SEC: GameStop Frenzy ‘Tested the Capacity and Resiliency’ of Stock Market

On Monday, the Securities and Exchange Commission finally released its report on the frenzy of retail trader activity surrounding GameStop's short squeeze and the skyrocketing value of various "meme stocks" and found that the episode “tested the capacity and resiliency of our securities markets in a way that few could have anticipated.”

“At the same time, the trading in meme stocks during this time highlighted an important feature of United States securities markets in the 21st century: broad participation,” the report noted. “Underneath the memes are actual companies, with employees, customers, and plans to invest in the future. Those who bought GameStop became co-owners of a company through a system of mutual trust and participation that sustains our economy. People may disagree about the prospects of GameStop and the other meme stocks, but those disagreements are what should lead to price discovery rather than disruptions.”

Late in January, traders in online communities like Reddit's r/WallStreetBets piled onto GameStop and a host of other stocks in a bid to push the prices higher and higher, based on a theory that the stock had strong fundamentals while institutional investors were overextending themselves in betting against it. As the meme stock rally carried on, institutional brokers and eventually Robinhood—the fee-free trading app where much of the retail activity was taking place—restricted trading of some stocks and sparked outrage that led to a Congressional hearing in February. 

In the months since, a series of theories and narratives have been floated ranging from accusations that hedge funds like Citadel and platforms like Robinhood colluded to halt the GameStop short squeeze to the notion that this retail trading frenzy represented a populist backlash against Wall Street.

The SEC report does not mention any alleged collusion and adds that while some hedge funds were hurt by the frenzy, others profited handsomely because they were long on GameStop or because they joined the rally for profit. “Staff believes that hedge funds broadly were not significantly affected by investments in GME and other meme stocks,” the report reads.

The report also goes so far as to question whether a short squeeze had any significant effect. A short squeeze is, typically, when short sellers betting against a company’s success are forced to buy shares to cover their short positions. This may force other short sellers to exit their short, pushing the price even higher. The idea with GME was to buoy the stock’s price, forcing short sellers to lose their bets and cover their shorts. 

There were large price increases happening at the same time as major short sellers covering their shorts to reduce losses, and the SEC report includes figures to show significant increases in buy volume during those periods, such as January 22 to 27. The report reveals, however, that not only were such trades a small fraction of the GME buy volume in that period, but that GME prices stayed high even after the period when short sellers were buying shares. 

"The underlying motivation of such buy volume cannot be determined; perhaps it was motivated by the desire to maintain a short squeeze," the SEC writes. "Whether driven by a desire to squeeze short sellers and thus to profit from the resultant rise in price, or by belief in the fundamentals of Gamestop, it was the positive sentiment, not the buying-to-cover, that sustained the weeks-long price appreciation of Gamestop stock."

The alternative explanation of a “gamma squeeze,” which retail traders insisted was another driver of Gamestop’s price momentum, was also dismissed in the report. This is when a market maker that sells a call option—a contract where you buy a stock at a set price in the future in anticipation of an increase—must now buy the stock as it rises to hedge potential losses, thus adding more upward pressure.

The SEC argued this didn’t occur in GameStop’s case, because gamma squeezes are driven by a huge increase in call option purchases. Instead, put option purchases—the opposite of call options, featuring a contract to sell a stock at a set price in anticipation of a decrease—drastically increased from $58.5 million on January 21 to $563.4 million on January 22, and then to $2.4 billion on January 27.

Even the notion that there was an unusual amount of short selling going on with the GameStop stock is debunked in the SEC report, one of the key explanations offered by message board traders as to why they launched their war against hedge funds. Naked shorts are positions taken without borrowing the stock itself, in other words an uncovered short position. The SEC found that "GME did not experience persistent fails to deliver at individual clearing member level" suggesting there were not a significant amount of naked shorts as online communities insisted.

Still, as the SEC itself notes, GameStop was the only stock with more short interest than shares outstanding. Large non-financial stocks, the agency reports, are usually below 2.5 percent short interest, while only a handful of stocks pass 50 percent; one footnote notes that even during 2008's financial crisis, only 12 stocks had short interest higher than 50 percent at a time. Short interest above 90 percent has only been seen during the 2007-08 financial crisis. GameStop short interest hit 50 percent multiple times: in 2012, 2015, 2016, and 2018, before beginning its climb further in 2019. Its highest point was December 31, 2020, when it hit 109.26 percent, which is around when GameStop began to see a huge increase in investment activity from Redditors.

To explain this, the SEC offers a simple alternative explanation: the same shares were lent multiple times by successive investors, appearing as if the stock was sold short twice when short interest was calculated. 

The SEC said it will need to do additional research to determine what steps, if any, to take as a result of the GameStop mania.