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How the GameStop hustle worked

How hedge funds and brokers have manipulated the market
 
by Lucy Komisar
 
Part 2 - Naked Short Selling and Fails to Deliver
 
The SEC allows traders to short a stock, which means to sell it even if they don’t own it, hoping to buy it back later at a lower price and bank the difference. Short sellers borrow the stock, usually from a broker, who either has it in their inventory, borrows it from another broker, or vows to “locate” the stock when the time comes and cover the short.

That promise is often fake. A broker handling several sellers will borrow synthetic or manufactured shares, or “locate” the same stocks for multiple shorts. Traders and brokers have been mildly sanctioned for this scam.

Sellers are supposed to send shares to buyers within two days. If they don’t convey the stock, there is a failure to deliver (FTD). This is also known as naked short selling. Traders that have outstanding FTDs are required to transfer the shares within a given time and are restricted from selling short until then. This rule is massively ignored or finessed, and the penalties are minor.

The major GME short sellers had to cover their shorts at a time when the funds had shorted much more stock than existed and when owners with real shares weren’t selling, even at higher prices. They were threatened with a short squeeze, with the price going so high that they cannot cover it with existing assets, and they get a margin call, a demand that additional money gets dropped into their brokerage account.

The short squeeze ended under peculiar circumstances. A January 28 spike in GME led Robinhood, the online broker that handled orders for many retail traders, to cut the buy option for the stock from its app. Robinhood CEO Vlad Tenev told the House Financial Services Committee in February that he had discussed the trade restrictions with the Depository Trust and Clearing Corporation (DTCC), which clears public trades, after it made a $3 billion margin call.

However, DTCC CEO Michael Bodson told the committee in May that “the decision to restrict trading really was internal to Robinhood, we did not have discussions about that.” He noted that with Robinhood, “the system worked.” It stopped the buys while the big traders continued to sell. GME that day hit $483, but then the price plummeted, and the short squeeze was over.

Why would Robinhood shut down GME trading? It did not lose money on trades, because it did not have its own investments. The answer may be hidden in the murky relationships involving market makers and hedge funds.

Citadel Securities, a market maker, handled Robinhood’s orders on a “pay for order flow” basis (it paid for orders routed to it), which equaled 40 percent of Robinhood’s revenue. Citadel Securities is a division of a company founded by billionaire Ken Griffin. Another division, the Citadel hedge fund, helped provide short seller Melvin Capital with nearly $3 billion in funds during the GME short squeeze. Citadel Securities would have the clout to persuade Robinhood to shut down trading, and the motive, given its other division’s investment in Melvin. (UPDATE: Robinhood COO James Swartwout stated in sworn court testimony in February for a case in California that “no third party, including either Citadel or Citadel Securities, requested that Robinhood apply restrictions on stock or options trading or played any role” in the decision to limit trading.)

Citadel Securities also has a knack for running afoul of the trading laws. It has been fined 58 times in the last few years for violating trading regulations, many about naked short selling. In February 2021, the same time frame as the GME trades, Citadel Securities was fined $10,000 for failing to close out a failure to deliver of shares it had sold short.

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