Retail Investors Riot; Class Warfare Or Casino?

For years, Wall Street has taken advantage of retail investors.

In 2000, they dumped companies with no earnings or revenue on unsuspecting individuals, eventually costing them their retirements. In 2008, it was outright mortgage fraud. From 2009 to the present, Wall Street has used algorithms, high-frequency trading, and user data purchases to front-run the little guy by scalping them for profits.

Interestingly, this past week, retail investors hit back. Just as individuals used social media platforms to organize protests and riots across the country, traders used websites like “Reddit” to organize a successful short-squeeze on Wall Street hedge funds. That short-squeeze, which forces hedge funds who were short stocks to cover the positions, has sent a handful of stocks to the moon. Notably, GameStop, a retail store that is on its way to bankruptcy, has been the movement’s poster child.

If you happened to be visiting Mars over the last few days, here is what I am talking about.

That chart is what a “short-squeeze” looks like when those short a stock have to “buy to cover” at the prevailing market price. It hasn’t been pretty, and the “Wall Street Bets” Reddit group took credit earlier this week for forcing Melvin Capital, a hedge fund short GameStop, to get a $2.7 billion bailout from its hedge fund friends.

From that moment, it didn’t take long for Wall Street to show its true colors by locking retail investors out of being able to buy GameStop. Robinhood, Schwab, WeBull, and others all restricted trading in the stock, which resulted in immediate class action lawsuits.

The Margin Problem

While Robinhood, and other brokers, took a lot of heat for restricting trading in shares of the most heavily shorted names, there was a reason – collateral requirements.

Without getting into all of the minutiae of capital requirements and margin accounts, the simple fact is that the NSCC is required, by SEC rules tracing back to Dodd-Frank, to make sure there is always cash to settle.

Depending on the net of buys and sells, the brokerage (like Robinhood) is on the hook to pay or receive the trading’s net cash. That is simply credit risk. The NSCC takes on that credit risk. To mitigate the risk of a brokerage failure, they demand firms post a deposit of 10% of the collateral.

Here is where the problem comes in. When firms are already heavily on margin (currently at a record level of negative cash balances), sharp changes in the underlying collateral value can lead to immediate demands for more deposits from the brokers.

On Thursday, Robinhood had to raise nearly $1 billion in capital to secure the ability to cover collateral requirements. We also saw margin requirements being adjusted by the DTCC.

Of course, the risk to the markets is that with brokerage firms already running too lean, if a firm like Robinhood failed, the ripple effect through the financial industry would likely rival that seen during the Lehman bankruptcy in 2008.

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