GameStop affair: when ordinary traders beat professional traders

One story recently dominated major financial media for about a week: that of followers of WallStreetBets, a community on the Reddit social media platform.

For those unfamiliar with the story, GameStop, a video game retailer that sells new and used games, has been singled out by professional short sellers as a business with a limited future. They felt that games are being sold more and more often online and that the distribution of games would follow suit, rendering GameStop's retail business obsolete.

It could have been the end of the story if one of the short sellers, Citron (lemon, in French) research, had not published an article outlining his thesis.

This article was picked up by WallStreet Bets (WSB), most of whose 5 million members belong to an age group that GameStop holds in high regard. They apparently objected to the idea of ​​professional investors trying to profit directly from the disappearance of a store, which many of them had regularly visited.

Their reaction was to start buying GameStop stocks and then stock options. Many WSB members also owned commission-free stock trading accounts and it didn't take long for GameStop's stock price to soar. The company's market capitalisation grew from a few hundred million dollars to over $12.9 billion in a matter of days.

A Korean hedge fund that had invested a few million dollars in GameStop's long position last March suddenly found itself with nine-figure profits it goes without saying that they cashed in.

However, the short sellers did not have the same luck, as Citron Research and Melvin Capital, GameStop's largest short sellers, had to scramble to hedge their positions.

This was no small feat, as they competed not only with WSB traders who bought GameStop, but also with options market makers, whose gamma covers dictated them to buy other GameStop stocks as well.

In addition, it turned out that the total short position on GameStop was 140% of the outstanding shares.

In short, this means that the market was "short" by more GameStop Corporation shares than there are physically.

This is due to a process known as remortgage, where the same parcel of stocks can be loaned or borrowed, to support multiple short positions in those stocks.

Like many other banking products, remortgage is based on the idea that customers don't want or need their money, or in this case stocks, all at once.

The practice and availability of securities borrowing is, of course, the mechanism that supports short selling via CFDs on shares or Contracts for Differences if they are hedged in the market and not just B-booked by the CFD provider.

There is a cost to borrowing and lending stocks, and the greater the demand, the higher the costs. In the case of GameStop, those fees recently reached 323%.

The securities lending industry newspaper, the Securities Finance Times, considers a stock popular if its borrowing costs exceed 4.9%.

Melvin Capital and Citron were able to close their short positions on GameStop, but at a cost. The finances of hedge fund Melvin Capital had to be bailed out with a $2.75 billion capital injection from Steve Cohen's Point 72 and Ken Griffin's Citadel.

But the fallout does not end there, as brokers and their counterparties as well as service providers have also been directly affected. Margins or collateral requirements on options and physical stocks positions on GameStop and a host of other stocks, which WSB members and day traders subsequently targeted, have also increased. Up to 100% of the value of open positions.

It's not that unusual, but it can be problematic for a broker and their balance sheet when collateral requirements run into the billions of dollars.

As a result, popular trading platforms such as Trading 212, Robinhood, TD Ameritrade and others have been forced to block the trading of GameStop stocks, and other similar securities. Meanwhile, Bloomberg reported that Robinhood was drawing on lines of credit it held with its bankers, presumably to consolidate its own liquidity.