So a bunch of Reddit traders bid a stock to the stratosphere to command a market capitalization of $22 billion and suddenly all the politicians are panicking. Amazon which is trading at a valuation of $1.6 Trillion is not an issue. The issue is Game Stop.
So the question is why?
[ This is a super-long post but for the benefit of all, we will provide our conclusion up front. Market makers went short GME and AMC off the Robinhood order flow, thinking that they could profit from the amateurs. They did not know that the stocks itself were heavily shorted and waited to cover so as not to sustain a loss. And they waited. And waited. And when they started to hemorrhage cash, they cried to the Big Daddy. Its no longer Reddit crazies vs a few hedge funds. Its all the crazies in the world versus the combined might of Wall Street. ]
First lets be clear on how dumb the shorts were as Investment Genius Patrick Star explains the thesis on shorting a stock like GameStop.
Before we go through the financial side of this analysis, we must consider the Information Warfare part of this analysis.
Let’s look at how Big Media is framing this clash between the bad, horrible, proletariat Reddit traders vs. the innocent, kindly, good-nature Hedge Funds.
I think it is this precise hypocrisy by Big Media and Big Technology which will prove to be the Hedge Fund’s downfall. This news had massive coverage worldwide and judging by the responses in social media, an overwhelming majority of the public does not see share the moral judgement placed by the establishment.
In any introductory economics course, one is introduced to the concept of the actors in an economy as being differentiated between the Government and the Households. Note to Hedge Funds and their acolytes : “Don’t enrage the Households.”
Let’s get back to the point in question: Why is everybody panicking? To us, the answer is an entity so central to derivative clearing, whose existence could be threatened by this popular uprising . Let’s look at such entity, hypothetically called using our Gen Z inspired, Mancunian vocabulary, ‘Man-like-Citadel‘
Man-like-Citadel is no ordinary hedge fund, it actually is a sponsored member of the DTCC, Derivatives Trust and Clearing Corporation, which allows it to “clear” trades. Currently we do not know the size of Man-like-Citadel‘s derivative book, and the positions it currently holds, but we have access to last year’s financial statement for Man-like-Citadel Securities LLC, which can provide a rough picture. (Link is over here).
Now lets understand something here – Man-like-Citadel is no JP Morgan. JP Morgan’s total capital as of 2019 was $242 billion, comprising of CET 1, or the highest form of capital of $187 billion. Man-like-Citadel is a hedge fund owned by a single billionaire – meaning, it will be difficult to sustain a hit of the order of $5 – $10 billion at a single stroke. There is a limit to Man-like-Citadel‘s capital resources. Read on more about the same condition at Man-like-Citadel.
So, let Man-like-Citadel die. Why is that such a big issue?
First we have to understand how “Man-like-Citadel” can get caught in the GameStop rebellion. For that we refer to the following disclosure on the SEC on Key Points on Regulation-SHO. Bear with us, we will un pack it.
“Naked” short selling is not necessarily a violation of the federal securities laws or the Commission’s rules. Indeed, in certain circumstances, “naked” short selling contributes to market liquidity. For example, broker-dealers that make a market in a security generally stand ready to buy and sell the security on a regular and continuous basis at a publicly quoted price, even when there are no other buyers or sellers. Thus, market makers must sell a security to a buyer even when there are temporary shortages of that security available in the market. This may occur, for example, if there is a sudden surge in buying interest in that security, or if few investors are selling the security at that time. Because it may take a market maker considerable time to purchase or arrange to borrow the security, a market maker engaged in bona fide market making, particularly in a fast-moving market, may need to sell the security short without having arranged to borrow shares. This is especially true for market makers in thinly traded, illiquid stocks as there may be few shares available to purchase or borrow at a given time.”
So what this regulation states is that a market maker like “Man-like-Citadel” can suddenly find itself in a short position in a stock if it agreed to sell a stock without actually being able to provide it!
One key to detect this will be the volume of “Fails-to-deliver’ of the stock over a period of time. If for example, the Fails to Deliver for Game Stop suddenly shot up to 14.7 million shares in December 2020, then it could be evidence that Man-like-Citadel is actually short Game Stop as a result of Market Making.
