To Prevent Future GameStops, Promote Stock Futures
(Bloomberg Opinion) -- It’s the biggest betting event of the year. Yes, I’m referring to the Super Bowl this Sunday but I could just as easily be talking about GameStop Corp. After all, the amounts bet are roughly the same—probably high single-digit billions of dollars—and the news coverage is similar in its intensity.
Shares of the retailer soared in recent weeks, rising from around $10 a share to almost $500 on Jan. 28, before collapsing to around $54 yesterday – all without any meaningful change in the company’s fundamentals or outlook. Large packs of small investors are believed to be behind the moves. Some people are concerned about the welfare of these investors, saying they are foolishly “betting” in the stock market and putting their financial health in jeopardy.
But if they are “betting,” than they are getting a better deal than in a casino. In fact, they would pay 5% “vigorish” placing a sports wager in Las Vegas, while Wall Street “bets” now carry zero commissions and effective transaction costs about 1/100 of what bookies charge. If anyone is really worried about retail gambling, close down State lotteries first—which charge 10 times the Las Vegas edge--and then ban sports betting and casino play, before outlawing RobinHood Markets and Reddit.
Other people are not worried about the financial health of these bettors, but about the disruption they bring to capital markets and the economy. This is similar to National Football League officials worried that sports betting will influence the outcome of games if players, coaches, staff and referees are allowed to bet, or if gamblers try to bribe players or otherwise fix results. The NFL and the FBI try to insulate the game on the field from the much larger game of betting on it.
When investors pile into stocks because they are going up or to join some imagined battle with shadowy Wall Street villains, it doesn’t just redistribute dollars from losing bettors to winning bettors. It affects real financial and economic decisions. Companies may raise capital at temporarily inflated valuations. Holders of convertible bonds may convert the securities into shares. Foolish projects may be undertaken and wise projects neglected. Prudent investors saving for retirement may see balances batted around like a fluttering pass thrown by a quarterback who takes a hit just as he releases the football.
There is an established financial solution to this problem: the futures markets. Hedgers and speculators can trade passionately, far from farmers, miners, drillers, processors and other dealers in physical commodities. While futures and physical markets are connected—loosely at times—by prices, the mechanics of the futures trading runs independent of physical production, processing and use. This fails occasionally, as in April 2020, when for a few hours around futures delivery prices of oil futures from Chicago collided with physical storage constraints in Oklahoma, sending the price of crude below zero, but it works almost all the time. Futures open interest can be greater than available supply, or can collapse to zero, without disrupting fuel deliveries or causing retail gasoline price gyration.
If GameStop bettors used single-stock futures, they could have bet with each other as much as they wanted without disrupting actual trading in the underlying stock. There are no short squeezes in the futures markets, no naked shorts and much less risk of disruption from traders failing to meet obligations.
Suppose there had been active single-stock futures trading in GameStop all along. Short-sellers would definitely prefer the futures market because there’s no need to find stock to borrow, to pay borrowing fees and to risk a recall of shares. This would push the futures price down relative to the actual stock price, something called the “futures basis.”
Long-term investors would not be attracted by the somewhat lower futures prices because they must replace or “roll” their futures every month, and the transaction costs eat up the cheaper initial price. Also, futures do not come with corporate voting rights or tax advantages that are important to long-term holders. Therefore, the people willing to go long in the futures market would be active money managers with shorter holding periods, who don’t care about corporate voting and don’t get the tax advantages of long-term holders anyway. There would be two markets, one for long-term holders and one for shorts and short-term traders.
Now, you get a frenzy like from Jan. 25 to 28 when retail investors bought 74 million GameStop shares and sold 75 million shares to each other , sending the stock price wildly up and down, transferring billions of dollars amongst each other. Essentially all of this activity would have been directed to the futures market. Dealers would “cross” or offset those trades, and hedged only the net 1 million share exposure in the futures market. Instead of needing collateral to cover trades of 149 million shares over a two-day settlement cycle, in the futures markets collateral is collected at the end of the day, after netting out all the buys and sells and all the intraday price moves. Retail purchasing of options was also significant, but in this world the options would be written on the futures, not on the actual stock.
Single-stock futures exist and are legal, but never got much interest from traders. It’s something of a mystery why. Prior to 2002, it was blamed on disputes between the Securities and Exchange Commission —which did not want to give up authority over stocks—and the Commodity Futures Trading Commission —which was jealous of its power over futures. But the agencies reached a compromise and single-stock futures exchanges opened to little enthusiasm. Some researchers blame dealers protecting their profit while others blame the conservativism of investors. But in 2021 we have a demonstration of why they are needed.
You can’t stop people betting, and I would argue you don’t want to even if you could. But you can keep the link between bettors and players loose and indirect so chaos in one arena doesn’t spill over to the others. We know how to do this, and have been doing it for 170 years.
These are figures from Citadel Securities, but likely represent market proportions reasonably well.
An even simpler idea is not legal. It goes by the pejorative name of “bucket shop.” A bucket shop takes bets on stock or commodity prices, and covers the bets itself like a bookie. It may buy or sell the underlying securities in the financial markets as a hedge, but it does not match individual customer bets with market transactions. This allows it to “cross” many offsetting customer bets—just like a bookie takes bets on both the Kansas City Chiefs and the Tampa Bay Buccaneers—and only hedge any imbalance.
This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.
Aaron Brown is a former managing director and head of financial market research at AQR Capital Management. He is the author of "The Poker Face of Wall Street." He may have a stake in the areas he writes about.
©2021 Bloomberg L.P.