Reader Question:
Do you think regulators should make any reforms to prevent future instances of the GameStop saga (and do you think they actually will)?
I am usually a proponent of simple regulatory reforms that a majority of rational market participants would support. Before relating this to GameStop, let’s rewind back to the Great Recession more than a decade ago. As was explained beautifully in The Big Short, one of the biggest problems with the mortgage crisis was the pervasive use of credit default swaps, which is just a fancy type of “insurance for creditors.”
Having a way to hedge your investment is not inherently bad. The problem with CDS is that there were no limits on who could buy it and how much they could buy. Imagine Company A has $10 billion of debt on their books and the holders of that debt want to hedge against a bankruptcy filing. It is logical that regulators would allow insurance to be purchased on that debt, but the maximum insured amount should really only be $10 billion. The situation gets very dicey when anyone can buy this insurance (even those who don’t hold the debt) and they can do so in any amount another party is willing to write for them (e.g. $100 billion of insurance on a $10 billion bond).
If the debt becomes worthless, in this example, whereas the economic loss should have been limited to $10 billion, instead the markets have to absorb $110 billion of losses. So a manageable problem becomes a major calamity in short order, and can bring down an entire market.
So how does this relate to GameStop? Well, it has been widely reported that the short interest in GME stock at one point was ~140% of the public outstanding float. How on earth can more than 100% of a stock be borrowed and sold short? Well, because the short selling rules, much like the CDS rules, don’t place any limits on how many times the same share of stock can be lent out and sold.
Therefore, if I lend 1 share of GME to a short seller, they go out and sell it to someone else. The new long holder of my share doesn’t know if their share was lent out or not, they just know they are long one share. And they are allowed to lend that same share out to another short seller, who takes it and sells it to someone else. In this case, we are dealing with 1 share of actual stock that gets lent out twice. 3 people are long 1 share and 2 people are short 1 share, which nets out to 1 long share. but the short interest (2 shares shorted) is equal to 200% of the float (the original single share owned).
Just as limiting the use of CDS contracts to the principal amount of the debt being hedged, and to only those who actually own the debt itself, would be considered a logical, fair, and reasonable regulation (no, such a rule does not exist post-mortgage crisis… CDS operate exactly the same as before), we can easily argue that short selling should be limited in some way. How about only allowing each share of outstanding stock to be lent out one time, thereby eliminating the chance that the short interest ever rises above 100%?
Do I think such regulations will be enacted? No. These issues have a way of disappearing quickly enough that people are let off the hook for making sound reforms. In the case of the current GameStop situation, hedge funds will pull back on their shorts enough that extreme cases like this do not reoccur, and the regulators will likely punt on reforms again. Heck, GME is already trading sub-$50 per share.
Author’s note: Theoretically, a short interest above 100% is not actually accurate, even in cases like the one described above. In that example, there are 3 longs and 2 shorts, so the actual percentage of shorted shares is 67% (2/3). When viewed this way, continuous lending and shorting of the same share would result in a short interest approaching, but never exceeding 100%. There is an insightful article discussing this on the ShortSight web site.
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