The Securities and Exchange Commission’s (SEC) bombshell report on GameStop (NYSE:GME) is drawing an awful lot of eyes and quite a bit of criticism today. The lengthy report explains what happened earlier this year when a large group of retail investors mobilized on GameStop (GME) stock and saw its price fly far beyond the expectations of both the investors themselves and analysts who had been tacking bearish price targets to the stock. The data backing the report is dispelling the theories around the price momentum being the result of a short squeeze. Many remain unconvinced, though.
The report covers a whole lot of trading knowledge that retail investors might not know about. Thus, it’s a very educational read regardless of where you stand on the short squeeze theories. Nonetheless, the real reason everybody wants the SEC’s take on the matter is to gauge where the body is heading in the future. Investors want to see the committee take to task the hedge funds and market-makers who they believe swindled them. On the other hand, many of these institutional traders want the SEC to look into those they believe were manipulating GME values through social media.
Well, the body did not indicate either way how they feel regarding any sort of punishment, much to the chagrin of both sides. What they did do is clear the air on a few things using data it sourced over the course of a lengthy investigation into the event. Let’s take a look at some of the biggest takeaways.
SEC Report Claims ‘Naked Shorting’ Did Not Take Place Through the GameStop (GME) Stock Squeeze
One of the biggest bombs dropped in this report is that the SEC believes no “naked shorting” took place in January, at least with GameStop (GME) stock. Naked shorting is an illegal practice; it is the lending of shares that don’t actually exist. Lenders manufacture these shares and then lend them out without the borrower even knowing there’s no real share.
Naked shorting is a huge point of contention among retail investors concerned with the bad actions of institutions. Many retail traders believe naked shorting took place in order to help institutional short sellers cover their positions. As prices of GME rose, short sellers would have to take increasingly larger losses in order to cover. With naked shorting, they could flush the market with these shares. This in turn dilutes the float and decreases the price of GME.
That’s certainly how retail investors think things went down when prices of GME began to decline by the day and shares continued to join the float. However, according to the SEC, this didn’t actually happen. When a naked short sale occurs, there is a failure to deliver (FTD). Retail traders used FTDs as a way of indicating that naked shorting was occurring.
However, the SEC asserts that FTDs were not particularly prevalent with GME stock at the clearing member level. And although it does note that FTDs did in fact spike, it declines to call this evidence of naked shorting, since investors who are long on a stock can also fail to deliver, making them an imperfect measure of the practice.
Was GameStop’s Rise Really the Result of a Short Squeeze? The SEC is Unconvinced.
Even bigger than the SEC’s assertion that naked shorting didn’t occur is its claim that the event wasn’t even a short squeeze to begin with. The committee remains unconvinced of the event being anything less than a pump of the stock; rather, it says the event is almost entirely the result of high retail investor sentiment.
The report does note that at the end of 2020, GameStop (GME) stock had a short interest of nearly 110%; that means there was more short interest than shares outstanding even. It’s worth noting here that retail investors assert this to also be evidence of naked shorting; the SEC says this is possible because lenders lend shares multiple times, which is in fact not illegal.
However, the report shows that the government entity is unconvinced that this was due to the short interest. It may have mobilized investors toward the stock. But, the report says the event falls outside the bounds of a short squeeze. Under those circumstances, short sellers would move “en masse to purchase shares to cover their short positions.” However, the report infers this did not happen.
The SEC notes that major price squeezes do occur around periods where short sellers began to close their positions. However, they allege that the price momentum around these periods was due to vastly increased buyer sentiment of GME, rather than a short squeeze.
This is a bit of a pedantic claim; there’s obviously correlation between buying patterns among retail investors and covering of short positions. Regardless, the SEC’s claim is based in the fact that the volume of retail investors buying GME was so vastly far beyond the volume of short positions being covered. Specifically, it says that the “run-up in GME stock price coincided with buying by those with short positions. However, it also shows that such buying was a small fraction of overall buy volume.”
Of course, this is true — these retail investors want to “stick it to the hedge funds.” Therefore, they ensured there was as little float as possible for funds to cover with. They wanted to keep short sellers’ buy-volume low. The chart evidences the fact that the retail traders were sticking to their plans to keep outstanding shares out of the hands of hedge funds. However, the SEC is choosing to interpret the volume as simple bullishness on the stock’s fundamentals.
The Report is Preceding Further Investigation into Commission-Free Brokerages
Investors who find the report’s findings unsatisfying have one silver lining — the SEC is not stopping yet. The report concludes with a series of four areas that the committee plans on investigating further. These topics all point to further scrutiny being placed on payment for order flow (PFOF) brokers like Robinhood (NASDAQ:HOOD), which became public enemy number one among retail traders after blocking trading at the height of the event.
The first area of investigation will be into the causes that push a broker to restrict trading. In January, Robinhood removed trading of GameStop (GME) stock from its platforms; this in turn is causing investors to theorize that its market-maker caused the stoppage in an effort to keep hedge fund peers from losing money. Whether or not that’s true is up for debate. However, Robinhood denies these claims. The SEC will, according to the report, continue searching for a cause to the halt.
Moreover, it intends to scrutinize the entire practice of PFOF. This execution model, which allows Robinhood and other brokers to remain commission-free, is highly controversial. Many believe it causes the brokers to act against the best interests of its users in order to maximize profits. The model remains controversial many years after its pioneering by none other than Bernie Madoff; the committee intends to research further into its gray areas.
Short selling itself will be another large area of interest for the SEC moving forward. In particular, it will look into improving the reporting of short selling in order to further clear the air around the market’s operations. It also plans to further research dark pools, or private forums for trading off-exchange.
On the date of publication, Brenden Rearick did not have (either directly or indirectly) any positions in the securities mentioned in this article. The opinions expressed in this article are those of the writer, subject to the InvestorPlace.com Publishing Guidelines.
