The long and the short of market manipulation

Below is a lightly edited transcript of the podcast:

JOHN HELTMAN: Back in January, something unusual happened. GameStop, the brick-and-mortar video game retailer that has been losing money for all but 13 of the last 38 quarters — going back to 2012 — saw its stock rise. Exponentially.

CNBC: Check out shares at GameStop surging another 51% today. The record move driven by a retail rebellion. An army of day traders going to battle against noted short seller Andrew Left who laid out five reasons why he thinks this stock will go to 20 bucks a share that commentary sparking big outrage from shareholders online and prompting Left to release a letter within the last few hours …

HELTMAN: GameStop’s stock, listed as GME, traded at $15.80 on December 1, and peaked on January 27 at $347.51. That monumental jump was spurred by a large number of retail investors and day traders all buying GME stock at the same time. And they bought it — and in many cases held it — at least in part to rectify what they believed was an unfair effort by institutional investors to artificially depress GME shares by shorting them. Betting that the stock’s value would go down, in other words. And lots of other stocks got caught up in this as well — theater company AMC, Bed Bath and Beyond, even commodities like silver got caught up in this craze.

JIM CRAMER: We all wish people were … can make as much money, and we wish they were making on Apple, or we wish they were making it on Microsoft, but they're making it on companies that the three of us know are actually not doing that well. I'm not saying the Game Stop should ever been as low as where the short sellers were selling it, because, obviously, there was a very smart buyer, Ethan Cohen came in was the fellow the … you know, the guys that ...

CNBC: Yeah, Chewy.

CRAMER: ... started Chewy. He bought a lot of stock, at eight bucks, and he's a bright guy. But, you know, what's his return? At $338, do you believe that if you were to poll every single member of the board of directors right now, right? Every single member, you know, every single member would sell it, and their families would sell it and their lawyers and their doctors and their dentists and the PTs would all sell. This is and that's what I don't like about this. Now, of course, I've seen some information not condoning that, but there wasn’t anyone who was involved with GameStop in any sort of way, shape or form, who would accept the fact that this company should be at $338.

HELTMAN: There’s a better than even chance that you’ve heard this story already, because it was everywhere a couple of months ago. But the part of the story that didn’t get enough attention was the thing that started it in the first place: short selling. Short selling is a mechanism where investors can profit off of securities losing value, and it happens all the time. But is it good for markets, or is it a way of profiting off of failure — or worse, pushing hard-luck companies into an early grave?

From American Banker, I’m John Heltman, and this is Bankshot, a podcast about banks, finance, and the world we live in.

CHANA SCHOENBERGER: Hey, how are you?

HELTMAN: Good. How are you?

SCHOENBERGER: Good. Let me just get my microphone. Make sure I'm on me. Yeah, I am. I have my, my fancy podcasting mic here.

HELTMAN: This is Chana Schoenberger.

SCHOENBERGER: I'm Chana Schoenberger. I'm the editor in chief of Financial Planning magazine.

HELTMAN: And a sister publication of American Banker. Let’s start at the place where the whole meme stock phenomenon began: online. Or, more specifically, Reddit.

SCHOENBERGER: So there's a subreddit devoted to stocks called Wall Street Bets. And this is where people go and hang out and talk about what they're buying and selling and what they're shorting. And it's kind of raucus and crazy, and it's a good time. And people like to hang out there if you're the sort of person who day trades and wants the company of other day traders, especially during a pandemic when you can't physically go anywhere. So at some point, there was a poster there who posted that this guy had had gotten involved in GameStop.

HELTMAN: This guy she’s referring to is Ryan Cohen — not Ethan Cohen — and he co-founded an online pet goods company called Chewy. He also started increasing his stake in GME back in September and started pushing the company’s board to review its operations and strategy. Wall Street Bets took notice.

