The Big Squeeze
Image: Tontine Coffee, House Francis Guy, c. 1797
Soundtrack: The Tendieman has Come - WSB
Watch: Betting On Zero (2016), The Big Short (2015)
Tracker: http://isthesqueezesquoze.com/
The news cycle this week has been ablaze with Reddit's Wall Street Bets putting a short squeeze on a few Hedge Funds including Melvin Capital.
Former SEC Commissioner Laura Unger compared the short squeeze to the Capitol Hill Riots, saying that “If you don't have the police in there at the right time, Things go a little crazy. And that's what kind of feels like what's happening with this much lesser degree. It's financial harm...” While Bloomberg News headlined by calling it “A Stock Market Insurrection”
Accusations flying about the foul play from every pundit with potentially an SEC investigation into "abusive activity”; So let’s put this into a little context to understand what happened.
The Casino
In 1791, as New York started to hold daily public auctions of federal government debt, dealers started to agree to "self-governance" rules in attempts to form cartels. In addition to limiting trade with outsiders, to limit fraud, rules were created to preventing self-dealing and required that stocks numbered or "fairly and distinctly described".
These efforts would fail among the Panic of 1792, where a run on the newly formed Bank of the United States was triggered by one cartel of bankers attempting to use large loans, while self-issuing credit, to seize control of enough Bonds that could effectively edge out the Bank of the United States. Treasury Secretary Alexander Hamilton managed to stabilize the market by basically offering to secure and bailout the Bank of New York.
Down the street from where Washington was inaugurated, on May 17th, 1792, twenty-four very wealthy men concerned about the negative impacts of market competition formed the Buttonwood Agreement; To only trade with each other and settle on a common 0.25% commission. This thereby cut out the more traditional auctioneering and established these brokers as the [ trade association | cartel ] that would grow into the modern-day NYSE.
Now that they had captured a large portion of the market power, the next step was to collect rent on the externalities; So with an initial raise of [ £40,600 (1792) | £6,080,615 (2021) | $8,338,043 (2021) ], they built the Tontine Coffee House. It would serve as the heart of the market while working to push out Hamilton's Federalist traders who operated across the street at The Merchants’ Coffee House [1787–88].
When ships arrived in the New York Harbor, the captain would first register their cargo at the Coffee House. It was said to be a place filled with bankers, underwriters, traders, politicians, and people of all "social strata" meeting to trade and engage in civics; However, don't let the words of English travelers distract, the things traded were slaves or often the things slavery produced, like coffee; The first securities were War Bonds.
This Invite-only membership of Buttonwood would remain pretty small and had to be approved by secret ballet whereas any three nays would blackball you.
In 1817, the Buttonwood Cartel reformed as the New York Stock and Exchange Board adding the additional constraint that "have been in the business for the term of one or more years, either as a Broker or an apprentice", this was almost immediately raised to two years.
In April, after only a month, a bylaw was added to fine "any member leaving the room during the calling of Stocks", ensuring that all members could profit from pricing information equally.
Later that year this was expanded to "Resolve that no member of this Board, nor any partner of a member, shall hereafter give prices of any kind of Stock, Exchange or Specie, to any Printer for Publication" These prices would then be asymmetrically traded on until the secretary would print in the newspaper "to furnish the prices of Stock but once a week to one price current only at his discretion".
The game was a balancing act of privately setting the price, then front running that information, before authoritatively publishing it in the papers to ensure that it became true. This process is slightly more refined today with the advent of such fine institutional establishments as CNBC's Mad Money.
In 1820, with a membership of now 39 persons, an [$25 (1820) | $556.57 (2021)] initiation fee was added, along with rules to suspend any member who becomes insolvent or otherwise failed to comply with their contracts.
Should any client of these brokers refuse to pay a commission or outside broker not adhere to the rules, their names would be recorded by the Secretary in "the Black Book", barring anyone from transacting with them "under pain of immediate suspension".
This power allowed the Board to enforce [ "time bargains" | futures contracts ] despite them being intentionally nullified and rendered unenforceable in New York courts after the 1792 panic. Effectively leveraging into a local monopoly on trading futures.
While the power of the board was increasing, It was not uncommon for people to assemble at the corner of Wall and Hanover and trade in the open air at approximately three times the volume trade within, but the board effectively set the prices nonetheless; This influence was then spread with the advent of the telegraph.