More on this in our upcoming hit piece. We are of the opinion that the Redditers have managed to weaponize RobinHood against Men-like-Citadel.
To understand this in depth, we will need to look in a bit more detail as to how Banksters account for derivatives. Our candidate is JP Morgan, just to help everybody work through the example. We are using JPMorgan just as an example for derivative accounting and not that JPM is exposed to the Game Stop rebellion, (Bank of America may be more appropriate). Neither are we calling those who bank with Goldman Sachs as ‘Muppets’.
Let’s refer to an excerpt from JP Morgan to get some idea:
While useful as a current view of credit exposure, the net fair value of the derivative receivables does not capture the potential future variability of that credit exposure. To capture the potential future variability of credit exposure, the Firm calculates, on a client-by-client basis, three measures of potential derivatives-related credit loss: Peak,
Derivative Risk Equivalent (“DRE”), and Average exposure (“AVG”). These measures all incorporate netting and collateral benefits, where applicable
Ok let’s unpack a bit about what JP Morgan disclosed in their 2019 Annual Report. Bear with us as we have to go through some gobbledygook. We will try to make it as simple as “Wumbology“.
JP Morgan has 3 measures for derivatives-related credit loss:
- Derivative Risk Equivalent (“DRE“)
- Average Exposure (“AVG“)
The first thing to understand is that all 3 measures are statistical, or risk, measures, meaning that they are not something you plug into the balance sheet directly.
JPMorgan defines Peak as “a conservative measure of potential exposure to a counterparty calculated in a manner that is broadly equivalent to a 97.5% confidence level over the life of the transaction. Peak is the primary measure used by the Firm for setting credit limits for derivative contracts, senior management reporting and derivatives exposure management.”
[ Ok a note here. When the say a 97.5% confidence interval, it means a 1 in 40 month event for an exposure of 3 years or a the worst 3 days for an exposure which is 3 months . To put things into context, the Game Stop rebellion has been compared to the 1901 short squeeze involving Northern Pacific Corner is a 1 in 100 year event. So any entity who has entered into a derivative contract referencing Game Stop is definitely encountering a head on collision with a risk limit brick wall ]
DRE is defined as : exposure is a measure that expresses the risk of derivative exposure on a basis intended to be equivalent to the risk of loan exposures. DRE is a less extreme measure of potential credit loss than Peak and is used as an input for aggregating derivative credit risk exposures with loans and other credit risk.
AVG: measure of the expected fair value of the Firm’s derivative receivables at future time periods, including the benefit of collateral. AVG over the total life of the derivative contract is used as the primary metric for pricing purposes and is used to calculate credit risk capital and CVA.
Ok – what this means is that a derivative has a funny characteristic that is unlike a loan exposure. You give a loan of $1 million to a hedge fund, the most you can lose is $1 million. However for a derivative it is not the case. There is a measure called ‘Peak‘, which means “sort of the” worst case loss you can sustain, a measure called Derivative Risk Equivalent, or DRE,, which means what you expect to lose given the borrower’s credit standing and lastly AVG, which means the average amount you can expect to lose over the lifetime of the derivative contract.
So lets look at the above table to get a better idea of what all this means.
The figure shows a snapshot, that is on the 31 Dec 2019 at 23:59:59.99999 , JP Morgan was owed $33 billion by their derivative counterparties. This is an exact figure that was correct at that precise time instant. 3 days later, even if no new contracts were entered into, the figure would have been guaranteed to change as the inputs to these derivative contracts change. That is why merely looking at a balance sheet to get a measure of derivative risk is misleading – the Peak, DRE (most appropriate) and AVG exposure can give a better idea of what is the true risk taken on by the bank.
So lets look at the first rung, the AAA/Aaa to AA-/Aa3. As of 31 Dec 2019, JP Morgan was owed $8.3 billion by these folk. For argument sake, lets assume that there was only 1 counterparty, the US Federal Reserve. In this case, it does not matter if JPMorgan was owed $8.3 billion or $830 billion, because the Federal Reserve won’t default. It is those counterparties who are not as strong as the Federal Reserve, or those further down the “ratings ladder of doom” that should be the cause for concern.