SCHOENBERGER: And maybe this meant that GameStop was going to rocket to the moon, as they put it, you can picture the rocket emoji here. And the idea was that he had a lot of internet expertise, he knew a lot about online retailing, and he was the right person to transform this boring, stodgy mall retailer into a company that could really compete on the internet, the Netflix of games. Now, whether or not he can do that is speculative, but the Reddit community thought that he could and they started egging one another on to buy the stock. And it started rocketing to the moon, it went way up, it got to the point that everyone in the news media was writing about it. And it really took off. It was insane. It was on the front page. And of course, what happens is that on the other side of those trades going up — the long trades — you get the short trades, because GameStop was a favorite of short sellers, because its business model is completely outdated. You know, it's … its real estate is in malls. Malls, everyone knows, are going under, and it was sort of a classic example of a buggy whip manufacturer that was just going to go under. So there were plenty of places where you could find short sellers in GameStop.

HELTMAN: And there are plenty of places to find short sellers in all kinds of things, and there have been for a very long time.

J.C DE SWAAN: I think the emergence of shorting in a fairly widespread way was post-World War II, because if you go back to the inception of hedge funds, and the concept of a hedge fund, the first one was started, I think, in the late 1940s. And its strategy was long/short equity, meaning that it put on trades to both bet on the long side that some stocks would go up, and on the short side, betting that some of these share prices would go down.

HELTMAN: This is J.C. de Swaan.

DE SWAAN: My name is J.C. De Swaan. And I divide my time between the teaching in the economics department at Princeton, where I'm affiliated with the Bendheim Center for Finance, and working in an investment fund, Cornwall Capital, based in New York. I'm also the author of Seeking Virtue in Finance, which recently came out and, and the book is about trying to determine how to lead a virtuous life as a finance professional in an industry that is objectively very conflicted.

HELTMAN: Before we talk about what shorting is, we should describe what a long position is. So to create a long position, first you buy something. And ... that’s basically it. You see something that looks like it may go up in value, you buy it, and then when it goes up in value you sell it or hold on a little longer.

By contrast, the classic example — but not the only example — of shorting works like this. You, the investor, identify something you think is overvalued for whatever reason. It can be a stock, but it can also be a bond, a commodity, whatever. So you find an institutional investor that has a long position in that thing you think is overvalued — their strategy is to hold that asset regardless of day-to-day price fluctuations, because that’s their strategy. You offer to borrow the stock for some length of time for a fee, and at the end of that period of time you give them that stock back. But in the interim, you sell the stock, wait for the price to go down, and when it does, you buy it back for less than you sold it for, give the investor back their stock, and you pocket the difference. That tactic can be deployed for pure speculation, but it can also be deployed to hedge a long position.

DE SWAAN: You've always wanted to at least hedge part of your portfolio in order to manage your portfolio in a way that was ... that was reasonable. And you want to be ... you want to protect yourself against certain events. And that's the way you would do it. I mean, the other way is to sell your sell your portfolio and go to cash. But to the extent that you want to have long exposures, there's always been an interest in having also short exposures to protect yourself.

HELTMAN: Shorting, like anything in the market, also comes with risks. Actually, pretty significant risks.

DE SWAAN: Shorting is not a mirror image of going long, because of ... there's just greater risk involved in in shorting a stock, for instance, because if you're buying a stock — meaning if you're going long a stock — then the most you can lose, unless you put leverage on it, the most you can lose is the amount that you paid for the stock, if it goes to zero. But if you go short a stock, you can lose a lot more than … than the value that you borrowed. Because the stock can go up 100%, it could go up 200%, it could go up more. And so historically, shorting has been associated more with institutional investors than retail investors.

HELTMAN: In other words, for a short to work, the stock has to fall somewhere between where it is and zero before you have to give it back, and you have to pay someone else for the privilege of borrowing their stock. If it doesn’t go down, you have to buy it back somewhere between where you sold it and infinity. That’s called a short squeeze, and that can get real expensive real fast — as it did for hedge funds shorting GameStop.

SCHOENBERGER: So the hedge funds were having to cover — they were having to go in and buy more stock at prices that were causing them to lose money. And then and then story started to get written about that. And the redditors thought this was hilarious. “Here, we are sticking it to Wall Street. We're the little guy, we're going to mess with the big guy, aren't we cool? It doesn't even matter if we make money, we're just having a good time.” So they're, they're having fun doing this, the shorts are losing money and losing money and one hedge fund, Melvin capital actually got into so much trouble that they had to get basically taken over by another hedge fund, which is just one example of something that happens in the stock market every day, but seem to be a big deal in this case, because this was one of the first cases where memes on social media sites like Tick tock, and especially Reddit, were able to really move the price of a stock.

