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Another storm brewing on Wall Street?

By Devangshu Datta
February 12, 2021 09:22 IST
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Given the dimensions, it is bound to have at least ripple effects across markets.
Could ripple turn into cascade? asks Devangshu Datta.

Illustration: Dominic Xavier/Rediff.com
 

Can an obscure, loss-making company with a broken business model trigger a global crisis?

Price moves in GameStop (listed as GME on the NYSE) have caused over $5 billion in hedge fund losses and pushed one fund to near-bankruptcy.

GME's swings have also led to desperate manoeuvres by discount brokerage Robinhood, which is struggling to handle conflicts of interest.

GME has 53,000 employees. It retails video games in 5,000 physical stores across the US.

It lost $275 million in 2020 on $5 billion revenues since gamers prefer to buy online.

In an initiative driven by new board member, Ryan Cohen, GME is pushing its online presence.

Cohen founded and sold pet-food retailer Chewy for $3.35 billion in 2017.

He is also the largest individual investor in Apple, owning over 6.2 million Apple shares.

He joined the GME board in September. By January 2021, he owned 12.9 per cent of GME.

The stock rose from $3.5 per share in August, to $18 on January 2.

Then it received attention on a Reddit forum WallStreetBets (r/wallstreetbets or WSB), where 2 million individuals discuss trades.

A Reddit poster, which uses the obscene handle 'Deepfxxxxxgvalue', had bought $50,000 worth of GME call options in September.

Those are now worth over $15 million.

As he gloated, others piled on, including a couple of billionaires.

Meanwhile, some hedge funds thought GME was overvalued.

They bought puts and sold the share short too. Melvin Capital, with assets under management of $12 billion, bought $55 million of long puts, for example.

Options 101 tells you losses for option buyers are limited to the initial investment, while potential profits for option buyers are unlimited.

On the obverse side, losses for an option seller are unlimited.

So GME call-sellers tried to hedge by buying GME shares, so a rise in share price would compensate for call-losses.

As the price rose, so did demand from call-sellers.

The put-buyers had also sold stock short.

They did not possess shares they had sold.

Unlike options, which are cash-settled, a short stock position is settled by delivering shares.

Thus, a short-seller can not only lose money; he can go to jail if he can't deliver shares.

This is where the fun really starts.

GME has a total of 70 million outstanding shares.

In addition to Reddit traders and call sellers, short-sellers were trying to cover positions by buying stock.

By January 18, 'short interest' volumes, meaning short positions due for delivery, exceeded 70 million!

Day-trading volumes (including trades settled without delivery) was regularly hitting 70 million shares plus.

This is a classic 'short-squeeze'.

Desperate short-sellers trying to book losses pushed price up, and up.

On January 28, GME briefly crossed $480 per share and hit post-trading levels of $311 for a market cap of over $21 billion.

Over 178 million shares were traded making it the most traded stock globally.

Discount brokerage Robinhood is popular with WSB traders.

Much of the action took place there.

Robinhood sells order flow information to hedge fund Citadel.

It was fined $65 million in December by the US regulator, the Securities and Exchange Commission, for not disclosing this to clients.

Citadel gains two ways, by processing orders, and gauging retail attitude.

Robinhood halted trading in GME and it was instantly hit by class-action suits from retail clients.

To add fuel to conspiracy theories, Melvin Capital received a $2.7 billion bailout from Citadel, and Point72 Asset Management (another hedge fund, said to have lost 15 per cent of its $19 billion corpus in January) on January 25.

Further losses must have occurred in the next three sessions, not necessarily in Melvin Capital.

Hedge funds are highly leveraged, borrowing multiples of equity.

The stated losses are relatively small but borrowing can lead to cascading defaults.

In 1999-2000, Long-Term Capital Management nearly caused a global crisis when it suffered $4 billion loss in Russia treasuries.

The Lehman Brothers bankruptcy in 2008 involved $600 billion in assets and contributed substantially to the global crisis.

Multiple US lawmakers have already commented on GME.

Given the dimensions, it is bound to have at least ripple effects across markets. Could ripple turn into cascade?

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Devangshu Datta
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