New York's senate passed a bill in 1836 that was intended to make board meetings public. The Board fired back arguing that if they did try to regulate the Exchange, they would simply move to Philadelphia; Past that there are no reasons to make these meetings public, as it's totally normal for a business to meet in private, while contending that there was no fraud, and thus no reason to open up. In fact, in the boards' view, without state-supported futures contracts, they were already overly regulated.
In the background of this debate, the banks of New York had started to offer "call loans" to [ traders | gamblers ], built upon the stored savings of farmers between the autumn harvest and the spring sewing.
Leading into the Panic of 1837, stock prices would seasonally swing based on this injection and reclamation of this capital. When the stock prices crashed in 1792, while certainly risking the current hegemony, it did not mirror broader economic trends, this period of "unbounded speculation" was notably different as the economy dived into a national depression that lasted for years.
Despite a 17% decrease in the cost of living between 1820 and 1848, the membership fees would continue to be raised to [$400 (1848) | $13,188.56 (2021) ] as the board grew to a "very exclusive in character" 75 members.
Broker Henry Clews in his autobiography recalled how speculators would pay [$100 (1850) | $3,339.41 (2021)] for the "privilege of listening at the keyhole during calls". In 1857 Clews was an outsider, and while he could easily continue to profit from following the cartel's 0.25% commission structure, he aimed higher, and needed leverage to get there.
I at once inserted an advertisement in the newspaper and proposed to buy and sell stocks at a sixteenth of one percent. each way. This was such a bombshell in the camp of these old fogies that they were almost paralyzed. What rendered it more distasteful to them was still was the fact that, while they lost customers, I steadily gained them
That would be enough for Clews to secure himself a seat at the table; While not the British Minister his father educated him for, he would find himself swapping letters with President Lincoln and Secretary Chase all the same.
In 1858, the NYSE was now the largest exchange in the country, and thereby referentially controlled pricing nationwide. This power would successfully lobby for New York to reinstate futures contracts but by then the NYSE had already developed their own miniature "self-regulating" legal system into the age of Robber Barons.
The term Robber Baron comes from Raubritter who were medieval lords who, under the Roman Empire, charged illegal tolls for crossing the land they controlled.
When NYSE transation to be a public company in March 2006, the now 1,366 seats were worth approximately [ $5,500,000 (2006) | $7,106,185.52 (2021) ] each.
The Table
In response to the Market Crash of 1929, Roosevelt had the mandate to bring Securities under federal control. So as part of the New Deal, in 1933, Congress would pass the "Truth in Securities" act as the opening shot in the war on securities fraud.
This mainly hit primary markets like the NYSE, by standardizing the requirements for registration and shareholder disclosures.
This was then followed with the Securities Exchange Act of 1934, establishing the SEC and regulating the secondary markets, which are facilitated by Dealer-Brokers who essentially monetize their access to the Brokers of primary markets.
Amidst the Great Depression, in 1937, with the leverage of massive unemployment, the finance class, in protest with the New Deal's undistributed profit tax, decided to engage in a Capital Stike by freezing both spending and hiring until Congress passed the Maloney Act in 1938. They starved a country and blamed it on the new order.
This amendment to the Securities Exchange Act carved out room for the creation of the self-regulatory organization (SRO) under the SEC. This would become the National Association of Securities Dealers (NASD), the predecessor of the Financial Industry Regulatory Authority (FINRA) that we see today.
Traditionally Retail Dealer-Brokers would collect a commission on each trade extending the platform created by Buttonwood Cartel, into the NYSE's market; But to fulfill these orders they could trade with any larger institutional fund that was able to take the deal.
Among the deregulation wave of the 80s and 90s combined with the latest technology, Bernard Madoff Investment Securities would start to operate as a Market-Maker.
The pitch was that they could offer [ retail ] investors a better deal by cutting out NYSE and matching trades on their own computers, then making their toll on the spread between the bid and ask prices; This thereby creating a "third market", and NASDAQ.
Then in order to capture more of the market, profits would be applied as "Payment for Order Flow" "remuneration" towards the brokers who sent the mostly retail traffic his way; This allowed Madoff's firm to siphon roughly 10% of NYSE's volume into his own market.
...It was the SEC's decision in the 1990s not to take a stand on the controversial issue of "payment for order flow" that helped fuel the rise of Bernard Madoff Investment Securities, the successful broker-dealer operation two floors above Mr Madoff's private fund operation in Manhattan.
