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Meme-Stock Frenzy Gets a Fresh Look That Questions SEC Narrative

New research contends that GameStop's stock rally really was caused by short covering.

(Bloomberg) -- Meme-stock mania might have been a case of traders banding together to take down hedge funds after all.  

That’s the contention of new research that challenges the Securities and Exchange Commission’s view that a so-called short squeeze played little part in pushing GameStop Corp. into the stratosphere in January 2021. The regulator failed to examine relevant securities-lending data and didn’t study a long enough stretch of transactions, a half a dozen academics from Columbia University, the University of Notre Dame and elsewhere asserted in a paper sent in recent weeks to SEC Chair Gary Gensler. 

The claim puts a new twist on one of the most closely watched, and debated, periods in recent memory for the U.S. stock market. 

When GameStop spiked more than 1,000% in less than a week and triggered giant losses at some hedge funds, the reason was screamingly obvious to investors chronicling the hysteria on social media: bulls attacked short sellers by snapping up shares, and that fueled even crazier price gains because it forced the bears to join the buying frenzy to exit their short positions.  

But an SEC report released in October questioned that stance, arguing shorts who closed out their bets only played a minor role in driving the rally. Although regulators said they couldn’t determine exactly why GameStop jumped, they speculated it was because traders were optimistic about the videogame retailer’s prospects or thought they were triggering a short squeeze.

Read more: SEC GameStop Report Debunks Conspiracies, Backs Gensler Plan

Now, the academics say conventional wisdom could have been right all along. 

“The SEC’s October analysis used incomplete data and flawed methods to reach erroneous conclusions regarding the events of January 2021,” said Joshua Mitts, lead author of the study and a Columbia University law professor. Our “findings suggest that the SEC’s response to GameStop and other meme stocks may be deeply misguided.”

The SEC also fell short, according to the paper, in examining the effects of a so-called gamma squeeze, which occurs when options dealers buy a rising stock to balance their exposure to contracts they have sold, pushing shares even higher. The SEC focused on call contracts in its analysis, while overlooking the effect of put contracts, which can contribute to gamma squeezes, the academics said. 

What happened last year has been embraced by retail traders as a rare case of Davids joining together en masse to stick it to Wall Street Goliaths. Even some U.S. lawmakers welcomed the populist narrative, arguing that the market has been tilted against the little guy for far too long. 

Yet Mitts said the episode actually exposed the market’s fragility to schemes that can cause share prices to trade at levels that have little connection to a company’s earnings. Should prices normalize, it can hurt the same types of investors who cheered GameStop’s rocketship rise, he said. 

“Anti-fraud and anti-manipulation rules need to be overhauled for the social-media era,” said Mitts, who has long petitioned the SEC to toughen rules around short selling. “The SEC should focus on the distortive effects of short squeezes and gamma squeezes on the market and the harms they cause ordinary investors.” 

An SEC spokesman declined to comment on the academic study. Mitts said it wasn’t funded by hedge funds or any other third party.

‘Small Fraction’

In its study, the SEC said shorts purchasing GameStop to close positions made up “a small fraction of overall buy volume” during the company’s surge, and the stock price remained elevated “after the direct effects of covering short positions would have waned.”

Mitts and his coauthors described what they viewed as multiple flaws in the SEC’s analysis. The regulator, according to the paper, didn’t examine individual customer accounts or include data on all short sellers, the academics argued. The agency also didn’t review short-selling data before Dec. 24, 2020, and thus didn’t see that shorts had already mostly bailed on GameStop before the stock went especially haywire in January 2021.

Mitts’ paper highlights posters on Reddit calling for a short squeeze in GameStop months in advance of the massive jump in price. In October 2020, a Reddit user named u/stonksflyingup posted a short video on the WallStreetBets subreddit titled “GME Squeeze and the Demise of Melvin Capital,” a hedge funds that garnered widespread attention for betting against GameStop. 

Reddit posts about Melvin became more frequent with users promising to drive the price of GameStop “to the moon.” Melvin, run by money manager Gabe Plotkin, did suffer a massive blow months later -- losing about 53% in January 2021 -- that required it to take a cash infusion. 

New Rules

The SEC didn’t offer specific policy recommendations tied to short squeezes in the agency’s October report. But the regulator did say it would examine what prompts brokers to restrict customer trading. Last week, the agency said it will begin considering rules about how long it takes to settle stock trades. The SEC has said previously said it wants to reduce the time for transactions, which now take two days to finalize. 

Mitts’ coauthors include Robert Battalio, a finance professor at the University of Notre Dame; Jonathan Brogaard, a finance professor at the University of Utah; Matthew Cain, senior fellow at Berkeley Law School; Lawrence Glosten, a professor at Columbia Business School; and Brent Kochuba, who runs SpotGamma, a financial data company. 

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