Over the past few days, the level of hedge fund short interest in GameStop fell sharply. Or did it?
On the evening of Monday, Feb. 1, Bloomberg reported that “GameStop Short Interest Plunges in Sign Traders Are Covering.”
Two separate research firms, IHS Markit and S3 Partners, reported the drop:
“Short interest in the video-game retailer plummeted to 39% of free-floating shares, from 114% in mid-January, according to IHS Markit Ltd. data. Data from S3 Partners, another market intelligence firm, showed a similar pattern, with GameStop’s short sales having fallen to about 50% of its total stock available to trade, down from a high of roughly 140% reached earlier this year.”
The reporting coincided with a big drop in the value of GME shares. This is clear evidence that the hedge funds are winning, and that the Reddit army is losing.
Unless the short interest data is being manipulated, which is also a real possibility.
If the U.S. Congress does any real digging when it holds hearings on the GameStop situation, it will uncover some very interesting quirks of the market, many of them revolving around shorting practices.
Most people understand “naked shorting” to be an illegal thing, and it is — sort of.
On the other hand, there are plenty of instances where naked shorting is more of a gray area — not so much a violation of the law as a minor infraction worthy of a parking ticket — and other instances where certain players can short a stock beyond 100% of the float, or short nakedly, in a wholly legal way.
This is where the reported sharp decline in GameStop (GME) short interest gets intriguing.
There are at least two plausible explanations for GME short interest declining — giving the appearance of hedge funds covering more than half their shorts — even as the GME share price fell sharply alongside.
The first explanation is that GME squeezers lost their discipline and broke ranks.
If a critical mass of holders on the long side of GME started selling to realize profit in GME, that would have given the hedge funds an opportunity to cover their shorts — via buying back their shares — at progressively lower levels as the share price fell.
Plummeting short interest along with a plummeting GME share price, in other words, could indicate that the Reddit army is headed for the hills, and the longs were selling early, giving the shorts a means to cover, as the longs got out.
The notion that the squeezers broke ranks, and that the hedge funds are winning, is certainly the perception that was created. The Bloomberg article strongly suggested that the Reddit army has lost.
“Short squeezes can only last as long as there is a large short position in a stock,” the chief market strategist at Miller Tabak & Co. told Bloomberg. “Once that dissipates, the situation changes completely.”
But there is another possibility, which is that the hedge fund short interest in GME didn’t really dissipate.
If the long holders of GME shares did not break ranks and sell en masse, it would have been impossible for the share price to fall and hedge fund short interest to fall at the same time.
That is because, without a critical mass of long-side holders selling into the market, the hedge funds covering their shorts would have nobody to buy from as they covered (bought back) their short positions.
In this second scenario, though, the hedge funds that are short — with tens of billions of dollars on the line — could have decided to play a high-stakes trick.
The trick would be: “Make it look like we’ve covered our shorts when we really haven’t (because we can’t), so that short interest falls and the Reddit army gets demoralized, thus breaking the squeeze.”
The way the hedge funds could have done this — made it appear as if they covered their shorts, even when they really didn’t — involves trickery in the options market.
The tactics involved are not a secret. In fact, the Securities and Exchange Commission (SEC) knows all about such tactics, and published a “risk alert” memo on the topic in August 2013.
The SEC memo is titled “Strengthening Practices for Preventing and Detecting Illegal Options Trading Used to Reset Reg SHO Close-out Obligations.” You can read it here via the SEC website.
The memo contains a dozen pages of highly technical language, but here’s a quick rundown:
- If short sellers are facing a squeeze because shares are hard to buy, or scrutiny for holding an illegal short position, they can create an appearance of having closed their short position through the use of deceptive options trades.
- A hedge fund that is short a stock can write call options on a stock — meaning they are now “short” the call options, having sold the call options to someone else (typically a market maker) — and simultaneously buy shares against the call options.
