Is Short Selling Leading Retail Traders into a Trap?

As the Robinhood—Citadel relationship recently suggested financial rigging, it is time to ask the big questions. Is speculation a sustainable method of developing a prosperous society? More immediately, are retail traders equipped to deal with a financial system that has in-built, exclusive speculation?

Short Selling Has a History of Financial Disasters

Renewed GME stock trading brings into focus the nature of short selling. This method of making money—speculating on the decline of stocks or securities—has a long and controversial history. It all began with The Great Bear of Wall Street, Jacob Little. By being bearish—betting on stocks to fail—he began to short them all the way back in 1822.

It took a century, after the Wall Street Crash of 1929, which was largely attributed to short selling, to finally ban the practice with the so-called uptick rule. This rule prohibited short selling of shares during a downtick. In 2007, the Securities and Exchange Commission (SEC) removed the rule, once again unleashing short sellers.

GME’s Phantom Shares

The digital era exacerbated short selling severely. As the GME House hearing revealed, modern finance allows for trading in phantom shares. This was noticed by Rep. Nydia Velazquez (D-NY) when asking the question:

“GME (GameStop) sold short 140 percent. Why isn’t that manipulation?”

The extra 40% existed in buyers’ trading accounts as “digital entitlements”, which can be leveraged for loans or selling. They have the effect of increasing market supply of shares, which lessens their value. In turn, this makes the market more irrational and unpredictable.

In the end, as the Bloomberg report shows, this meant that $359 million worth of GME shares “failed to deliver”. Exemplifying Warren Buffet’s misguided view on Bitcoin as “rat poison squared”, it rings true when applied to these shares as nothing but digital garbage. On one hand, the buyers’ cash depleted, while on the other hand, the sellers’ pool of shares depleted to settle trades.

GME’s Multiplicative Shares

To make things even less transparent, shares have the property of being harnessed multiple times by different clients. As an artefact of shares becoming digital entitlements, Keith Gill noted this phenomenon:

“The ability for the same share to be shorted infinite times is a pathology. We don’t have the ability to track what shares are shorted and how many times.”

With phantom and multiplicative shares in hand, resultant failed trades are then moved on to the following trading day. In turn, these failed trades are then bought and re-shorted, with the expectation that brokerages will have to buy them back within a certain time period.

Furthermore, amid this chaos, brokerages such as Robinhood, Webull, TD Ameritrade and others ceased trading on GME, AMC, and other select securities. This effectively siphoned the air out of the lungs of Reddit WSB traders, crippling their momentum against established Wall Street hedge funds. Does all of this seem like a viable financial system?

The Pretense of Free Market Punctured

As WallStreetBets’ growth from 2.8 million to 9.3 million members in less than two months attests, glaring inequality can rapidly become a rallying cry for “getting even”. However, if Occupy Wall Street 2.0 is to outlive its original version, the following asymmetry of power has to be taken into account:

• Legal sanction is embedded into the cost of doing business and dished out unevenly.
• Wall Street holds effectively infinite resources to adapt and develop counter-strategies.
• Inter-personal networks in tight social circles cannot be underestimated.
• Social media figures can easily craft a narrative that pulls in one direction or another, wittingly or unwittingly.

There is no better case to illustrate this asymmetry than the pump and dump scheme of Eastman Kodak: leveraging retail traders as the pump, leveraging governmental influence, and taking advantage of an exclusive social circle. One would assume it would result in some kind of sanction—but it ultimately resulted in zero consequence.

Leveraging Legitimate Grievances for Greater Wall Street Gains

In previous decades, when convicted of insider trading, the cases of iconic Wall Street figures—Michael Milken, Ivan Boesky, Dennis Levine—show that some form of legal sanction was still in effect, either in fines or token prison sentences. As the Eastman Kodak scandal shows, alongside numerous Senators caught in similar acts, it seems that even that standard is beginning to fade.

At the same time, is it reasonable to expect retail traders to receive the same treatment? More importantly, is it more likely that retail traders will exploit the tricks of tricksters? Can they out-trick those who designed the system to benefit them as a well-oiled machine with many hidden levers inaccessible to retail traders?

To answer that is to answer if the gratification of one won battle makes for a solid groundwork moving forward.

There are those who lost thousands in GME trading, yet they don’t regret it because it “served the cause”. Do you think it is sensible to NOT leverage such wealth in building better institutions instead?