HOWARD LINDZON: I think what made GameStop so interesting for the first time, at least on a short squeeze, and maybe even first time, just in general, that you had this kind of moment, where it seemed like the whole internet cared about the stock market. My name is Howard Lindzon.

HELTMAN: And what do you what do you do? What's your ...

LINDZON: Um, my day job is I'm a venture capitalist. I invest in early stage software companies.

HELTMAN: He’s also the co-founder of Stocktwits, a kind of twitter for stock market chatter.

LINDZON: GameStop kind of came along, and it ... and it memed its way, or it … it got itself into the consciousness of the whole internet at once. And probably that couldn't have happened without COVID. It couldn't happen without a Robinhood, it couldn't happen without all the players, that ...

HELTMAN: Stimulus checks ...

LINDZON: Stimulus checks, yeah, all the things that like piled up for this moment in time where everybody on the internet, it seemed to be either talking about or pushing the, "Buy me one option, or one share of GameStop on the Robinhood app." It was like a combination of everything building, and then BOOM — just so happens that the whole internet trading madness came about and put all its energy into GameStop.

HELTMAN: The way the market is supposed to work involves a kind of mindset, and that works like this: Everyone is going through the marketplace looking for discrepancies between where something is valued and what its actual value is — individual participants looking to see something the rest of the market doesn’t see. But many participants moving in the same direction can also drive a surge higher than it would otherwise be on the long side, or crater a stock that shouldn’t be cratered on the short side. These moves influence prices, and they should. But long and short positions aren’t treated the same, and in most cases, short sellers can short an asset without revealing what they’re actually doing.

DE SWAAN: You can typically short without, without revealing your position. And because there are all sorts of ways to short while masking your position, and you can do through options, for instance. And you can pick any of the recent scandals and blow-ups and where there were a lot of short sellers. And very often we don't know who's on the short side — we can see at an aggregate level how many shorts there are, because that's reported. But it's harder to ascertain who's actually shorting specific stocks. And it's interesting, because heavily shorted stocks, often … so it just creates a lot of noise around a stock, because that means there's just a lot of institutional investors who believe that the stock is overpriced. And there's been some interesting research that shows that more than 50% of the [time] they're correct — so that the noise is actually associated with a real underlying issue. But that means there's a very high proportion of situations in which it's incorrect and the shorts are actually wrong.

HELTMAN: This question of the market utility of short selling and whether short positions need to be better disclosed made it to Congress in February during a hearing of the House Financial Services Committee. This is Rep. Nydia Velazquez, A Democrat from New York, at that hearing, questioning Melvin Capital CEO Gabriel Plotkin — the same Melvin Capital that got an emergency injection of cash from rival hedge fund Citadel in January because it got caught in short positions in GameStop.

VELAZQUEZ: Over the course of my time in Congress, I have been concerned and spoken out about the dangers of short selling. While I understand that short selling can be used for legitimate purposes, too often I have seen abuse, and it ends up harming ordinary workers and families.
I first saw it against the people of Puerto Rico. And now we are seeing it here against GameStop. Large investors, including hedge funds like yours, have to disclose their loan positions when they own 5 percent of more of the company's shares, but not such disclosure is required for short positions. As we consider reforms, is this type of disclosure for short positions something you would support? Mr. Plotkin?

PLOTKIN: Yeah, Congresswoman, thank you very much for the question. I think it's a really good question. You know, whatever regulation is put forth in the marketplace, we will obviously, you know, operate within those rules. It's certainly something I'd be happy to follow up with the committee …

VELAZQUEZ: But what about the — my question about short selling?

PLOTKIN: Yeah, I think it's a really good question. You know, it's not for me to decide. But if those are the rules, I'll certainly abide by them.

HELTMAN: And this is Rep. Blaine Luetkemeyer, a Republican from Missouri, also questioning Mr. Plotkin.

LUETKEMEYER: I understand that GameStop's stock was short sold 140 percent, and Mr. Plotkin, you made the comment in your testimony a minute ago that you were not trying to manipulate stock, yet if you are short selling a stock 140 percent — for me on the outside looking in, it looks like that is exactly what you are doing. Explain to me why that's not manipulating the stock.