- The shares bought against the call options could be “synthetic” longs — meaning they are not part of the original share float of the stock — as sold to the hedge fund by the market maker that takes the other side of the options trade.
- This works because, if a market maker buys options from an options writer, the market maker has legal privileges to do a version of “naked shorting” as part of their hedging function. This is necessary, under the current rules and the current system, for market makers to protect themselves when facilitating options trades.
- As a result of the above transaction, the hedge fund that sold short calls was able to buy synthetic long shares against the calls. (A synthetic share is one that has a long on one side and a short on the other but wasn’t part of the original float.) The synthetic long shares are the other side of the naked shorts, legally initiated by the market maker, so the market maker can hedge.
- The hedge fund that bought the shares can now report that they have “bought back” their short position via buying long shares — except they actually haven’t! The synthetic shares they bought are canceled out against the short call positions they initiated, a necessity of the maneuver by way of the market maker’s hedging of the call position they bought from the hedge fund.
It gets very complicated, very fast.
But the gist is that hedge funds can use tricks to make it look like they’ve covered their shorts — even if they haven’t truly covered, and can’t, for lack of available float — by way of exploiting loopholes that exist due to an interplay of reporting rule delays, market maker naked shorting exceptions, and legal practices of synthetic share creation (new longs and shorts made from thin air) relating to market-making.
Below is a section of the SEC memo (from page 8) that gets to the heart of it:
“Trader A may enter a buy-write transaction, consisting of selling deep-in-the-money calls and buying shares of stock against the call sale. By doing so, Trader A appears to have purchased shares to meet the broker-dealer’s close-out obligation for the fail to deliver that resulted from the reverse conversion. In practice, however, the circumstances suggest that Trader A has no intention of delivering shares, and is instead re-establishing or extending a fail position.”
In plain language, “Trader A” in SEC parlance could intentionally be giving the appearance of closing their illegal short position — when in reality they have no intention of doing so (or no ability to do so).
Under normal circumstances, tricks like these were used to help hedge funds maintain short positions that, legally speaking, they weren’t supposed to have because the shares were never properly located.
The GameStop squeeze is a unique scenario, however, because it is a very public fight to the finish between the Reddit army and the hedge funds that are short. Either the Reddit army wins and the hedge funds pay four-digit prices ($1,000 or more) to cover their shorts because of margin calls, or the hedge funds win and the GME share price falls back to the low double-digits.
In a battle like that, with public coverage influencing both sides, perception is a weapon. As such, if the hedge funds can generate the appearance of having covered most of their shorts, while driving down the GME share price through aggressive selling on low volume (something known as a “short ladder attack”), then the hedge funds increase their odds of breaking the squeeze — in part because media outlets will report things like “GameStop Short Interest Plunges” without looking deeper.
To be clear, it is also possible the first scenario is true.
GameStop shares may have fallen precipitously, with hedge fund short interest falling alongside, because a critical mass of long GME holders simply lost faith and tried to sell before the squeeze was complete.
But it makes a lot of sense to question that narrative, given the wide array of deceptive tricks that some hedge funds (certainly not all of them, or even most of them) have used to perpetuate questionable or even illegal shorting tactics for a very long time.
And again, these tricks are so pervasive and old, the SEC wrote a “risk alert” memo about them in 2013.
As such, whether the drop in GameStop short interest was real or smoke and mirrors, the fact that changes in the level of short interest can be faked — with hedge funds making it look like they have closed out, but haven’t — is a serious compliance loophole that should be forcefully addressed.
As a side note, the answer to this problem likely resides in the blockchain.
Apart from market maker privileges, the three big reasons hedge funds can play games with short positions — delayed reporting requirements, time windows of days (or even weeks in some cases) for trades to settle, and related transactions being executed in different places, or with different counterparties, for the sake of deception — could all be answered with a blockchain-based settling and clearing system where transactions are noted instantly and made visible to all parties (plus the SEC).
