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GameStop And Financial Markets – Complete Misundertandings

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Financial markets are pretty coll things, giving people a manner of saving for their future while also having a place in the financing of productive investment in our society. Sadly, that doesn’t stop people from entirely misunderstanding that place:

What started out as a call to the gaming community to save one of the last big bricks-and-mortar retailers from the US hedge funds that were known to be “shorting” its shares quickly turned into a mass movement that has sent shockwaves through the financial world, on both sides of the Atlantic.

Whaddayamean “save”? The value of the stock has nothing at all to do with the existence of the business or not. GameStop could go to 3 cents a share and the existence or not of the stores would be determined y exactly the same details inside the business as before. How many games is it selling, at what price, against what are the costs of selling those games? The same would be true of the stock being at $500.

OK, a slight proviso, the value of the stock makes a difference to being able to get new capital into the business but that’s a secondary matter. The business itself doesn’t change dependent upon the price of the stock. A fall in the stock price doesn’t change those internal numbers for the business. To think otherwise is the pushing on a piece of string theory of finance.

There are other failures of thinking too:

As speculation rather than productive investment has become the fuel of the stock market,

Stock markets aren’t the place that primary investment gets financed. Sure, they can be used for that, but that’s not the point. A stock market is where you go to sell an investment. That there is a secondary market in investments lowers the cost of capital for the primary investments, that’s the economic function.

However, we are these days told that we must “follow the science”. On this particular point the science being Robert Shiller and his Nobel. His point is that the efficient markets hypothesis works only within certain caveats, one of which is that markets must be complete. If people can buy something then we get the views of those who think it will rise. If people can not buy something then we get the view of those who, perhaps, have no view. Only if people can go short can we gain the views of those who think the thing should or will fall in price.

Given that we should follow the science these days that’s the answer to those who think we should ban short selling.

Finally there’s all that hoo ha about Robin Hood and the like banning GameStop purchases, or selling people out of positions. No, this is not a Wall Street conspiracy against the little guy. It’s just the way that markets work.

If you buy on margin – which many were doing – and the stock price falls – as it did at times with GameStop – then there will be times that your positions runs out of margin. It’s right there in your contract that when this happens the broker will sell out your position in order to provide a stop loss on your position.

Then there’s that no mas on trades:

Well, they are in a way–but NOT the way that is being widely portrayed. What is going on is an illustration of the old adage that clearing and settlement in securities markets (like the derivatives markets) is like the plumbing–you take it for granted until the toilet backs up.

You can piece together that Robinhood was dealing with a plumbing problem from a couple of stories. Most notably, it drew down on credit lines and tapped some of its big executing firms (e.g., Citadel) for cash. Why would it need cash? Because it needs to post margin to the Depositary Trust Clearing Corporation (DTCC) on its open positions. Other firms are in similar situations, and directly or indirectly GME positions give rise to margin obligations to the DTCC.

The rise in price alone increased margin requirements because given volatility, the higher the price of a stock, the larger the dollar amount of potential loss (e.g., the VaR) that can occur prior to settlement. This alone jacks up margins. Moreover, the increase in GME volatility, and various adders to margin requirements–most notably for gap risk and portfolio concentration–ramp up margins even more. So the action in GME has led to a big increase in margin requirements, and a commensurate need for cash. Robinhood, as the primary venue for GME buyers, had/has a particularly severe position concentration/gap problem. Hence Robinhood’s scramble for liquidity.

Robin Hood was running out of money to be able to finance the trades that customers were making. That’s it, that’s all.

Personally I’m laughing like a drain over this story. I love that a – however loosely directed – concert party screwed over some hedge funds. But what won that battle was the detail that over 100% of the stock was shorted. That’s a situation just ripe for a short squeeze and so it turned out. The same attention to detail needs to be applied to the other parts of the story. Which isn’t, as above, being done.

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1 COMMENT

  1. Anyone know how long the short contracts are in this case? If they’re just a couple of months the squeeze has a much better chance of holding on than if they’re a year.

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