Game-ification of the markets, entertain-ification of the markets — call it what you will. No-commission trading. Fractional shares. Pandemic-related lockdowns leaving us stuck at home, battling bouts of boredom. Non-stop news flow and continuous contact with social media. Technological disruptions — not to mention circumstance — have made it easier and cheaper to trade the markets from wherever, whenever. Anyone with a smartphone and a dollar can open up an account and trade. But set against the climate of social discord present today, it is not surprising that tensions are spilling over from politics and protests into other pockets of society. Combine these dynamics with a large segment of people that feel disenfranchised and disaffected to the point of ire and revenge, and it is not surprising that GameStop has become a rallying cry for the markets to “stick it to the man”. Mix in Twitter and the propagation of misinformation and you have the perfect recipe for the manifestation of this rage. Massive stimulus is the icing on the cake.
There have certainly been some interesting opinions on recent events — including takes on what is happening in the markets, what the responses have been, and what the effects might be. Here’s mine.
The system needs to breathe
Let’s start with the announcement in the last week of January to halt trading on the so-called “meme stocks”. Retail investors were told to hold their horses when a number of free-to-trade app-based brokerages, as well as traditional brokers, halted trading activity. While the rallying cry that resulted was that suits were trying to protect hedge funds, the truth really was somewhere else. Simply put, the back-office activities of settling trades were getting overrun and the system was about to crack under its own weight. Let me explain.
When you place an equity trade, there is a two-day settlement period, which is the time when cash changes hands. You deliver the cash to me to pay for the purchase and I receive those proceeds from the sale. If I buy a stock on Monday, it does not actually settle with the seller until Wednesday. Cash does not change hands for the transaction until two days after trade date.
What we need to keep in mind, however, is that free-to-trade brokerage accounts typically sign up users for margin accounts. A margin account is a type of brokerage account that allows investors to purchase securities with borrowed funds. Technically speaking, this means that trading apps are essentially lending money to any and every one interested in trading stocks between text messages. It also means that regulatory requirements force these brokerages to put up cash via their clearing firm on the trade date to insure settlement activity takes place two days later. These requirements reduce counterparty risk across markets — the cash is there, so why worry?
Under normal market conditions, this payment is not a big deal. Firms know that they have to come up with the cash for settlement and typically do not have a problem in doing so. But the recent explosion of volume in these popular meme stocks meant that the funding requirements for a few stocks suddenly soared dramatically. Imagine being the free-to-trade app-broker that now needs to go out and find a few billion dollars to borrow on short notice to help settle these trades. Note that while you are doing so, your customers are continuing to take positions in these same names at an alarming rate — meaning you will need to come up with even more cash. Add in the fact that the Depository Trust & Clearing Corp, the settlement warehouse for the US market, raised collateral requirements for these same meme stocks, further upping the cost for funding settlement procedures. Why raise collateral requirements? Volatility. The potential collateral costs were rising. As volatility increases, the odds of loss increase, and the clearing house wants more insurance to protect against this.
Is it any wonder, then, that the rush to raise money to meet settlements was overwhelming, and that the one way to slow pace was to limit trading on said names? Think about it. If I sell a stock, I am expecting the proceeds to hit my account in two days. I line up other transactions against this, expecting to have that money in my account. What happens when the broker cannot come up with the payment? I cannot deliver that money to the next person whom I owe money to. That leaves them short on cash, including anyone they owe — and so begins the chain reaction of trade fails. This is also sometimes referred to as “contagion”. The worst-case scenario here? The system grinds to a halt and potentially collapses under its own weight.
If the trade-for-free brokerages that are letting clients trade on margin cannot deliver the cash and perform on behalf of their clients from a financial perspective, then the brokerage goes into bankruptcy and all the accounts are liquidated. Bankruptcy? Liquidation? Not good for market sentiment, to say the least. Bottom line: Halting trading was a rational decision by these brokerages, designed to prevent the system from blowing up. It prevented them from failing to meet their financial obligations and ultimately going bust. This was not a hidden agenda to protect hedge funds; it was the system functioning as designed and coming up for air.
Remember risk appetite
We constantly talk about risk appetite and how important it is for the direction of the market. Increasing risk appetite pushes the market higher. A loss of risk appetite tends to lead markets lower. Supply and demand is driven by risk appetite; it is at the heart of the market. Everything can be whittled down to risk appetite, and markets today provide us with a great example.
