Recent OCC Regulatory Moves Indicate GME/AMC Short Sellers May Go Bust
In a fragile, debt-ridden, pandemically wounded economy, market upsets could trigger an unpredictable cascade. For this reason, it is better for financial entities with high exposure to shorts to be liquidated than for them to cause a market liquidity crisis.
GameStop Exposed the Haziness of the Centralized Stock Market
A massive regulatory change may soon be implemented that would kick many short sellers out of the game. This may end up being the culmination of ripples in the wake of GameStop’s short squeeze. Two weeks ago, the third House Financial Services Committee hearing even had a ban on payment for order flow (PFOF) on the table.
If you recall, a bulk of Robinhood’s income comes from this business model, managing to triple its revenue from just one year ago. Citadel Securities alone made up 43% of Robinhood’s revenue in Q1 2021. Yes, Citadel Securities, the same market maker that funded Melvin Capital to engage in short-selling GME stock while Robinhood’s millions of retail traders tried to short squeeze it.
This is why PFOF practice is banned in both Canada and the UK. In fact, the South Korean equivalent of WallStreetBets – KStreetBets – exerted enough pressure on regulatory bodies to extend several ban extensions on the practice of short selling itself. Moreover, GME trading shined a light on a disturbing host of irregularities – duplicated shares, stocks as digital entitlements, phantom shares, and naked short selling.
Altogether, this obscure mechanism from point A (retail trader enters the market) to point B (brokerage executes the trade) has led to a failure-to-deliver (FTD) of some $359 million worth of GME shares. A major culprit for this FTD could very well be naked short selling engaged by various hedge funds. Naked shorting is like typical short-selling, except the short seller doesn’t own/borrow shares that are to be delivered to the buyer.
Naked Short Selling Reckoning
On the last day of March 2021, the Options Clearing Corporation (OCC) filed a rule change to the Securities and Exchange Commission (SEC). OCC is a clearing house, just like Depository Trust Company (DTC), except the OCC is in charge of options while DTC is in charge of clearing stocks. Clearing houses are critical cogs between traders and brokerages, making sure that all parties settle their trades, thus avoiding unwelcome FTD scenarios.
To that end, both Robinhood and Citadel Securities are members of DTC and OCC, along with every bank and hedge fund you ever heard of. If members default on their settlements, OCC takes a hold of their assets to put on an auction. Then, when the bidding finalizes, OCC repays the loans that covered for the losses of a defaulted member. The proposed rule change, which will enter into effect on May 21 if not delayed by the SEC, is all about smoothing out this process by increasing the number of bidders.
The filed rule change states:
“Competitive bids are necessary for OCC to sell the portfolio at a market price that minimizes the loss to OCC and its Clearing Members, and enable OCC to successfully complete an auction in a timely manner and thereby manage a Clearing Member default in a timely manner.”
More tellingly, OCC issued memorandum #48718 to all clearing members, on May 17th, 2021, notifying them of a “temporary increase to clearing fund size”:
“The temporary increase would result in an increase of $588,378,155 to the Clearing Fund, which will be allocated proportionately among Clearing Members.”
The OCC rule change also made it possible for non-members to bid for the assets of defaulted members. This would include entities such as BlackRock, the world’s largest asset manager in partnership with the Federal Reserve.
Let’s say Robinhood/Citadel default to this new clearing threshold. In accordance with established bankruptcy rule — 190.00(c)(3)(ii) — Robinhood’s trades would become the property of the bidder:
“The Commission is adopting § 190.00(c)(3)(ii) to address the division of customer property and member property in proceedings in which the debtor is a clearing organization. In such a proceeding, customer property consists of member property, which is distributed to pay member claims based on members’ house accounts, and customer property other than member property, which is reserved for payment of claims for the benefit of members’ public customers.”
In other words, regulatory bodies might be preparing for the GameStop and AMC Entertainment short squeeze fallout. If it happens, all those hedge funds and brokerages with exposed shorts against GME/AMC holders will likely be absorbed by cash-flushed asset managers. Just yesterday, Ortex analytics firm had reported that GME and AMC shorting have incurred a whopping $930 million loss during the last week alone.
While exposed centralized market makers like Citadel Securities may soon find themselves in more trouble than they can handle, automated market makers (AMMs) continue to flourish. As a harbinger of the ETH 2.0 upgrade, Polygon (MATIC) DeFi platform has exploded with yield farming activity since the end of April, serving just one example of several.
From April 24th to press time, MATIC price surged by 503%, without any shenanigans involved thanks to smart contracts that eliminate an endless parade of mediators – such as the DTC, OCC, SEC, Citadel, or Robinhood.
Do you still hold short-squeezed stocks? Are you looking forward to the end of the saga? Let us know in the comments below.