The recent story of Robinhood and the “short squeeze” on GameStop has raised the question whether Robinhood was doing some squeezing of its own, applied to the delicates of the small traders it serves. The comedian and renowned financial analyst John Stewart said it was all, somehow, “bullshit.” An article in New York magazine declared “Robinhood banning GameStop proves the free market is a lie” without, however, saying whether the “lie” is that “the free market” works in some sense or, instead, that we have “the free market” at all. Strange bedfellows Alexandria Ocasio-Cortez and Ted Cruz “fully agree” that the situation is “unacceptable.” The New York Times, however, has published an establishment-friendly piece explaining “Why Robinhood had to risk infuriating its customers.” Who are the good guys here and who are the bad guys? Elon Musk wants to know. He recently grilled Robinhood’s CEO, demanding, “Did you sell your clients down the river or did you have no choice?” Good question, that.
Recall the elements of the story. GameStop looked like a business on the brink of collapse. It seemed like a good bet that its stock price would fall. Hedge funds put in bets that the price would indeed fall by “shorting” GameStop stock. That means they 1) borrowed the stock, promising to return it to the owner by a specified date and 2) sold the borrowed stock right away. You can see how this works. If the price goes down, you’re selling it now at the high price and buying it back later at the low price. Ka-ching! But if the price goes up, you’re selling it now at the low price and buying it back later at the high price. Ouch!
In the GameStop episode, traders on the subreddit r/wallstreetbets started buying the stock. That drove the price up. That’s a “short squeeze,” in which short sellers must scrabble to buy potentially over-valued stocks. Okay, ouch for the hedge funds. Ho hum. But here’s the thing: “at the end of December more than 138% of its shares available for trading were sold short.” Yep. It’s possible to have more than 100% “short interest.” If you buy the stock from one short seller and then lend it to another short seller, that one stock is owed to two parties. If that sort of thing happens enough, you can have more than 100% of the stock sold short. A short squeeze plus 138% short interest caused the price of GameStop stocks to rise – a lot. On the first trading day in January, the price was $17.25. On the last trading day, it was $325. That’s an increase of 1,784%. Ouch! Ouch! Ouch!
The “Redditors” squeezed the heck out of the hedge funds. A win for the little guy! But then suddenly you couldn’t buy GameStop on Robinhood, the broker so many of these “Redditors” used. Robinhood had restricted trading in GameStop stock and several other stocks experiencing similar gyrations.
Does this episode prove that “the free market is a lie”? I suppose it depends on where you think the lie is. I think it is no “lie” that free markets generally “work,” although simple formulas can lead you astray. We should heed Hayek’s admonition to eschew the “wooden insistence” on “the principle of laissez faire.” The “lie,” which is no lie at all but just an unfortunate error, is that financial markets are free. Financial markets are heavily regulated and have little to do with “the free market.” Let’s look at Robinhood’s action in the context of all that regulation.
Robinhood is a broker. It is a FINRA-regulated broker-dealer. It relies on a clearing house to clear its transactions. The clearing house it uses is the National Securities Clearing Corporation (NSCC), which is a subsidiary of the Depository Trust & Clearing Corporation (DTCC). Thus, Robinhood is a “member” of NSCC. The NSCC is a “designated financial market utility” as defined in the 2010 Dodd-Frank Act. Thus, it is “a financial market utility that the Council has designated as a systemically important.” (“The Council” is a regulatory body created by Dodd-Frank. Its ten voting members include the Treasury Secretary, the Fed chair, and the comptroller of the currency.) NSCC is a provider of “financial market infrastructure” (FMI). As such, it must publicly promulgate rules for the computation of the “Clearing Fund” every “member” must maintain with it. While the FMI is responsible for designing its own rules for determining the clearing fund, they are subject to approval or rejection by the regulatory authorities. In particular, the SEC may prohibit any changes NSCC wants to make in its formula for computing the clearing fund of each member. The Bank for International Settlements (BIS) has promulgated a set of “principles” that member states should adhere to in regulating payment and settlement systems. These include, “An FMI should maintain sufficient financial resources to cover its credit exposure to each participant fully with a high degree of confidence.”
Thus, the regulatory authorities require clearing houses to require members to keep a risk-adjusted balance with them as a guard against credit risk. In the case of Robinhood, the short squeeze drove this formulaic value up sharply. Robinhood didn’t really have much of a choice about how to respond. It had to both pony up more money for the clearing fund and act to hold off (to the extent possible) further increases in it. Robinhood had to borrow a lot of money to maintain its clearing fund.
We can now answer Elon Musk’s question. Given the institutional environment it occupies, Robinhood had no choice but to suspend purchases of GameStop. And, as far as I know, Robinhood did not shape that environment. As far as I know, Robinhood is an institution taker, not an institution maker. What about Robinhood’s clearing house, NSCC? It didn’t have a choice either. It had to demand increased contributions to Robinhood’s clearing fund. The algorithm for determining the clearing fund was locked in at that point. The much-discussed restrictions on trading GameStop were not ad hoc, discretionary, arbitrary, or avoidable. Not, at least, given the pre-existing and overarching regulatory environment. It’s just not true that “Wall Street” somehow “decided” to screw the Redditors. Nor is it true that “the government” somehow “decided” to screw the Redditors. Once the short squeeze was on, restrictions on trading GameStop were pretty much inevitable.
No one specifically decided to give the Redditors a smackdown. So everything’s great, then? No! The regulatory environment is not meant to help the little guy. It rigs the system in favor of Big Players and incumbent interests. As I have explained elsewhere, “The Dodd–Frank Act creates a regime of discretionary regulation.” It is discretionary because “the regulatory requirements on a nominally private institution vary from firm to firm in ways that are difficult to rationalise or anticipate.” Thus, the regulators are discriminating among individual market participants and applying different rules to different parties even when they have the same legal charter. (That’s how NSCC got classified as “systemically important.”) Not all is for the best in the best of all possible regulatory worlds.
I think we need reform in the regulation of financial markets. But we should reject the error that the problem is “free markets.” When Elizabeth Warren says “It’s a rigged game,” she’s not wrong! But her call for “the SEC to get off their duffs and do their jobs” is asking the fox to do a better job guarding the henhouse. We don’t need more regulation; we need better regulation. We need the rule of law not only in monetary institutions but in financial markets too. We need to replace the “regulatory leviathan” in financial markets with “a regulatory constitution.”
Roger Koppl is Professor of Finance in the Whitman School of Management of Syracuse University and Associate Director of Whitman’s Institute for an Entrepreneurial Society (IES).