The epic short squeeze in GameStop Corp. has become infamous as a battle between retail investors and hedge funds. But the most serious effect was – and may continue to be – a concern about settlement risk and solvency among Robinhood and other larger broker dealers.
That’s according to Charles Gradante, a renowned hedge fund manager who spoke at a live CorpGov event on February 10 (prior to congressional testimonies on the matter) to discuss the retail-fueled rally in GameStop, AMC, and other stocks that nearly wiped out hedge funds including Gabe Plotkin’s Melvin Capital Management LP. Mr. Plotkin’s fund took billions of dollars in bailout money from Steven Cohen’s Point72 and Ken Griffin’s Citadel to stave off potential collapse while many retail investors suffered catastrophic losses when GameStop shares retreated.
Highlights including all of Mr. Gradante’s comments are in the video below:
Mr. Gradante said that hedge funds ultimately bear responsibility for poor risk management. Aided by the use of derivatives, hedge funds and other institutional investors drove the effective short interest in GameStop to more than 100% of the float, or shares available to trade, setting the stage for a squeeze. In short, poor risk management by the institutional side created the opportunity for the squeeze by the retail side. It was an historical first, creating a need for change.
“We saw that the hedge funds were muscling retail holders of GME and AMC and the other stocks into submission,” he said. “They got a little greedy. And greed usually precedes a major correction in the situation.”
Retail investors exposed poor risk management at Melvin Capital and other funds, he said, adding that the situation bears resemblance to Long-Term Capital Management’s collapse in the late 1990s.
“We can talk about the Russian default in 1998, which led to the debacle with Long-Term Capital, you can talk about other things with respect to the hedge funds, shorting GME, but the common denominator is greed,” he said. “They overshot it, they shorted so much of the stock that it didn’t take too much mediocre mathematics to figure out how to conduct a short squeeze.”
He said the hedge funds were clearly mistaken to short such an extreme amount of GameStop shares. “I mean, I would never have a guy trading for me at Drexel Burnham wanting to short 100% of the float,” he said.
The amount of risk on Robinhood’s books became more than it could manage, which required it to get a bailout of its own from Sequoia. The fact that not only Robinhood but other brokers began to limit trade in specific stocks suggested broader liquidity concerns.
“Robnhood wasn’t prepared for this from a capital point of view,” Mr. Gradante said. He went on to point out that this debacle created liquidity traps for the long retail traders as well as the hedge fund short sellers, in addition to the broker dealers.
He also said that the two-day standard settlement, known as T+2, may have exacerbated the problem because it prevented broker dealers from knowing precisely how much risk was on their books at the end of any given trading day.
“The bottom line of all of this… is that if they had same-day settlement and clearing, the broker dealer would have known exactly what their risk was,” he said. “If you peel away the facts, you’ll find out that trading on a T+2 basis results in a dilemma.”
He explained the problem was a disconnect between how investors trade and how broker dealers can execute those trades. For instance, traders may take intraday profits and then plow the proceeds into new positions before trades have cleared and settled. If one broker dealer were to default, countless trades would get “busted” and potentially create a domino of failed trades on the Street and a liquidity crisis among broker dealers.
“That’s what we now call settlement risk,” he said. “Back in 1987, I was around when the crash happened. And those days, it was T+5. So, it took five days to clear and settle trades. And we had to shut down Wall Street for three days in order to allow the back office to catch up with the trading.“
As for solutions, Mr. Gradante said that margin requirements on stocks should increase in proportion to short interest. More broadly, same-day settlement – possibly through the use of blockchain – could eliminate many of the risks associated with real time trading and multiday settlements. (Several days after Mr. Gradante spoke, Mr. Griffin advocated for a shortened settlement cycle, though one day rather than real time).
“They have to get it down to same day clearing and settlement and blockchain technology – in my mind – is the only way to go,” Mr. Gradante said. “Of course, it will take a couple of years to do all this maybe a decade. But that is the vision that the people running Wall Street should have for the environment, when you have real time trading, you’re going to need real time settlements.”
Turning to GameStop specifically, Mr. Gradante raised the question of why the company didn’t issue equity when its stock was elevated. The concern, he said, may have been that they simply didn’t have a legitimate use for new capital and taking advantage of GME pricing could have created legal risks for the board.
Ultimately, Mr. Gradante doesn’t blame short selling on any blanket basis but poor risk management among short sellers. He was in adamant support of short sellers as they play a healthy role in keeping markets efficient, he said.
In many cases, short sellers may even know company fundamentals even better than long buyers. “But short sellers play a role,” Mr. Gradante said. “They provide liquidity, they provide pricing.”
After a successful career at Citigroup, Mr. Gradante joined Drexel Burnham Lambert in 1986 and spearheaded the firm’s efforts in Europe which led to his position as CEO of the failing Chelsea National Bank for which he engineered a turnaround and sale. He subsequently became a partner of the Hennessee Hedge Fund Advisory Group, then a part of E.F. Hutton and later spun off as a wholly-owned private company (Hennessee Group LLC), where he co-founded the Hennessee Hedge Fund Index (the first of its kind) providing hedge fund research to clients. The Hennessee Group LLC managed $1.6 billion. Not long afterwards, in the wake of the collapse of Long-Term Capital Management, Mr. Gradante repudiated public perception of the hedge fund industry as “ruthless risk takers threatening the stability of capital markets” when he testified before the House and the Senate in 1998 and again in 2004. In 2007, Charles predicted the subprime mortgage meltdown, which triggered a global financial crisis. He continues to manage money today in a private fund.