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Lost Investment Opportunities, out of Pocket Losses, Market Manipulation, Or Disgorgement of Cost Savings?

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Lost Investment Opportunities, out of Pocket Losses, Market Manipulation, Or Disgorgement of Cost Savings? WHITE PAPER SHORT SQUEEZE& OPEN TRADING DAMAGES Lost Investment Opportunities, Out of Pocket Losses, Market Manipulation, or Disgorgement of Cost Savings? PREPARED BY JULLAVUT KITTIAKARASAKUN, PH.D, SEAN T. MALONE, PH.D. & MAURICIO VIDAURRE, M.S. SHORT SQUEEZE TRADING DAMAGES ConContents- tents 1 Introduction 1 Recounting the Events Leading to Litigation 5 Difficulties Measuring Damages 5 Alternative Methods to Estimate Damages 10 Conclusion 11 About Us The authors would like to extend their gratitude to Dr. John Wald for his valuable comments and insights on this paper. 01 | ANALYTIC FOCUS, LLC WHITE PAPER Introduction The stock market suffered more than ordinary tumult on January 28, 2021, due to the endeavors of several entities engaging in trading. These players include retail investors, broker-dealers, clearing houses, and investment funds. Each of these had their own set of incentives and were affected in different ways. This paper lays out what happened leading up to and on January 28 from the perspectives of these disparate groups. Some or all of these stakeholders experienced losses. Naturally, the stakeholders want to recover those losses and have filed lawsuits that are in their nascent stages. The problem for parties embroiled in this litigation is understanding what happened and how this may lead to damages. After a summary of what happened, this paper addresses the process of measuring damages. The process suggested here builds on the impacts potentially experienced by each stakeholder. Recounting the Events Leading to Litigation Consider Melvin Capital, a hedge fund, which has held a short position in GameStop stock since 2014. This fund believes that selling video games in physical stores is being overtaken by digital delivery. For this reason, it believes the share price of GameStop is higher than it should be. By maintaining a short position, a decrease in the stock price will create positive returns for Melvin Capital’s investors. One way to have a short exposure to GameStop is to sell borrowed shares. To open a short stock position, one borrows shares of a stock and sells them to another investor. This creates an obligation to return the borrowed shares. If the short seller is correct in their anticipation and the price of the stock falls, they can buy shares from the market at a lower price than the price for which they sold them. The difference between the sale and purchase price is a measure of their profit. But, if the price of the stock SHORT SQUEEZE TRADING DAMAGES | 02 increases, the value of their obligation to return the borrowed shares increases. At some point, the short seller must close the position. They must buy the shares from the market and return the borrowed shares to the rightful owner, even if they must pay a higher price. This highlights a key difference between a short stock position and a long position (buying a share of stock). Short positions receive a credit when opening, but create an obligation of an uncertain value in the future. To make sure the trader has enough cash to meet the obligation, they must post “margin”. If the price of the stock being shorted rises, the trader may be subject to a margin call. A margin call requires the trader to deposit more funds to maintain the position. A dramatic price increase likely will create liquidity problems for the trader. This could force them to exit other investments or to cover their short position at a loss. If there is a very large aggregate short position, where many or all short sellers face this possibility, a “short squeeze” may occur. When a large concentration of traders is shorting a stock, an increase in stock price can trigger a feedback loop to the detriment of all the short sellers. As some short sellers buy shares to cover their position and to prevent further losses (or as lent shares are recalled), they add to the demand for the stock. This places more upward pressure on the price. As the price continues to increase, more short sellers may follow suit as losses and strains on liquidity grow larger. A spiral of losses is created. Savvy retail investors on social media noted the possibility for short squeezes in several stocks. Some discussions by these commentators focused on a more fundamental bullish outlook for GameStop. Other discussions focused on sparking a short squeeze and benefitting from its impact. Many investors use Robinhood as their broker- dealer. Just after 5:00am ET on January 28, Robinhood received its daily collateral notice from NSCC (National 03 | ANALYTIC FOCUS, LLC WHITE PAPER Securities Clearing Corp). The NSCC is a subsidiary of the DTCC (Depository Trust and Clearing Corp) and serves as a central counterparty for equity trading. The purpose of a central counterparty is to reduce counterparty risk. Counterparty risk is the risk that