In 1990, the NASD empanelled a group of experts to study the subject. The committee was headed by former SEC chairman David Ruder, and included Mr Madoff. The so-called "Ruder committee" delivered a report in July 1991 dubbed, "Inducements for Order Flow". The report found no legal basis for restricting the practice of payment for order flow, but recommended that the NASD require its members to disclose in advance the "factors that influence their order-routing and execution decisions".
While this style of rebate could be seen as a natural conflict of interest, denoted by firms in the late 90s routing retail investors' orders in unfavorable ways, effectively stealing from their clients, it was allowed to continue under disclosure.
It's been suggested that the SEC felt that a little market competition would be good for the market of monopolies, pulling power away from the now somewhat regulated NYSE. Unfortunately for Gates, the DOJ did not feel similarly about such rebate schemes.
After decades of normalization of Payment for Order Flow would become a channel for High-Frequency Trading Firms to basically buy [ retail | disadvantaged ] orders and bundle them against orders from institutional accounts.
While Madoff originally structured the profit as the take between public spreads, with the creation of "third markets", unlisted or "dark pools" could then be connected allowing HFT firms to mirror the Buttonwood Cartel's closed-door pricing leverage into a modern real-time practice call Latency Arbitrage, while then also gaining valuable data on retail order sentiment for front running in public markets.
Robinhood, with a product strategy competing with likes Juul and Fortnite, would be created through this system of Payment for Order Flow to feed these retail orders into several different HFT/Market-Makers that per SEC findings in December, that favor the highest bidder.
As the SEC’s order finds, one of Robinhood’s selling points to customers was that trading was “commission free,” but ...orders were executed at prices that were inferior to other brokers’ prices...The order finds that Robinhood provided inferior trade prices that in aggregate deprived customers of $34.1 million even after taking into account the savings from not paying a commission.
The majority of Robinhood's Order Flow is serviced to Citadel Securities LLC, along with others, helping to feed a growing now 40% of trade volume done outside of public exchanges with execution against dark pools.
The Hand
With the shorting of the American Dream of 2008, still fresh in everyone's memory people on Reddit's Wall Street Bets started to notice in September that stocks like GameStop were being heavily shorted, despite having solid cashflow fundamentals.
Wall Street had simply decided, in much the same way that Sears was liquated, that GameStop time had come to an end; However, after years of sitting on his hands, Activist Investor Ryan Cohen, the founder of Chewy, decided to move long into GameStop effectively taking the other side of the bet.
In a Long, where you buy the stock, the most money you can lose is the amount you spent; whereas with a short, the sky is the limit.
To bet against a company, you Short the stock, which is a process of basically renting the stock from someone who owns it, then selling it back to the market. When it comes time to close the position, you have to repurchase the stock at market price and return it. The spread is your profit or loss.
A naked short is a short created without first buying the share to sell; This is generally illegal but appears to be largely unenforced, partly because shorts allow a share to be effectively sold and thus bought again multiple times. This loop makes it possible to short more shares than even exist, let alone available.
To maintain a short, cash must be provided as collateral to cover the margin. As the price of a stock goes up, a margin call is triggered, and either you need to increase your collateral or settle the account.
This makes bubbles almost impossible for anyone but a King to time, as your position can be completely wiped out moments before the fall; and why maintaining a short position very quickly can cost billions; But if you do, it’s a very quick way to seize a lot of money.
Normally a market will short around 20% of the shares, if that; but as these numbers grow the shares can become squeezed by the trading volume, or liquidly, of available shares.
In September, it was noted that GameStop (GME) was shorted to 86% of all shares, with an adjusted float suggesting that 112.3% of liquid shares had been shorted; By January this was pushed as high at 140%.
The Call
On January 11th, Activist Investor Ryan Cohen used the shares he acquired over the last year to place himself and two others on GameStop's Board. This would cause a mass return to public speculation on Reddit and YouTube about the protentional to short squeeze given the renewed confidence in the company.
This would be enough to start to light the fuse as Wall Street Bets started to buy into the position, feeding more growth and news, escalating in a flow-on effect.
As the price continued to climb into the fourth week of January, the exposed hedge funds are then required to ante up more collateral to maintain or close the position.
Without much of a choice Melvin Capital Management, as the most exposed Hedge Fund, raised $2.75 Billion from Citadel LLC and Point72 Asset Management to stabilize the fund while joining others in liquidating their other positions. It should be noted that Citadel LLC is a different company Citadel Securities LLC, started by the same Ken Griffin.
