Defending the short sellers: GameStop saga is more than a battle between good and evil

There has been a tendency to see the GameStop confrontation between chatroom-inspired retail traders and hedge funds in “white hat versus black hat” terms, with the little guys triumphing over their predatory opponents amid widespread and enthusiastic applause.

The view that retail investors – or buyers of shares more broadly – are good and hedge funds, particularly short-sellers, are evil is, however, misconceived. It creates an apparent moral dimension to trading in the market where most of the time there is none.

GameStop day traders have been galvanised by a moral crusade. Credit: AP

Absent “pump and dump” schemes on the buy side (which could be a strand in the GameStop story), or the spreading of malicious misinformation on the sell side, the activities of short sellers are simply the mirror image of what happens when investors take out a long position. There’s nothing nefarious in either type of trading.

It is one of the many ironies of what’s transpired in the market for GameStop’s shares that the retail investors who poured out of the Reddit chatrooms and drove the shares up from under $US20 to nearly $US350 couldn’t have done it without the hedge funds.

Another is that, in doing so, they have created one of the most obvious shorts of all time, except that the hedge funds, having lost about $US20 billion on their GameStop positions and seen the cost of borrowing stock to cover a short position blow out from about 30 per cent to 80 per cent, are probably in no position or mindset to take the Reddit crew on again.

The reason GameStop is such an obvious opportunity is that its market value is so obviously out of kilter with any realistic conventional valuation and that, as the retail investors start to try to cash out their extraordinary profits, there will be only very limited buying support at the still-inflated levels.

GameStop shares crashed from $US325 last Friday to $US225 on Monday but are still way above the $US40 or so levels at which they traded before the short squeeze rally got under way last week.

Viewing short sellers as predators, while a popular opinion, mischaracterises them.

Conventional investors buy shares that they think will continue to increase in value or sell those they think are fully valued, or over-valued. Short sellers essentially sell shares that they think are over-valued but, unlike conventional sellers, retain an exposure to the shares and therefore profit the further the shares fall.

Some basics. For a “covered short” the trader borrows the stock from a shareholder and then sells it after contracting to return it (which means having to buy the same amount of stock at some point in future). The lender of the shares gets a fee for making the stock available.

Existing investors and aspiring buyers aren’t motivated to look for fraud, overvaluation or flawed strategies. Short sellers are.

While some query why an investor would facilitate a transaction that essentially allows the other party to bet against them, lending stock generates extra income for investors who self-evidently believe the short sellers’ opinion is wrong.

“Naked” shorts - contracting to sell shares that the seller doesn’t own and hasn’t borrowed - are supposedly illegal in most jurisdictions (including Australia), partly because of the risk of transactions being unable to settle, but can still occur.

Indeed, with the short positions in GameStop peaking at 140 per cent of the available float, it appears there was significant naked shorting.

It is conceivable that the same shares were unwittingly borrowed more than once – the short-seller borrowed the shares from a conventional investor and sold them to a buyer who immediately on-lent them – and it is also conceivable that there were “synthetic shorts” in the GameStop market created via options trading.

The extent of the shorting magnified and facilitated the squeeze because hedge funds generally have risk models, and risk appetites, that would have forced them to start covering their positions by buying shares as GameStop shares soared and their paper losses mounted.

The sheer scale of the retail investor buying made the exits from the short positions excruciatingly expensive and painful.

Overall the hedge fund are estimated to have lost just under $US20 billion ($26.2 billion), with the fund with the biggest position in GameStop, Melvin Capital, seeing more than half the value of its assets wiped out. It needed a $US2.75 billion bailout from other institutions to stabilise its finances.

Those sorts of losses for short sellers aren’t aberrational. Last year, despite an estimated $US343 billion of profits in March as the pandemic sent sharemarkets reeling, hedge funds are estimated to have lost nearly $US250 billion in aggregate over the entire year as the markets bounced back and kept rising. The sharemarket boom/bubble has been difficult and unrewarding for short-sellers.

The sharemarket boom/bubble has been difficult and unrewarding for short-sellers.Credit: Richard Drew

It’s not clear why the funds have become so controversial, other than that conventional investors buy shares with the conviction that they will rise in value and therefore regard short sellers – investors with the opposite conviction – as opponents who are out to destroy their wealth.

The funds add liquidity to the markets and aid price discovery. Activist funds – those who not only take short positions but broadcast their reasons for doing so – might be particularly controversial but have also demonstrated their ability to identify outright fraud and other misbehaviours.

It was short sellers who unmasked Enron’s industrial-scale frauds, and more recently Wirecard’s. It was an activist fund, Glaucus, that brought down forestry group Quintis and another group of short sellers who identified the flaws in the accounts, business model and valuation of a UK professional services firm that Slater and Gordon acquired that saw the Australian law firm effectively collapse.

Existing investors and aspiring buyers aren’t motivated to look for fraud, overvaluation or flawed strategies. Short sellers are.

In the absence of market manipulation – the spreading of false information, for instance – there is nothing sinister about short-selling per se.

Indeed, in the GameStop situation, there is a far greater likelihood that the market was manipulated via a “pump and dump” scheme or a concerted effort to drive the share price into the stratosphere within the chat rooms than some (clearly very unsuccessful) strategy by hedge funds to drive down the price.

The success of the chatroom strategy, and their losses, will discipline hedge funds as the new and emboldened “flash mobs” of retail investors search the market for new targets they can put the squeeze on.

The costs of borrowing stock and the funding of short positions will rise in line with the increased risks and it won’t surprise if there is a push by regulators to put ceilings on the proportion of companies’ free floats that can be shorted (and to require brokers to hold more capital) to try to avoid the threat to the stability of brokerages, clearing houses and market integrity that the GameStop short-squeeze and the likelihood of copycat confrontations pose.

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