Robinhood’s shutdown of GameStop stock trading via its platform has led to a massive public uproar. As a beneficiary of this outcry, DeFi and crypto have gained the attention of politicians, retail investors, and entrepreneurs alike.
Wall Street faces huge losses over GameStop stock rally
On January 11, GameStop agreed to a deal with Chewy.com’s founder, Ryan Cohen, to add three Chewy.com veterans to its board as part of a plan to embrace eCommerce and had a subsequent 60% increase in stock price.
Just 10 days later, on January 21, Citron Research and short-seller Andrew Left argued that they expected GameStop to drop in value. Around that time, a group of retail investors on the famous subreddit WallStreetBets noticed that the Grapevine, Texas-based video game retailer was short over 140% on its stock’s float.
They began to buy call options on the stock and the stock began an unprecedented rally of roughly 1,500%. This led to two major problems for Wall Street.
1. A short squeeze
A short position is where an investor has a borrowed a stock and sold it with the hope of its value dropping. Once its value drops, the investor would plan to buy the stock back and return the stock to the original lender, and pocket the difference in the price. A short squeeze occurs when the stock being shorted has its price rise significantly and the short investors try to buy stocks to prevent further losses.
One major hedge fund, Melvin Capital Management, held a significant short position in GameStop and scrambled to close their position as the price rallied. According to Reuters, sources close to the fund said it lost more than 30% and got a $2.75B lifeline from Ken Griffin’s Citadel and Steven Cohen’s Point72. An Insider article cited exclusive data that showed $19 billion in overall losses by hedge funds and other institutions as of today.
2. A gamma squeeze
When the retail investors bought call options, the institutions that sold to them (known as market makers) also buy the stock to hedge their risk. When gamma (the rate of change of the ratio between option price movement and stock price movement) starts to rise, the market maker needs to buy more and more stock to hedge their risk. This occurred in the case of market makers for GameStop call options.
These two squeezes led to investors with short positions and market makers try to purchase more and more of the GameStop stock which further drove up the prices. This led to the next major turn in this story: the suspension of trading of GameStop stock by some major trading platforms like Robinhood.
Robinhood stops GameStop stock trading on its platform
There are two major thoughts on why Robinhood halted trading of GameStop and other short squeezed stocks on its platform:
First, Robinhood faced pressure from institutions and market makers to halt the trades.
Citadel is an investor in Melvin Capital, which got run over by Wall Street Bets. Citadel is also Robinhood’s biggest customer. ?
— Tyler Winklevoss (@tyler) January 28, 2021
This theory is amplified by the fact that Robinhood makes most of its money by selling its user’s trades to market makers like Citadel Securities (the same institution that tried to bail out Melvin Capital Management). Citadel can then make money by filling these orders by themselves.
The alternative theory is that Robinhood was facing significant solvency issues and that there isn’t significant nefarious activity between Robinhood and Citadel.
Ok – here’s my best explanation of why @RobinhoodApp restricted trading in the short-squeeze stocks.
Spoiler: the story isn’t the Ken Griffen called Janet Yellen who instructed DTCC to raise margin on Robinhood to force them to shut down the speculative buying.
Here goes …
— Silent Cal (@KralcTrebor) January 29, 2021
To sum up the Twitter thread, when a trader buys or sells a stock on Robinhood, the trade doesn’t settle for a couple of days. During that time, the net buys/sells’ cash value must be paid or received by Robinhood and this credit risk.
As explained by the thread, the NSCC handles this credit risk but requires brokers to pay a deposit as collateral. The idea for this theory is that Robinhood was unable to continue posting these deposits. This would explain why Robinhood had to draw on hundreds of millions from bank credit lines and why they raised a bridge round of $1 billion from existing investors.
How DeFi can solve these problems
Regardless of which of the two theories is true, crypto and decentralized finance could help prevent this from repeating.
Decentralized markets for securities like stocks would be relatively immune to collusion or pressure from outside forces to halt trading like the first theory says Robinhood did. A decentralized market would run on the power of a network of traders and open-source code as opposed to the approval of an individual or entity.
Today showed us that the SEC has had it wrong. The problem isn’t that some cryptos may be securities. The problem is that all securities aren’t yet cryptos.
Now is the time to draft a bill that legalizes security tokens.
— balajis.com (@balajis) January 29, 2021
Furthermore, the credit risk described in the second theory could be greatly minimized by crypto as trades would settle in minutes not days. Trading would also occur 24/7 meaning that traders would not have to wait for market opens to trade.
This has led to widespread recognition for crypto in the last week. Many retail traders have begun to trade in Dogecoin leading to a 285% increase in volume in the last 24 hours. Major public figures like Tesla and SpaceX founder Elon Musk, influencer Mr. Beast, and Twitter CEO Jack Dorsey have also added #Bitcoin to their bios.
Russell Okung, an OT for the Carolina Panthers and a major Bitcoin advocate who receives half his salary in Bitcoin, has been asking people to add #Bitcoin to their bio and has garnered responses from Reddit founder Alexis Ohanian Sr. and others.
Whether this pro-crypto sentiment leads to more adoption and growth is to be seen but WallStreetBets’ efforts to squeeze GameStop short positions have led to significant attention for crypto innovation. Some crypto experts worry about crypto’s ability to handle sudden adoption but overall the crypto community seems to be excited about the future of DeFi.
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