By Spencer Mindlin and Christian Benson
If you’re confused about what’s been going on with GameStop and its wider implications, you’re not alone. Throughout this week, I have been receiving inquiries from friends and colleagues keen to understand what this all means. The truth is that, far from being a simple market occurrence, the events of the past week represent the intersection of institutional investments, retail day-trading, equity market structure, and regulation. Like I said, it’s complicated.
The prevailing narrative seems to be that this episode is fundamentally about the evils of speculative hedge funds, or even the dangers of the modern internet with a millennial-style frictionless investing. It strikes me that these “hot takes” are off the mark, as the GME story is really about something far less sexy: the flaws in U.S. equity market structure. Short interest should never rise above 100% of the company’s shares outstanding. The present system of the Securities and Exchange Commission’s Regulation SHO, which allows shares to be borrowed and then lent out over and over again, is doing great harm to confidence in the U.S. equity market. Period.
This is not the first time we have been here. Excessive short interest of the magnitude that we are seeing with GME, up 1,744% by close of trading in New York on Wednesday, rarely occurs with individual stocks and is more common with exchange-traded funds. In 2007 and 2008, extreme short interest of more than 1,000% in some ETFs, such as the SSGA S&P Retail ETF (XRT), dealt a blow to underlying companies, such as Sport Supply Group, PC Mall, ValueVision, and HSN, particularly as the companies themselves were not allowed to opt out of the index. The first half of the prior decade witnessed heated debates in the news media and inside the halls of Congress about whether the combination of ETFs and securities lending was a ticking time bomb. And while the SEC tightened up the rules on fails-to-deliver, shortened the U.S. equity settlement cycles, and outright banned naked shorting, issues still persist. Rules are punitive rather than preventive, and the events of the past few days illustrate that there is still a long way to go.
Over the past few years, a number of voices have been blowing the whistle on excessive short interest and the potential havoc that these squeezes in either direction could wreak on small companies in particular. Yet regulators have done too little to protect the interests of entrepreneurial small companies. It was unfortunate that, when the SEC created its equity market structure advisory committee four years ago, not one member of the 14-person committee represented the perspective of issuers. The convoluted system of regulation and market structure has given rise to derivative products and enormous growth in securities lending revenue, while there has been too little focus on market-structure first principles and whether they adequately serve the needs of the issuers and their long-term investors.
The regulator's focus over the past 25 years seems to have shifted away from market fundamentals and toward reducing frictions and costs for retail investors above all else. Consequences abound.
One of the fundamental shifts in the U.S. capital markets landscape over the past few decades has been the tendency for companies to stay private for longer and longer. The proliferation of alternative sources of funding outside the glare of the traditional stock market has hampered the ability of the U.S. public to participate and invest in the innovative and dynamic companies that drive growth in the country. Companies such as the “unicorns” are now only coming to market with eye-wateringly high valuations, pricing out much of the investing public. Events of the past few days do little to restore faith in U.S. public markets. Chief financial officers don’t split shares like they used to. And now discount brokers have figured out how to offer fractional shares to retail investors. What’s happening with GameStop will prompt more small companies to eschew the public market. This won’t end well.
A growing chorus of voices is calling for short selling to be banned. I remember the then-president of the NYSE Tom Farley (a fellow Hoya) describing short selling as “icky and un-American”—a sentiment that has been revived in recent days among policymakers on Capitol Hill.
While it may not be popular to say right now, short selling has its place in well-functioning markets as a means to contribute to price discovery through fundamental analysis of companies. How else can firms signal to the market that they believe a particular stock is overvalued? Short selling represents an important market mechanism to correct overly inflated prices. Yet this is not to excuse the way the current system, in which the repeated lending out of the same share has allowed for too many externalities and is actively harming companies and their investors.
The rehypothecation of assets is an important tool for creditors and financial institutions. But it’s questionable whether an industry of hedge funds should be allowed to perform unchecked speculative shorting of public companies’ shares and whether those strategies are in the best interests of a market that is supposed to fuel innovation, support livelihoods, and encourage reinvestment. Yes, the market should allow floundering companies to fail. And short selling helps facilitate the market’s price and liquidity discovery process, and is an important tool for risk mitigation. But perhaps it’s time to reassess whether the rules and infrastructure that enable securities lending need to be revisited and shored up.
Not to say that retail investors can’t or shouldn’t be able to monetize negative views on a company. It’s kind of ironic that many of the same millennials and Gen Zers buying GameStop’s stock on Robinhood to squeeze the short sellers are probably the same kids that shifted demand away from the store’s brick-and-mortar locations to online video games and app downloads. The equity options market enables retail investors to buy puts by paying an appropriately priced premium—a fact seemingly absent from the recent debate.
One possible solution might be to look at how other jurisdictions have handled similar problems. In 2010, Japan cracked down on short selling ahead of new equity issues, arguing that such strategies punish long-term shareholders unfairly. Recently, Japan’s Government Pension Investment Fund, the world’s largest pension fund, announced it had suspended stock lending for short selling in order to promote long-term investment horizons. Following Japan’s lead and redesigning the incentive structure to better balance short-term risk taking in financial markets is one way the U.S. can use this episode to strengthen its system of equity market structures.
So while an outright ban of short selling is not the answer to the problems posed by GME, neither is the regulatory inaction and inertia that we have seen in recent years. The existing system of regulations has hampered trust and public participation in U.S. financial markets for too long. Following the example of other jurisdictions, such as Japan, U.S. market participants and policymakers should work together to promote longer-term thinking and financial stability for the good of the U.S. economy and people.