Robinhood and the short-sellers: Same old story, a few new names

Citadel realizes how smooth brained Melvin Capital really is from r/wallstreetbets

It has been a wild week with attention-grabbing headlines involving the eye-popping moves in the stock of heavily-shorted names, especially GameStop Corporation (GME).*

No less startling have been the decisions by discount brokers such as TD Ameritrade and Robinhood to freeze new buys in stocks that have been going up "too much" (such as GME), or even to close out positions without having been instructed to sell.

The media -- and the politicians -- are all focusing on the most predictable and obvious aspects of this story, painting the price action in GME (and the pain that it is causing to short-sellers, who are primarily hedge funds) as some kind of "revolt of the little guy" against the big Wall Street hedge funds, and the shutting down of the ability to buy more shares (by firms such as TD Ameritrade and Robinhood Markets, Inc.)* as collusion by brokers to help ease the losses of their friends (and major clients), the hedge funds.   We certainly acknowledge that this is taking place and believe that brokers should not be colluding with anyone -- least of all hedge funds -- by stopping retail buyers or even closing out their positions "for their own protection."

But we would also argue that there is a lot more to this story and that there are a lot more lessons to be learned from the astonishing recent events -- and that while it may seem like a "new situation," it is really part of a very old story, and one that the media and politicians have been overlooking for decades.

While most people generally understand that the insane volatility in names such as GameStop have to do with a "short squeeze" in which speculators who bet against GameStop by selling shares of GME short (primarily these short-sellers are hedge funds) are hammered by waves of buying (much of it driven by participants in the Reddit board known as "Wall Street Bets"), and while the media and politicians have cast this market action as "the little guy vs the big hedge funds," the real elephant in the room is the practice of "naked short selling," a fact which gets very little if any attention in the media and even less from the politicians.

Naked short selling is illegal -- and yet it still continues to go on quite blatantly, and has for years, despite the efforts of some investors to call attention to this illegal activity.

Short selling, as most readers already know, involves selling a stock first and then buying it back later (the "buying back later" part is known as "covering"). But how can you sell it first and buy it later -- in other words, how can you sell something you don't own? (It should be pretty obvious that if you sell it first and buy it later, you didn't own it when you sold it).

The answer to that question is that you have to borrow the stock before you sell it, and then you return the stock later, when you buy some more shares at (what you hope will be) the lower price. 

Note that this fact of having to borrow the stock in order to short it already means that short-selling as a practice is inherently a short-term activity, because when you borrow anything you typically have to pay interest on the loan, which means that short-sellers do not tend to hold their positions for years and years, as long investors will sometimes do (at Taylor Frigon Capital, we sometimes hold our investments not just for years but for decades -- short sellers can never do that, due to the mechanics of the arrangement just described).

The practice of "naked" short selling, however (which is, as mentioned above but which we repeat for emphasis, illegal) means placing a short order without even borrowing the stock. When the time comes to "cover" and close out the position, the short seller gives an "IOU" instead of returning the stock. This practice, of giving an IOU instead of settling the trade with the stock itself, is known as "failure to deliver" and it is a term that is meant to cover delays in settlement due to various clerical or technical delays that might take place in an otherwise-functional market. Practitioners of naked short-selling, however, are taking advantage of this ability to give an IOU instead of settling the trade with actual stock in order to make even more money on their trades, because by deliberately shorting naked they can drive the stock price down even further using what are, essentially, counterfeit or non-existant shares.

The problem of naked short selling was highlighted in a 2007 special report which aired on Bloomberg TV entitled "Phantom Shares" and which you can still find on YouTube. This expose on naked shorting is well worth watching, especially this week which has exposed the fact that this problem has obviously not been dealt with, almost fourteen years after that program was first broadcast. Here are the links to part one, part two, and part three of that special report from 2007. 

There appears to be very little media focus thus far on implications of the fact that when the buyers from Wall Street Bets and elsewhere began piling into shares of GameStop (GME), the company's net short position was equivalent to 140% of the outstanding shares issued by the company!

Readers might ask themselves how it is possible for there to be a net short position of 140%, if short selling by its very nature requires the shorts to borrow the stock first before selling it. One would certainly expect that enterprising journalists in the media who are talking about the events of this week, and that concerned politicians who are also diving in with their opinions, would ask themselves the same question. How could anyone sell short more than the total number of shares outstanding?

Clearly, there is some naked shorting going on -- in fact, there's a whole lot of naked shorting going on.

If politicians and the media really want to address the problems that have been exposed by the crazy volatility in a few stocks over the past week, they should start with the problem of naked short selling, which is already illegal but which is obviously still extremely prevalent. They should ask how it is still taking place and who is enabling it to happen, and why the regulators seem unable (or unwilling) to put a stop to it. 

That would make a lot more sense than asking whether we need to put restrictions on bulletin boards such as Wall Street Bets, which are not illegal and are not at the heart of this problem. 

From there, instead of asking questions about whether Reddit boards should be restricted in some way, or whether investors should be prevented ("for their own protection," of course) from buying high-flying stocks, we might ask why we even allow any short selling to begin with, whether naked or not!