At the same time, as more retail investors continued to join buying shares and option calls, brokers would temporarily halt access to the market at various points in time.
Robinhood allows you to immediately start trading, moving cash around between banks and the casino is done via the ACH network and Depository Trust & Clearing Corporation (DTCC), which takes what is known as T-2, Transaction Date + 2 days, to settle. This caused Robinhood to draw on lines of credit in an attempt to stay in the money printing game.
The amount of cash required to handle these orders is determined by in part regulatory oversight, including Dodd-Frank, but mostly by self-regulated by DTCC, and includes volatility math for handling the fact that shares can crash during the two days.
Typically the collateral is between 1-3% until settlement, but sometimes can be as high as 10%. As transactions float back and forth, settlements between the clearing firm are handled on a net cash basis.
In the middle of trading, DTCC exercised their Margin Liquidity Adjustment Charge clause to adjust the collateral requirement to 100% for the heavily shorted stocks that WSB was going after. Which then effectively made it impossible for retail brokers to front the capital requirements to trade on the shortlisted stocks.
At best retail brokers could have cannibalized the rest of their business by locking up all of their cash into GME until they seized. Hundreds of Billions of Dollars flowed through GME, whereas Robinhood’s total assets are only $20 billion; Traditionally retail makes up maybe 10% of total volume, though coronavirus has shifted that a bit.
As money flows through the system, each party is responsible for underwriting or carrying the risk that they touch. Melvin Capital's meltdown exposed the system to counterparty risk, and it was becoming increasingly likely that Melvin would be insolvent as prices continued to climb. So while they could potentially buy the shares to settle their position, they were losing the ability to actually settle those shares.
The DTCC to protect the system from a Lehman Brothers-style cascade raised the capital requirements to effectively contain damage in case Melvin become insolvent; But the lever they did this with also effectively cut the pipes for the retail investors whose brokers were not capitalized enough to meet the requirements, thereby also reducing Melvin's exposure by preventing further retail cashflow into GameStop.
The Score
At the time of writing, Melvin Capital is reportedly out from under the shorts; with most of the other hedges exiting as well. It’s not clear how, but if I had to guess I would point at the “third markets” and the dark pools. There is a lot of speculation, but the truth is anyone’s bid.
CNBC and other talking heads are quick to say that retail investor doesn't know the value of a share, and they should leave the betting to the investor class, and their system of appraisal; But as they echo the closed-door traditions of wealth, who's to say the value of anything?
Sometime around the 1830s our idea of "fair-market" pricing, controlled by a cartel, was baked in to include the betting of traders. All pricing, by reference, is a matter of tradition.
While regulation has gone back and forth over the last several hundred years, trying to make this iteration of the system more stable; I don't actually think the thing we are trying to stabilize is the economy, but a casino of hegemony built on its back fueled by the Cantillon Effect.
This isn't to say that there isn't value that can be developed from statistical predictions about the future entered by a large sampling of different models competing for the most accurate result; but price discovery aside, does a share of GameStop or any other stock fundamentally change in value rapidly over the course of a day, a week, a year? Certainly not one 64 millionths of a second.
Wall Street Bets decided that GameStop is a company they value, so they made their position clear; And to protect itself the system froze out retail investors who had a different opinion about the future governance of GameStop.
It would be easy, particularly after 2008, to go after the short. It certainly could use some constraints, but the pessimistic bet is currently one of the few tools that incentivize people to go after companies like Eron or Herbalife.
Most stocks, in the abstinence of dividends and reprivatization, are no more than expensive trading cards used to shuffle around an unseen amount of wealth between a handful of vaults with an entire class of would-be administrators optimizing the best way to siphon their take. 2 and 20 anyone?
At the end of the day, all that really happened was that a game of internet spreadsheets caused players like Melvin Capital to lose some administrative control points over the system to the players who helped bail them out. At best I expect that SEC does an exam, maybe adjust some capital requirements. Naturally, everyone was firewalled, just playing their role in the market.
And while a few people won the lottery playing this hand, how many more people saw the news and thought they should start gambling on their phones? Thereby transferring their localized administration power to the accounts of their brokers to be sold away slice by slice as chum towards the growing dark pools of the third market.
If you had to design a system to launder multi-generational wealth of undistributed profits, by placing it into a system of private banking, then layering it with the chits of others, and letting it float a bit, before integrating it back into the economy in the form of market power; Well, that would be different, right?