A social crisis, a financial crisis, and back again
Will the Big Short Squeeze mean a melt down?
As promised, our update on the Big Short Squeeze situation. Like how we’re thinking about this? Follow us on Twitter, and subscribe!
A short squeeze is a feedback loop: prices go up on a shorted stock, forcing shorts to cover, driving the price up further.
A gamma meltup is one too: stock prices rise to the level of option strike prices, forcing the option seller to buy more of the stock as a hedge, driving its price up further and making them buy more.
The most dangerous feedback loop in the whole Big Short Squeeze of the last two weeks: a social crisis sparking a financial crisis which in turn creates new social crises, accelerating the meltdown of an entire society. This may sound melodramatic -- and hopefully it is. This week may determine just how bad things get.
The first social crisis is what we consider the first of the “Big 3” forces driving the world economy today, the long-term decline in capital’s profitability. As margins keep shrinking across the system, speculation becomes a more and more viable alternative to productive investment. State intervention can accelerate this process by artificially reducing risks -- usually by suppressing interest rates -- creating “moral hazards” that drive capital into speculation. When the risk comes anyways, the state swoops in with yet another bailout, increasing the hazard again.
The Robinhood crisis last week actually arises from moral hazards created after the Great Financial Crisis. The Dodd-Frank financial regulatory reforms sought to reduce risk without breaking up banks. One of the solutions: a series of carrots and sticks to force more trades to go through “central clearing counterparties,” or CCPs.
CCPs seek to eliminate “counterparty risk” -- the risk that someone will agree to sell an asset but the buyer never shows. This is a very real risk because stock trades appear instantaneously in traders’ accounts but actually take up to two days to actually settle. The CCP is who handles all that settling.
The main CCP for stocks and other securities -- the Depository Trust and Clearing Company (DTCC) -- operates very much like a bookie who moves the point spread to end up with equal bets on both sides of a game, moving money from the losers to the winners and collecting a fee from everybody. The DTCC “clears” paired buy and sell orders across all the brokers that use its services.
What happens if there’s significantly more action on one side of a trade? The DTCC mitigates this risk by requiring brokers to put up collateral commensurate to its uncleared position. Because these purchases can take a couple of days to settle, they also ensure that the collateral is big enough to handle any rapid price changes. If there’s a stock with disproportionate buy or sell orders and a highly volatile price, collateral requirements can go up rapidly.
This is where last week’s chaos came in. At one point a large majority of Robinhood users were buying GameStop stock and the short squeeze/gamma meltup had its price soaring -- nobody wanted to sell. That put Robinhood way out over its skis with the clearinghouse, with price volatility throwing more gasoline onto the collateral fire. We don’t know how much they had to put up, but they had to raise an emergency $1 billion from investors and pull down up to $600 million in credit from major Wall Street banks.
Of course Robinhood is not the only platform buying and selling these stocks, and the same phenomenon is affecting all major market players. Their collective capital requirements went from $26 billion to $33.5 billion in a matter of days. Big market players had to liquidate assets to come up with the cash, pushing down markets across the board.
Hedge funds, with their mix of long and short positions to guarantee returns for their megawealthy clients, “degrossed” -- cashed out by selling long positions and covering shorts -- at the fastest rate in six years. Of course, that covering action only sends the heavily shorted stocks up faster and higher, sending the cycle going again.
This threatened to further raise Robinhood’s collateral requirements, which is why the platform shut off all buying of the WSB meme stocks, moved fractional shares into “liquidate only,” and then only allowed laughably small purchases -- usually just one share at a time.
Robinhood and other major institutions seemed to be breaking their rules, but it is more precise to say that they are all exercising rights to break their normal rules that few of their clients knew about before last week. Google, for example, erased hundreds of thousands of one-star reviews for the Robinhood app -- they have rules about review brigading. And Robinhood also liquidated margin accounts without permission.
It's here that the risk of a social crisis returns. Longstanding talk about property rights, individual responsibility, and free and fair markets all ran up against the wall of major losses for institutions so powerful they are invisible most of the time. Last week the spotlight turned on them, and they were seen in all their ugly enormity, all seemingly in lockstep to prevent losses to an inconvenient counterparty -- millions of small investors.
Now these angry, reactionary forces who have already shown the capacity for significant coordination believe that the most important institutions in our society have tried to rob them, and as the squeeze unwinds most of them will be left with nothing to lose. If institutions respond with moves that only sap their legitimacy further, the ultimate feedback loop can get set off.
The lesson from last week: they may not have any choice but to fail.
Our only investment advice: Listen to more Steez.
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