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The meme-stock frenzy gets a facelift that SEC narrative matters

(Bloomberg) — The meme-stock frenzy could be a case of traders banding together to take down hedge funds.

It disputes new research that challenges the Securities and Exchange Commission’s view that a so-called short squeeze played little role in moving GameStop Corp. In the stratosphere in January 2021. The regulator failed to examine relevant securities-lending data and did not study the transaction long enough, a half-dozen academics from Columbia University, the University of Notre Dame and elsewhere insisted in a paper sent to the SEC in recent weeks. to President Gary Gensler.

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

When Gamestop rallied more than 1,000% in less than a week and triggered huge losses at some hedge funds, the reason was plainly obvious to investors chronicling the frenzy on social media: The shares attacked short sellers by breaking out, and even fueled insane price gains as it forced the bears to engage in a buying frenzy to exit their short positions.

But an SEC report released in October questioned that stance, arguing that shorts closing their bets played only a minor role in driving the rally. Although regulators said they could not determine why Gamestop jumped, they speculated because traders were either optimistic about the videogame retailer’s prospects or thought they were triggering a small squeeze.

Read More: SEC GameStop Report Debunks Conspiracy, Back Gensler Plan

Now, academics say the conventional wisdom could always be right.

“The SEC’s October analysis used incomplete data and flawed methods to arrive at incorrect conclusions about the events of January 2021,” said study lead author and Columbia University law professor Joshua Mitts. Our “findings suggest that the SEC’s response to Gamestop and other meme stocks may have been 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 rising stocks to balance their risk for the contracts they sold, selling the shares. Push even more. Academics said the SEC focused on call contracts in its analysis, while ignoring the impact of put contracts, which could contribute to a gamma squeeze.

What happened last year is acknowledged by retail traders as a rare case of David joining the collective to stick Wall Street Goliaths. Even some US lawmakers welcomed the populist narrative, arguing that the market has been tilted against the little man for too long.

Yet Mitts said the episode actually exposed the fragility of the market for plans that could cause share prices to trade at levels that have little to do with the company’s earnings. That said, should prices normalize, it could hurt the same types of investors who cheered GameStop’s rocketship growth, he said.

“The anti-fraud and anti-manipulation rules need to be overhauled for the social-media age,” said Mitts, who has long petitioned the SEC to toughen the rules for short selling. “The SEC should take note of the distorting effects of short squeezes and gamma squeezes on the market, and the loss to ordinary investors.”

An SEC spokesperson declined to comment on the academic study. Mitts said it was not funded by a hedge fund or any other third party.

‘tiny fraction’

In its study, the SEC stated that GameStop made up “a small fraction of total purchase volume” during the company’s boom, and that the stock price had “reduced after the direct effect of covering short positions”. Will happen.”

Mitts and his colleagues described as many flaws in the SEC’s analysis. According to the paper, the regulator did not examine individual customer accounts or include data on all short sellers, the academics argued. The agency also did not review short-selling data prior to December 24, 2020, and thus did not see that shorts had already been accumulated at GameStop before the stock’s particularly bad January 2021 run.

Mitts’ paper sheds light on a poster on Reddit calling for a small squeeze on GameStop months before a huge 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 Damies of Melvin Capital”, a hedge fund that gained widespread attention for betting against GameStop .

Reddit posts about Melvin became more frequent with users promising to drive GameStop’s price “to the moon.” Melvin, run by money manager Gabe Plotkin, suffered a major setback months later – losing about 53% in January 2021 – which required it to take a cash infusion.

new rules

The SEC did not offer specific policy recommendations related to the brief squeeze in the agency’s October report. But the regulator did say that it will examine what prompts brokers to restrict client trading. Last week, the agency said it would begin considering rules on how long it takes to settle stock trades. The SEC previously said it wanted to reduce the time taken for transactions, which now take two days to finalize.

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

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