PLOTKIN: Thank you Congressman. You know for us I can't speak to other people that were shorted, anytime we short a stock we — we locate a borrow; our systems actually force us to find a borrower so we always you know short stocks within the context of all of the rules.

HELTMAN: Those rules he’s referring to come from a couple of different places, and they cover virtually everything a broker-dealer does. And we’ll talk about those rules after this short break.

HELTMAN: So what is a broker-dealer?

TIM FOLEY: A broker dealer is an entity, or a person that is registered with the … the US Securities and Exchange Commission. And it is someone who's engaged in the business of effecting securities transactions for the accounts of others.

HELTMAN: That’s Tim Foley.

FOLEY: My name is Tim Foley, and I'm an attorney with the law firm of Alston and Bird. I specifically focus on broker dealer regulation and enforcement.

HELTMAN: Several U.S. banks, particularly the largest ones, are broker-dealers themselves, but nonbanks are a big part of that market as well. And there’s a long history of how the SEC has regulated short selling.

FOLEY: There's always this view that comes out of every major market event that short sale activity — that the, quote, "Bear Raiders" — are always part of the problem. And that was one of the concerns with the 1929 crash, and the sort of the less-well-known — except to academics and others — the 1937 crash, people always look to short sellers and blame them, and said, “See, it was these people who wanted the profit off the decline in the price, that that was really the problem.” And I use the term “Bear Raider,” — that's a shorthand for the idea of people who intentionally go out and try and manipulate the price of stock downward through concerted action or rumor mills, to cause a price to go down, and to be able to profit off that. That's, of course, illegal — being a Bear Raider, there's nothing legal about that, because what you're doing is intentionally trying to manipulate the price of stock downward. But with the framework of modern securities marketplace regulation having emerged out of those ideas, it was pegged early on by Congress, and then thereafter by the newly-formed SEC, that they had to get control around short sale regulation.

HELTMAN: And for a very long time, that regulation consisted of what were known as “tick tests,” which basically said that if you were shorting a stock you had to sell it for one-tick above the asking price — if you want to short a $100 stock, you have to initially sell it at $100.01 — overpay, in essence. That’s meant to discourage people who are already seeing a stock go down from getting in the game and sending the stock down even lower.

FOLEY: That rule was in was formed to counter the idea of bear Raiders, because, again, you don't have to make bear raiding illegal, it already is illegal, because it's manipulative trading. But what they came up with was this idea of, they would allow short sales to occur, but only under certain pricing conditions. And that rule right there was the rule was the primary regulatory rule that stood on the books for almost 70 years.

HELTMAN: Around the year 2000 the SEC revisited the tick test, asking market participants, exchanges and other observers whether the rule was working the way it was designed to work.

FOLEY: The long and short of it was they concluded that, that they weren't getting a lot of benefit — they didn't see a lot of benefit from continuing to use that rule. And then that's where the current technical regulation for short selling was finally implemented in 2004. And like I said, it's not a sort of principled regulation that regulates the situations under which I can or can't short sell as an investor. It doesn't make any sort of principal judgment on whether short selling is good under certain circumstances or bad under certain circumstances, it provides technical requirements, that that broker dealers have to adhere to.

HELTMAN: The new regulation was called Regulation SHO, or Reg SHO for short. Pun intended. And the rules mostly have to deal with reporting trades correctly, as well as ensuring that broker-dealers actually have shares they can borrow to affect a short sale, and are able to give them back when they say they will give them back. And there’s a circuit breaker requirement as well, one that actually was triggered early in the pandemic when markets were falling.

FOLEY: So that rule, it requires the securities exchanges to impose price restrictions that look like somewhat those tick tests I was describing earlier, but only when the market value of a security declines at least 10% intraday, or in one day. So it doesn't apply across the market. That's why it's called the circuit breaker rule. It's the idea that, "Well, if a security goes down 10% in one day, then maybe we should put in some restrictions." But it doesn't apply across the board all the time.

HELTMAN: So thereisregulation of short selling, and there has been for quite some time, but its most stringent aspects — which aren’t really that stringent — only apply when something is already losing value fast. Other countries, however, have been more aggressive in regulating shorts, particularly in the face of a financial crisis.

