What Traders Need To Know About GameStop And Naked Short Selling

GameStop Corporation GME and AMC Entertainment Holdings Inc AMC were the targets of a massive short squeeze in January that saw their share prices soar 1,041% and 624%, respectively, over the course of four days.

This week and last, AMC was targeted again and its shares skyrocketed 496% between May 24 and June 2 before retracing Thursday.

What Happened: The squeeze in GameStop was caused by retail and institutional traders rushing into the stock, and some hedge funds covering their short positions, which drove the price up to astronomical levels. Robinhood and a number of other brokers then restricted trading and caused an illiquidity event that dropped its stock down almost 90% over the following nine days.

Robinhood's restriction landed its CEO, Vladimir Tenev, in front of the U.S. House of Representatives in February to testify on the GameStop saga and reports of naked shorting, consequently, caused Rep. Nydia Velazquez to question why GameStop "sold short 140%. Isn't that market manipulation?"

What Is Naked Shorting: Naked short selling is the practice, most commonly executed over dark pools, where big banks lend shares of a security that don't actually exist to one of their clients.

The practice, which was made illegal following the 2008-2009 financial crisis, is made possible through loopholes that exist in the Security and Exchange Commission's rules as well as discrepancies between electrotonic trading platforms and paper trading systems.

Legally, for an institution to lend shares to a client, the institution must own, or be able to locate, the shares so that when the obligations of the sale need to be met the shares available. When synthetic shares are created and "lent," it gives institutions an unfair advantage by giving them more ammunition, in the form of counterfeit shares, to apply downward pressure to stocks than what is actually available.

Shares of a company with a high percentage of its float held in a short position are the most difficult to find, which explains why GameStop’s stock enthusiasts believe a huge amount of naked shorting is still taking place.

See Also: AMC And GameStop Short Sellers Have Taken A $12B Loss In 2021

Why It Matters: The retail traders of the Reddit forum r/Superstonk, a relatively new community of former r/WallStreetBets members, believe the short position on GameStop is still higher than the total amount of shares available and are enthusiastically awaiting the company’s shareholder meeting on June 9.

At 11:15 a.m. ET that day, GameStop will count its float by requiring "shareholders to provide proof of ownership through legal proxy and valid identification." If it's found that there are more shares being sold than are issued and outstanding, institutions could be held liable. The retail community believes this would be a bullish catalyst for GameStop.

The Wall Street Connection: Wall Street makes most of its money from stock lending, with its firms raking in hundreds of billions of dollars per year, according to Houston-based lawyer Wes Christian, a U.S. legal expert on naked short selling.

Each day firms are supplied lists of both easy to find and difficult to find shares of companies and when they're unable to find shares of a particular security, they can illegally manufacture synthetic shares, "wink" to their friends at hedge funds and lend out shares that don't actually exist.

“500 million to a billion shares per day are sold, but not delivered on all exchanges,” said Christian in an interview with journalist Lucy Komisar on Wednesday.

The interview was hosted by key r/Superstonk moderator Pink (u/pinkcatsonacid).

Photo by Tima Miroshnichenko from Pexels