Broker Check

Robinhood—did he steal from the rich or poor?

February 02, 2021

Dear Friends,

I’m sure many of you have caught word of what occurred in the markets concerning Robinhood, GameStop, AMC, Reddit users, and others. In case you haven’t, or you don’t really understand what happened, here’s an article that I suppose is as good as any to walk you through it.

Before we go further, though, I’d like to walk you through a slightly distilled version of what a short sell is.

  1. Let’s say you own stock in a company ABC worth $20.
  2. I think that stock is overvalued and will decline.
  3. I borrow the stock from you and sell it to Bob for the current $20 value.
  4. If things work out well for me…
    1. I buy the stock back from Bob after it drops to, let’s say, $10.
    2. Upon buying the stock back from Bob, I return the same amount of shares to you as what I had borrowed initially.
    3. Because I sold the shares to Bob for $20 and bought them back for $10, my profit is the $10 spread.
    4. As you can see, though, the transaction occurred in reverse: the sell came before the purchase, and the only reason that could is because I was able to borrow the shares—i.e., I didn’t have to own them.
  5. If things don’t work out well for me…
    1. When you engage in short selling, you have to have a certain amount of collateral, essentially, to secure, at least in part, the value of the stock that you have borrowed.
    2. If you do not maintain the proper amount collateral, you will be told that you need to increase your collateral position(s)—this is all fine and well, as long as you have the means to do so.
    3. If you do not act upon being told to raise your collateral, your broker will “assist” you by selling off other positions that you own to raise cash for collateral.
  6. This essentially highlights the risk involved with short selling:
    1. It’s always said that the risk is infinite, because at least in theory, a stock could appreciate in perpetuity.
    2. If a stock can appreciate in perpetuity, then that means there is potentially no limit to the amount of collateral that you must hold.
    3. Thus an ever-increasing stock translates to ever increasing collateral for me.

Here’s why the Robinhood situation matters so much…

In the scenario that I described above that didn’t work well for me, I was held accountable for my collateral position, and if ABC stock continued to appreciate, then I would be subject to all of the risk that presented. In the case of Robinhood, things didn’t quite go like that. Instead of the market continuing to function with all players on a level playing field, Robinhood put one set of traders at a disadvantage—those on its platform who wanted to buy GameStop stock and others. Presumably, the reason that Robinhood did this was to mitigate, to the extent that it could, the pressure that was being placed on the value of the stocks in question to appreciate, which would result from people wanting to buy the stock—i.e., you limit the number of buyers, then you limit the pressure on the stock to increase. Regardless of Robinhood’s motivations for doing something like that (e.g., its own integrity as a functional business), this has obviously left a very bad taste in the mouths of plenty, and understandably so.

What I would like to highlight, however, has nothing to do with whether any of the actors involved did anything right or wrong. Instead, something else that this situation has served to highlight is the oddity that is short selling.

The reason short selling is an oddity begins with the simple fact that stock represents ownership in a company. As such, stock is property. There is literally no other property type that any of us are allowed to sell short. In other words, if I came up to you and asked you if I could borrow your home, sell it to someone else, buy it back, and then return it to you, what would yo….you know what? Nevermind. I’m not even going to ask you what you would do or how you would respond, because all of us would respond the same way.

I don’t know about you, but I appreciate consistency. If you think about it, consistency is key when it comes to the ease or difficulty with which you comprehend and navigate the world. As an example, if you were driving a stretch of road that had a posted speed limit, then it seems pretty obvious that you would find it easy to follow the speed limit. Conversely, if you were driving a stretch of road that, instead, had a sign posted that read “Speed Enforced at Officer’s Discretion”, it would be understandable if you were a little uncertain about how fast you should drive, and maybe if you should even continue on that road at all.

This is essentially where short selling fits in. Out of all of the property types, a stock certificate is the only one for which this is allowed—just making sure you caught that. So, stock ownership represents an exception to a rule. The more exceptions you allow for a rule, the lower the integrity of that particular rule. The lower the integrity of a rule, the more insignificant that rule becomes and the more your confidence drops in simply knowing what to do, with respect to that rule.

If we want to live in a world where we are confident and feel free to move and prosper as we wish, then it would seem that the rules that are in-place need to be straightforward and of the utmost integrity. The simple fact that I started off this discussion with an explanation of short selling is because I am well aware that there are plenty of folks who don’t understand what it is. I do not blame anyone for not understanding it—it’s not an easy concept. After all, as I have pointed out, short selling represents a substantial departure from what all of us have always understood about property and the function of ownership.

Needless to say, it will be interesting to see how all of this plays out, but it seems clear that there is currently an exception to a well-known rule that is in need of being addressed, and for which the justifications seem slim, if not completely non-existent. I also hope that at this juncture it is also needless to say that we are not fans of short selling, nor is it a part of the strategies in our practice.