What drives risk appetite? Feeling secure in your prospects, job and finances. A level of comfort knowing that if you take a risk and fail, the damage done will be limited and absorbed with relatively minimal consequence. The other driving factor: fear of missing out. Ask yourself, or your friends — why are you piling into these meme stocks? Is it because you think they are cheap? Undervalued? Or is it because of the eye-popping returns that are showing up on your television, phone, or laptop screen? Put another way, is it because you see other people making money and you’re missing out?
This is the very definition of risk appetite. I believe that markets can put too much emphasis on fundamentals and too little emphasis on technicals and sentiment. Case in point here. Those that attempt to call market tops based on valuations should keep in mind that risk appetite can drive markets to levels well past what may seem rational. Valuations are nothing more than opinions — neither is ever really 100% right or wrong. But the bigger point, you have no idea of the price that I am willing to pay for something that I want. Risk appetite is the deciding factor. In part, valuations are an attempt to handicap a buyer’s risk appetite — the price I am willing to pay. Risk appetite can push valuations well beyond levels that sober analysis deems expensive.
Beware the Pied Piper
This brings me to my last few points. First, there will be winners as well as losers. Those who feel that they are “sticking it to the man” should look to their left and right. I have a sneaking suspicion that those traders piling into these meme stocks are not all “little guys”. In fact, I have a hunch that a few hedge funds are also buying the same names in the hopes that they grind higher, all while taking their share of profits. While these trades might inflict some damage on a few unlucky hedge funds, they’re probably minting a few million for a bunch more on the other side. Hedge funds are not stupid, and they are not sitting idly by watching potential opportunities go to waste.
Second, short squeezes are probably not a major risk to market health. These single name squeezes in and of themselves are probably not enough to cause a massive downdraft in the markets the likes of which were seen during the Great Financial Crisis or the dotcom bubble. The leverage in the system that was employed by the banks has been highly regulated in the years that followed. Could a hedge fund go bust? Maybe. Maybe not. In my view, these short-term squeeze plays are more idiosyncratic than systemic, so I’ll lean towards maybe not. However, the knock-on effect from these trades could present near-term risks to investors.
Investors may want to take note of where these squeezes are taking shape — penny stocks, thinly traded names, companies with a significant short interest. They’re happening in short-dated options markets where leverage (borrowed funds) can amplify their impact. Generally speaking, they are taking place in small pockets of the market, but the broader market is feeling it as well. Why? Risk management. As volatility pushes higher, risk officers tell traders and portfolio managers to take down their risk. That can mean “de-grossing” positions, or selling off positions in securities purchased with borrowed money. It could also mean selling long positions to reduce market exposure. This is likely why we saw relatively homogeneous selling across US equities through the last week of January — a sure sign of a broad-based de-risking. This is the knock-on effect that I am highlighting.
New players, new rules?
Longer term, I hope that this new wave of investors continues to flourish. A part of me does worry that some of these new market participants will become cannon fodder. Put another way, they will serve as buyers so that people who bought the stock early have someone to cash out to and therefore book their profits. Someone will be left holding the proverbial bag when this is all over. I hope that smoking crater will not be full of retail investors who had no idea what hit them, because if the “little guy” is the one who ends up getting hurt, a lot of finger pointing is going to take place. That could lead to greater regulation — for better or worse.
What might this entail? Well, the fact that anyone can open a margin account without having any experience in financial markets is to me a bit worrying. That may be a focus. Had these free-to-trade brokerage apps opened up normal cash accounts as opposed to margin accounts, these trading halts would not have been an issue and would never have happened.
As for the options market, my gut tells me that something may need to be done as well. The size of the options market is massive, and the ability to increase positions through its embedded borrowing facilities is something that likely needs consideration. All of this folds into the bigger takeaway here — the fact that new shortcomings of the market structure have been exposed. Regulations are in place to protect the interest of the client, and market rules are designed to prevent the system from self-destructing. What we’ve seen of late are these rules and regulations functioning as intended. Can they be improved upon? Of course. Or — probably. I don’t claim to have the answers. But I would certainly expect some regulatory changes related to the GameStop saga to be coming at some point.
Jack Janasiewicz is chief portfolio strategist and portfolio manager at Natixis Advisors.
