinhood’s customer agreement discloses that the firm can restrict its customers’ ability to trade, the fact is that Robinhood is a registered broker-dealer.

As such, Robinhood can only buy and sell stocks for its customers if the firm complies with the rules. And there are plenty of rules, some of which can leave a broker-dealer with no choice but to stop trading in certain stocks.

Various hedge funds have also come under attack for short-selling GameStop and other companies. There is, however, nothing inherently wrong with short selling.

Short selling helps provide valuable information to the market, and it can play a legitimate role in checking speculative bubbles and dampening volatility.

The primary regulator of broker-dealers is the Financial Industry Regulatory Authority, not the Securities and Exchange Commission. However, the SEC is responsible for the oversight of FINRA, and all of the rules that FINRA enforces have to be approved by the SEC.

Two of the most important rules for brokerage firms are the net capital rule and the customer protection rule, both of which are integral to the orderly winding down of a broker that cannot meet its financial obligations.

The net capital rule (Rule 15c3-1) requires broker-dealers to maintain a minimum capital ratio at all times. While the precise amount of net capital depends on the exact nature of the business, the rule generally requires the company to hold sufficient liquid assets to meet its liabilities.

A registered broker-dealer cannot operate if it fails to meet its minimum capital requirements under this rule.

The customer protection rule (Rule 15c3-3) complements the net capital rule by requiring brokers to implement various safeguards for its customers’ funds and securities. It requires brokers to promptly obtain possession of securities for its customers, and to properly segregate customers’ cash so that it is available when needed.

In addition to these types of regulations, broker-dealers also have to adhere to the rules set by the clearing firms that settle tradesRegulation SHO (regarding short sales), Regulation NMS (regarding the regulation of the equity secondary markets), Regulation BI (best interest), and many other SEC, FINRA, and exchange rules.

Clearing firms, such as the National Securities Clearing Corporation, and their parent company, the Depository Trust & Clearing Corp., have to comply with various risk management rules of their own, and these rules effectively set collateral requirements for the broker-dealers that do business with them. Generally, the clearing firms impose new collateral requirements each day, with factors such as market volatility and trading volume determining the final amount.

Title VIII of the 2010 Dodd-Frank Act imposed a new regulatory framework on clearing firms, and they are now regulated by some combination of the SEC, the Federal Reserve, and the Commodity Futures Trading Commission. The law essentially concentrated more risk in clearing firms and identified the largest of those companies as too big to fail.

In a sense, the new rules appear to have worked. Robinhood and other broker-dealers halted trading to allow more trades to settle and to reduce the number of volatile shares on their books.

That move reduced the collateral Robinhood owed to the National Securities Clearing Corporation and other clearing firms, and also lowered the clearing firms’ risk exposure.

But it appears that Robinhood had no choice but to come up with much higher collateral or limit its customers’ GameStop trades. The clearing firms’ risk-assessment process remains something of a black box, but there’s no doubt that Dodd-Frank increased regulations on clearing firms, leaving the largest ones in a more powerful position than they were previously.

There are, of course, many other rules and regulations, and the regulatory framework for U.S. financial markets was in drastic need of an overhaul long before the GameStop incident.

FINRA itself is in need of reform, particularly with respect to its arbitration process and regulation of small broker-dealers. The rules that define market manipulation are about as clear as mud. The rules and practices allowing the same share to be lent to short sellers more than once, and therefore allowing the short interest in a company to exceed its public float, also need to be revisited.

However, none of these reforms should include giving regulators more authority to judge the quality of individual investments, or to further restrict Americans’ ability to invest their own money. Investors, whether holding long or short positions, should be able to invest without the government putting its thumb on the scales.  

The GameStop controversy represents a small fraction of the overall market—the highly regulated market—and it should be kept in proper perspective.

This piece originally appeared in The Daily Signal