ADAM KULAM: Believe it or not, financial crises happen. All the time, across the world. My name is Adam Kulam, I work as a research associate at the Yale program on financial stability in New Haven, Connecticut.

HELTMAN: A financial crisis often accompanies a recession or vice versa, but a recession isn’t a financial crisis and a financial crisis isn’t a recession. A recession is generally defined as a fall in a country’s gross domestic product across two consecutive quarters, and that can be caused by anything — natural disasters, a pandemic, or a massive financial scandal, just to name a few.

KULAM: A financial crisis is different. A financial crisis is when credit is unable to flow between savers and borrowers. And so if you wanted to take out a loan, to purchase a house, or perhaps a piece of industrial equipment — you kind of look like a farmer — you might not be able to do so. A financial crisis can precipitate a recession, as we saw 10 years ago, but it's, it's not always the case that one necessarily leads to the other.

HELTMAN: But the fear of financial crisis — and by extension, the fear of recession — has spurred many countries to restrict short selling, either outright or on specific exchanges, or even on specific securities. And this happened a lot in the COVID crisis, from France and Spain and the EU to Turkey, Indonesia, Pakistan and Taiwan. Almost all of those bans happened around March and April of 2020, and most only lasted for a day or a week, though a few countries like Turkey and Indonesia banned certain kinds of short selling until further notice. And the SEC itself has some experience with shorting bans, having imposed a ban on almost 800 financial stocks in the early days of the 2008 financial crisis.

KULAM: And so in late 2008, a lot of financial stocks were being heavily shorted, because investors didn't know how much exposure financial firms had to mortgage backed securities and the market turbulence associated with the U.S. housing market downturn. So in sum, it would have been a really easy bet to just think, “I don't really know who's going to go down next. So I'm just going to bet that they're all going to go down or maybe … take a bank — it probably has exposure. So I'm just going to kind of take a bet against I'm going to speculate a little bit, I'm going to gamble.” And so this is the kind of activity that the SEC sought to prevent. I think the jury is no longer out on shorting bans in the United States. At least Christopher Cox, former SEC Commissioner, actually said a couple of years ago, "Knowing what we know, now, we would not have done the same thing again." So yeah, in the U.S., it's not going to happen, I don't think and how it turned out for the countries that enacted them in COVID, is still sort of up for debate, in part, because people are still analyzing the like, reams and reams and reams of data. The preliminary analysis that we've seen, especially from Spain's market regulator, is that the short selling bans of the COVID crisis, decreased liquidity of the stocks that were covered under the ban. And another issue with the word liquidity is that it has like several definitions, but basically what we mean by that is the ease with which a buyer and seller can agree on a market price and transact on that price without changing the price itself.

HELTMAN: That’s kind of the issue here, and one of the ways that stock trading isn’t the same as, say, betting on sports. If I bet $100 that the Dodgers are going to win the World Series, that doesn’t have an impact on whether they actually will. But if I bet that GameStop is going to rocket to the moon, if enough other investors make the same bet, it will. The same is true if enough people bet that GameStop will burn to the ground. That’s a powerful truth about markets — the very tools that we use to assign price can also be used to manipulate price. In other words, the biggest dangers associated with short selling aren’t really unique to short selling — you can manipulate an asset’s value by buying more easily than you can by shorting it, and at less risk. And shorting can really help a marketplace make informed choices as well — and regulators can inadvertently do more damage to markets by banning shorts than the shorts can do on their own.

DE SWAAN: Wirecard is, is a fascinating one, because it's, it was a German tech champion, that blew up, it was a very rare tech champion coming out of Germany. And I mean, at one point, its market cap exceeded that of Deutsche Bank. And starting in 2015, the Financial Times wrote reports questioning its accounting practices. And after these negative stories came out in the FT, there was a an important report that came out by a short seller in 2016, saying this was essentially a fraud. And what was fascinating about this is that the German regulator, so after this report, you saw a lot of short interest in this company. So a lot of funds starting shorting ... started shorting it. And what was interesting about this situation is that German regulator, BaFin, decided to, instead of investigating the company, it decided to pursue the short sellers. And then it actually pursued the Financial Times reporter. And, and then eventually, it blocked the ability to short this specific stock. So the regulators were so clear in their mind that it was impossible for this to be a fraud that their natural reaction was to go after the short sellers and the reporters and so on. And it turns out, they were completely wrong, the regulators. The shorters were correct. Wirecard was a money laundering operation, and accounting fraud. And in the end, this is a good example of the shorters preventing a bubble from expanding further and they shine the light on a company's shortcomings at a time when there's a huge amount of exuberance around it.