a party on the other side of the stock trade will not deliver the securities or cash as agreed on the settlement date. To guarantee that each party (two brokers) will deliver the securities and cash on the settlement date, the central clearing party requires its members to post collateral. Since the settlement date for equities in the U.S. is on a t+2 convention (trades settle two business days after the trade date), the value of the securities due at settlement is uncertain as their value can fluctuate. Thus, the collateral requirements for net unsettled positions is largely based on the security's price volatility. The price for GameStop and other highly shorted stocks had been extremely volatile during the week leading up to January 28, justifying unprecedented deposit requirements from the NSCC. Beyond the charge based on volatility, Robinhood’s notice also included a $2.2 billion excessive capital premium charge. NSCC levies these charges when brokerages have deposit requirements greater than their excess net capital. While NSCC later decided to waive the entire capital premium charge for all clearing members, Robinhood chose to place restrictions on purchases of several stocks. These restrictions would limit their unsettled positions in the stocks that were driving the extreme deposit requirements. Robinhood has since announced it has raised at least $3.4 billion to ensure that it can meet its deposit requirements in the future and avoid placing trading restrictions on its customers. Robinhood was not the only broker-dealer who restricted trading on January 28. Other broker-dealers also had increasing deposit requirements. The NSCC aggregate collateral requirements increased by $7.5 SHORT SQUEEZE TRADING DAMAGES | 04 billion from January 27 to January 28.1 This would include increases for Robinhood as well as other broker-dealers named in short squeeze litigation such as TD Ameritrade, Ally, Charles Schwab, and others. These restrictions took the customers of the brokerages by surprise. Those who believed the short squeeze thesis and wanted to purchase stock or call options could not. The skyrocketing prices only confirmed the beliefs of those who had already purchased shares. Many wished to buy more shares and more options. But, the brokers prevented them accessing the market for these transactions. From the traders' perspective, the brokerages held them back from profitable trading opportunities. The restrictions on purchasing placed by these brokers also gave a special opportunity to short sellers. The anger and confusion of retail investors unable to buy restricted securities was highly publicized. Short sellers, already suffering from the increased prices, knew more demand existed for these stocks. However, brokerages placing trading restrictions were preventing this demand from entering the market. This allowed short sellers an opportunity to cover their positions at prices favorable to those if the restrictions had not existed. Some of these short sellers (or those with investment interests in them) include large hedge funds like Citadel, Point72, and Melvin Capital.2 Perceived potential relationships between hedge funds that would benefit from suppressed prices and these brokers have stoked theories of conspiracy. For example, the hedge fund company of Citadel and Citadel Securities both share the same founder and majority shareholder, Ken Griffin. Robinhood Financial LLC receives payment from Citadel Securities for routing their order flow to them. This practice, known as payment for order flow, is key to Robinhood's business model and allows it to provide commission- free trades. The conspiracy theories allege brokerages placed restrictions on trading to suppress prices to protect short sellers at the expense of their customers. [1] See the February 18 statement of Michael Bodson (DTCC) to the House Financial Services Committee and Bloomberg News on January 29. [2] Melvin Capital claimed it closed its short positions on GameStop Corp. by January 27 (see Bloomberg News on 1/27). However, since short stock positions are not publicly disclosed, discovery will need to verify the short exposure of Melvin Capital and other funds at the time trading was restricted. 05 | ANALYTIC FOCUS, LLC WHITE PAPER Difficulties Measuring Damages Many retail investors who owned the restricted securities, and others who wished to purchase shares or call options, may have been damaged by these restrictions. There are several obvious difficulties in estimating damages for these two groups based on lost trading opportunities. First, while data from brokerages will identify owners of the restricted securities, an expert could not use this data to identify those who wished to purchase them but were unable to do so. Second, one would need to determine how many shares/ options each trader would have purchased (and at what times) in the absence of trading restrictions. Third, a damages expert also would need to estimate the prices the traders would have been willing to sell their shares for, if retail investors had been allowed to purchase them.
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