Day traders coordinating their efforts through the social media platform Reddit have not only boosted the stock of US GameStop, but also badly hurt hedge funds engaged in huge bets shorting the shares. One, Melvin Capital, is reported to have lost up to 30% of its assets as a result of GameStop position. But what does the event tell us about the risk involved in short selling and lending stock for shorting? Room151 gathered comment from experts.
William Bourne
With the prices of targeted stocks at nose-bleed high levels in principle we expect other short-sellers to come in, even if in the light of Melvin’s experience they will perhaps be more careful in how they manage their risk. Ultimately, this is not a battle the retail investors can win. Which leads to the fascinating question of whether or not regulators should try in their own interest to stop them losing their money.
On the one hand this has the hallmark of a Ponzi scheme in that early investors can make money if they make an exit but those left holding the stock at the end will lose most, or all, of their investment. The difference is that there is no Madoff-like entity trying to benefit from it. If there were, we hope the regulator would step in sooner rather than later.
Against that are the arguments that stopping this trade is manipulating the market in the interests of the establishment – first and foremost the hedge funds who suffered. It does look like that in the short-term but, if we are right that actually the institutions—at least in aggregate—will win this war in the end, maybe the little guys do need to be protected from their own folly. And if there’s no single orchestrator the regulator can close down, then they have to look at other ways of doing so.
Pension funds and other investors who lend out stock bear some responsibility for the activities of short-sellers. Most shorting settle their initial trade by borrowing stock through stock-lending. On the other side of that trade are large investing institutions with long-term positions who take a fee for lending out their stock.
The 2020 Stewardship Code’s Principle Four enjoins signatories to “identify and respond to market-wide and systemic risks to promote a well-functioning financial system” and, among other things, report how align their investments accordingly. If the current imbroglio over shorting is not a systemic risk to a well-functioning market, it is hard to know what would count as one. In our view it is not possible for institutions to argue that they are fully aligned with this principle while they are facilitating shorting through stock-lending.
Principle Nine enjoins signatories to “engage with issuers to maintain or enhance the value of assets.” Clearly engagement with a company will not stop its shares being shorted, but it is harder to discuss other issues when the asset manager or investor is actively profiting from an activity in contradiction with this principle.
William Bourne is principal and director at Linchpin.
Nicola Horlick
“I have spent many years telling pension fund trustees that they shouldn’t lend their stock because you can only short something if you can borrow the stock to cover that position and pension funds get tiny fees for lending their stock. What they’re doing in effect is allowing a hedge fund to go and destroy the value of their assets. It’s madness.
“In this particular instance, of course, it’s gone the other way, their asset has appreciated in value. But it’s a very odd idea, lending a stock for a small fee to allow somebody to destroy it.
“A lot of people don’t understand if you buy a share at a pound, the worst that can happen to you is you lose your pound. If you sell a share at a pound, and you’re short, and it goes up to £35, you’ve lost £34. You’ve got, in theory, an unlimited downside for the person who shorts.”
Nicola Horlick is chief executive at Money&Co.
As spoken on PM, Radio 4, 1 Feb, 2021.
David Crum
Given the furore around GameStop, short selling and its association to securities lending, what do I think LGPS officers and Elected Members should take from this episode? Two things.
Firstly, securities lending activity does indeed enable short selling. That’s not the only market activity that it enables, but there’s no denying that without institutional investors lending their assets, there would be no short selling of the kind seen with GameStop that was the trigger for recent events.
Secondly, your fund doesn’t need to support short selling, if you are really opposed to it. For example, the FCA is notified daily by asset managers who take short positions of a certain size in UK listed companies, and they publish this information on their website. Concerned funds could put in place a process to review this list daily, and use it to identify and remove any specific holdings from their securities lending programme, thereby denying the short sellers the assets they seek to run their strategies.
There’s clearly a lot more to the GameStop story than short selling itself, and it has the previously unseen dynamic of the “little guy” sticking it Wall Street en-masse. And while it’s hard not to feel some kind of empathy with that narrative, there is a market manipulation angle to this story—and by all accounts it’s the small investors who are going to end up badly burned by this whole episode.
If this represents the opening salvo in a more concerted attempt to attack short sellers, then there’s no way of knowing where this “irrational exuberance” will go. If targeted asset prices no longer reflect the reality of their trading situations because of these kinds of intense distortions, we’ve moved into very dangerous waters, where no amount of short selling restrictions will help.
David Crum is managing direct, asset steward solutions, Minerva Analystics.
Photo by Mike Mozart on Flickr
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