KULAM: I really wish regulators wouldn't do this. It's just not a good thing. Any small positive effects have largely been demonstrated to have been outweighed by the negative effects of reducing short selling at-large. Shorts or short selling, though it's morally questionable to some people is generally a healthy thing for the market, and to remove the positive effects associated with this specific trading action by banning it is kind of like throwing the baby out with the bathwater.

SCHOENBERGER: The thing about short selling is they're always these waves of regulation that go back and forth between extremely tight and extremely loose. And obviously, under the previous administration, it tended more to the loose side. There's a lot of thought that under a Gensler SEC, there will be tighter regulations now and the … there's been some indication that they're going to start regulating financial services more closely, which is their job. And it's not clear yet what will happen to short selling, it's unlikely that they're going to ban short selling outright, they probably won't. But it is a really sophisticated strategy that people should not be just doing.

FOLEY: You don't need a separate regulation, to say that manipulative trading is illegal, when you already have that broad-based principle in the rules that exist on our market. So you don't need a separate regulation to say "manipulative short selling is illegal" — it's the same as manipulative long selling. And to your point, the idea of, it's not manipulative for me to take a bearish view of, of a company, and a short sale, what's manipulative is if I enter into a short sale, and then I go about spreading false rumors about that company in order to drive the price down, or if I otherwise do … there are technical ways, with the low costs of trading these days, and the ability to automate trading strategies, a lot of regulatory energy is actually spent and focused on these sort of manipulative strategies like wash trading, layering, all based on the idea that what you can do, the way the marketplaces are built, is you can put in a bunch of fake trades, fake orders that you don't intend to keep to drive down or drive up a price. And then put in the trade that you want to keep on the other side of the market to benefit from that temporary decline that you cause.

HELTMAN: If market manipulation is the real danger here — either through shorting or other means — the challenge that regulators are going to have to reckon with is an exponentially expanded marketplace with exceedingly low barriers to entry. Those low barriers to entry are good in some ways — ordinary people should have the power to invest in securities that promise a greater return than, say a savings account. But there are dangers as well.

FOLEY: It's funny, when you look back at your scholarly writings over time, you go back, I think, in the 80s, there was a piece where the authors were arguing that you don't need to regulate for market manipulation, because it's so hard to manipulate the market in a successful way. Because one of the principles was, in one of the reasons was because trading is so expensive. And, and that, like it's comical to look at that today because part of what's happening right now — what happened with GameStop and AMC and these other issuers is it's the securities regulatory regime trying to catch up with commission free trading, right. It's the idea that people can, you know … it's so easy to put in stock trades now. It's what [people did] when sports went away because of the pandemic, you know? People who used to be just betting on … on sports recreationally, were now, for lack of a better way [to put it, started] betting on the stock market.

LINDZON: You're not going to make money unless you own great companies. So everything else is noise, right? So the easiest way for someone to wake up and say, “I'll throw $100 into this Gladiator of Idiocy battle where the internet will battle the internet.” And watch from afar with my $100 bet. That's the sports action part of the stock market, where I — and I rarely do this — will say, “Ah, there’s a game going on.” It is the idiots on the short side of GameStop — the pumpers, sorry, on the long side, versus the inevitable dumpers, which is all the people trying to make the game stop.

HELTMAN: Right.

LINDZON: And that's the way I would look at something like this, is pure entertainment, like you're watching a sporting event. And in doing so, don't wreck the sporting event by getting on the field with all these behemoths and getting run over. Get on the field by placing a bet with your bookie — which is like an options bet …

HELTMAN: Right.

LINDZON: … and saying, "Hey bookie, I'm going to bet this and if my If I'm right, the $100 will become $1,000. And make sure at $1,000, you take me out of the trade because I don't even understand what I'm doing. But at $1,000, put a limit order into get me out, because that's enough.” And no one was doing that everybody was treating it like they were part of the game.