We know the standard defenses of the institution of shorting, which generally center around the two excuses that short sellers supposedly "add discipline" to the market and that short sellers supposedly "add liquidity," and in the past we ourselves have agreed with those arguments. But upon further reflection, both of those lines of argument appear extremely dubious. 

The argument that short sellers somehow add liquidity to the market has been exposed this week as being false. We saw stocks which were heavily shorted experiencing extreme volatility to such a degree that shorts could not cover and that new market entrants wanting to take a long position were shut down from doing so by brokerage firms such as Robinhood and TD Ameritrade (and a host of others who followed their lead). And in fact, extreme volatility and illiquidity always tend to go hand in hand, for reasons that should be fairly obvious when one takes the time to think about it.

As for the oft-repeated conventional wisdom that argues that short sellers discipline the management of a company, we say: the shareholders themselves can discipline the management by selling shares: those shareholders don't need to loan their shares to someone else to sell those shares for them! 

We've already seen that for good and cogent reasons, short sellers are by definition short-term in their focus, as opposed to actual long shareholders who may own shares in a company for years or even for decades. What a ridiculous proposition it is to argue that the short-term, short-selling hedge fund speculators are more insightful and more capable of "disciplining" a management team than the actual owners of the stock, owners who in some cases have been involved in that company for many years and who have an interest in the company's success, rather than in its failure.

The more we think about this subject, the more we come to the conclusion that short selling is a mechanism for financial speculation and that is all that it is, and that it does not offer any redeeming qualities to offset its detrimental effects. 

If people want to be short-term in their market activities, that's up to them -- but let them actually buy and sell the shares themselves, just as they would have to do with virtually any other asset. We don't think "house flipping" is necessarily a good idea, but if you want to purchase a house and then try to sell it again in a short period of time ("flipping" it), you generally have to actually buy the house before you sell it. Why should people be allowed to sell stock that they don't own (thus driving down its price in the process), unlike most other assets that people buy and sell?

The same can also be said of options contracts, which are also at the heart of this week's stock market events. Options contracts on stocks (puts and calls and the myriad combinations of puts and calls) are another financial instrument which have no redeeming purpose other than sheer financial speculation, and which are themselves basically a form of gambling. 

To elaborate on the house-flipping analogy, if Jane wants to buy a house one week and sell it a few weeks later, that doesn't strike us as a very good idea, but there doesn't seem to be a need to restrict people from doing it if they want to. However, that doesn't mean that we should let John and Jim start setting up side bets on whether Jane is going to be able to sell that house two weeks later for more money (in which case John will get a payout) or for less money than the original purchase price (in which case Jim will get a payout instead of John). 

This kind of "off-track betting" is exactly what options contracts represent, and there are sound reasons why off-track betting is illegal in many states. We would argue that options contracts can and should be done away with altogether and society as a whole (and the functioning of markets in particular) would not be any worse off for it -- in fact they would be much better off.

The capital markets perform a vital function in enabling access to capital by corporations which create real industry, real medical advances, real technological breakthroughs, real goods and services of all kinds. Short-selling and options trading represent betting and speculation at the expense of industry and business, and often to the detriment of those very industries and businesses. 

Politicians and journalists who have been looking at the events of the past week should in fact be investigating this very angle on the story, if they are actually interested in the public good. It is the mechanisms of out-of-control financial speculation, namely short-selling and options writing (to say nothing of naked short selling) which are the real story here, not the novelty of "Wall Street Bets" and the question of what "those pesky Millennials" and Gen Z kids are up to with their memes and their retail brokerage accounts.

This distinction is so important for investors to understand. There is a world of difference between short-term betting or speculation and the concept of connecting your investment capital with real companies that have promising business opportunities. 

Some pundits are using the events of the past week to try to tell you that "it's all a giant casino (and a rigged casino, at that)" -- and we agree with them to this extent: if you "play" the markets in a short-term, speculative manner, then that is a very accurate description of what you will experience.

But, as professional investors who have been involved in business analysis and portfolio management for many decades (long-only portfolio management, we might add), we take a different lesson from the events of this past week. We believe that this story is actually nothing new at all -- only the names have changed a bit. 

We have always argued that short-term speculation is dangerous and destructive of wealth, and that the only safe path involves staying diversified in a portfolio of real companies held for a period of years rather than weeks, days, minutes (or seconds!), and focusing on those companies from a business perspective, day-in and day-out, to continuously assess their long-term prospects.

The increase in betting and speculation by hedge funds, the rise in high-frequency trading and algorithmic trading strategies, and the use of new media outlets such as Twitter or Reddit only makes it more hazardous to try to pursue a short-term strategy, in our view (it's always been nearly impossible to have long-term success by following a short-term strategy, but now it's even more impossible).

We doubt you will hear too many pundits, or too many politicians, making these points. We also doubt that short selling and options contracts will ever be seriously restricted or even stopped altogether.  But in the meantime, we advise investors to clearly understand the very serious distinction between gambling, speculation, and investment -- and by understanding that distinction, they will realize which category we've seen demonstrated by the events of this week, and which category they should be focused on with their own capital investments.

* At the time of publication, the principals at Taylor Frigon Capital did not own securities issued by Gamestop (GME), TD Ameritrade (owned by Charles Schwab Corporation, SCHW), or Robinhood (private).

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