Lessons from Gamestop
Business Standard, 8 February 2021
The `short squeeze' on Gamestop has got everyone thinking. Short squeezes are an old problem, they hamper short selling, and constitute one element of "market abuse". Financial markets regulation involves enforcing against short squeezes. What is new about the Gamestop situation is that an amorphous mob has done the short squeeze, which challenges traditional notions of enforcement. In India, short selling through the spot market is largely infeasible, but there is now a small threat on the equity derivatives market. Enforcing against short squeezes should be a first milestone of developing capability in enforcing against market abuse.
If a speculator believes a share price will go up, she buys shares. What about the opposite situation? When she forecasts that the share price will go down, she'd like to sell shares. But she might not own them. Selling shares is then done using borrowed shares. This requires the ability to borrow shares, and payment of a rental fee to the lender of shares.
If things go right, the short seller earns Rs.100 by selling shares, the price goes down to Rs.50, now she buys shares for Rs.50 from the market to return them to the lender, to make a profit of Rs.49 after paying a fee of Rs.1 to the lender. Of course, there is no guarantee that things will go right. After the shares are sold, there can be difficulty in finding a person to borrow shares from. The share price can go up, in which case the short seller has to go back to the market and buy back the shares at a higher price, in order to return them.
Short sellers improve market efficiency. The essence of financial trading is that a large number of people watch each security, forecast the future, and buy or sell based on their speculative views. Through this process, information about the security gets impounded into the price. For trading to work well, we need a large number of speculators who are equally able to buy or sell, based on their views. When we look at many weird situations with high share prices in the past (outside India), short sellers were key to restoring efficiency.
There is one mechanism of market abuse that involves harming short sellers. This is called a "short squeeze". A manipulative cartel sees that many people are short selling a stock. They try to grab all available shares, so as to make borrowing difficult and also to force the price to go up which will force some short sellers to give up and buy shares. When a short squeeze takes place, this generates a large non-fundamental increase in the share price, which benefits the manipulative cartel and harms the short sellers. Securities regulators worldwide enforce against short squeezes, as:
- The activity of pulling off a short squeeze generates a large non-fundamental increase in the share price, and
- To achieve market efficiency, we must foster all kinds of expression, whether it is optimism or pessimism.
The Gamestop short squeeze
In January, in the US, there was a short squeeze on the shares of a company called Gamestop. This caused the price to rise 30-fold, and imposed large losses on the short sellers. This was a novel situation in that numerous small traders, rather than a narrow cartel, pulled off the manipulation by coordinating their actions through an Internet website. Conventional methods of securities law enforcement are ill-equipped to investigate and prosecute a conspiracy by thousands of people. For an analogy, a police that knows how to investigate and prosecute when faced with one burglary at a time is not readily able to process a mob of thousands of people attacking shops on a road.
Some people are fascinated by the new power of little people. While it is true that in the past, a short squeeze could only be organised by a few rich people, this does not change the fact that a short squeeze constitutes market abuse.
Short squeezes in India
Turning to India, we face a more primitive landscape. It is very hard to borrow shares or bonds, therefore short selling is infeasible. We are all required to be optimistic or silent; expressing negative views through short selling is mostly not possible. Expressing negative views is only possible for the 140 companies where there is derivatives trading.
With derivatives trading, back in the late 1990s, it was understood that if derivatives have physical settlement (i.e. involving delivery of shares) there is the danger of a short squeeze. Hence, derivatives trading was all based on cash settlement. This institutional memory was lost in the recent years, and SEBI forced exchanges to shift to physical settlement. The dangers of short squeezes are thus prevalent to some extent on these securities.
Financial market regulation is at a nascent stage in India; relatively little is known about market abuse. The present state of law, regulation and enforcement practices against market abuse is confused, unpredictable and confers arbitrary power to officials. This is an important element of the agenda in building state capacity in financial market regulation.
The path through which state capacity is built lies in understanding one mechanism of market abuse at a time, and building capabilities covering it. A good place to start would be the short squeeze, which is actually reasonably easy in terms of the enforcement challenge. The required work program would run through the following steps:
- Build knowledge and datasets on short squeezes,
- Draft a regulation which enforces against it, through a consultative process,
- Draft a process manual for investigation of a short squeeze,
- Train regulatory staff in this process manual,
- Draft a process manual for prosecution against a short squeeze,
- Train regulatory staff on this manual, and
- Train the quasi-judicial staff on short squeezes and on these manuals.
Through this process, a regulator would achieve state capacity against one specific offence in the overall problem of market abuse. This work program might take about four years, after which a similar work program on a second offence such as "pump and dump schemes" can commence. This is the path, of obtaining mastery over one specific mechanism in market abuse after another, through which state capacity for combating market abuse can be constructed.
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