Specifically this will be those rated BB+/Baa1 and below, i.e. firms who have descended into the lower reaches of “Sub Investment grade purgatory“. Now for these firms, it does make a difference whether JP Morgan is owed $8.3 billion or $83 billion, because there is a big chance that JP Morgan may not be able to collect on what they are owed if the firm goes bankrupt.
Now readers may figure out, is the $33 billion the full exposure?
Yes it was, but only for that split second on 31-Dec-2019. To understand the maximum potential exposure, we have to look a the curve with pretty triangles called “Peak”. Statistically, the $33 billion should be closer to AVG than to Peak, and Peak can be up to 2.5x higher than Average.
So now, one question that will be important to consider is exactly how the hedge funds executed their short trade which led to the $70 billion loss mentioned?
If it was a pure securities lending arrangement, then it is not as bad because there will be a certain degree of initial margin applied to the arrangement. More importantly, there will be automatic risk limits that get executed and trades kicked out. Gamestop rose to $400 and you could not pose margin by 10 am E.T? Tough, we will whack your margin sell the stock and “see ya’ll another day”.
However, what happens if the position was via an Equity Derivative? In this case it gets really interesting.
This is because the automatic risk controls that kick in when a securities lending arrangement is entered into does not kick in when a derivatives transaction is entered into. There will be hand waving, barking, cursing and foaming at the mouth, all of this consumes valuable time which is what the hedge funds required in order to hope that the $400 price spike they witnessed on Wednesday only lasted for a nanosecond. They hope the next day, the price would be lower so that they can live to hedge another day.
Well, it did not.
(Hence everybody activates their minions to stem this rebellion)
It gets even more interesting if the bank themselves had taken a short position against these stocks as a way to protect themselves. So now they are short stocks like Gamestop in order to hedge themselves as they entered into a derivative contract with a hedge fund shorting the stock and now not only are they losing money on the short side of the trade, they may not even get paid by their hedge fund buddies.
(Hence everybody activates their minions to stem this rebellion)
The first point to understand is how has Man-like-Citadel‘s ratings changed from 1 week ago owing to this GameStop rebellion? We know Man-like-Citadel’s major shareholder had to pump in $2.75 billion into a sidekick, called ‘Boy-like-Melvin‘ capital earlier this week.
The question now is this the end of the story? Does Man-like-Citadel have any other exposures to the GameStop rebellion? More tellingly, what was the internal ratings for Man-like-Citadel prior to the infusion and has it changed?
Aha – but that is when things get interesting.
We do not know what is Man-like-Citadel‘s derivative book exposure and the point we are trying to drive at is that the nature of derivative trades with their reliance on netting creates unstable networks if one big fat link were to go down. Bankers believed that by moving trades to central clearing the system will become safe, we may see that notion put to the test.
Now back to Man-like-Citadel’s possible derivative book derived from the annual report of an entity like/kind-of-a Citadel Securities LLC.
Source: IHS Markit over here. Notice that the short interest had been high even when GameStop was trading at single digits. So you short a stock at $5 expecting it to go down to 0, and Wham-O! it goes to $500.
(Note: No politicians cared on the wisdom of shorting the entire outstanding issue of a stock at $5 then did they?)
Firstly, Man-like-Citadel Securities LLC total capital as per 31 Dec 2019 was $1.6 billion at the equity level and after including all debt instruments as total capital was a “massively YUGE ” $701 million in excess of the capital requirements specified by alternative
method as permitted by Rule 15c3-1 of the SEC. That capital is now all that is standing behind a derivative book that looked like this in Dec 2019 with $219 billion in Derivative Assets in notional derivative asset.
To give you an idea of what would have required to blow through the entire capital of “Man-like-Citadel” as stated on their balance sheet as of 31 Dec 2019 is a hypothetical situation where “Man-like-Citadel” to have entered into a $500 million notional equity total return swap referencing Game Stop, when Game Stop shot up to $100 per share early last week, with “Man-like-Citadel” as the paying party and some bankster as the receiving party. A secondary example is if “Man-like-Citadel” were to have sold 1 month call options on Game Stop at a strike price of $150 at the start of the 2021 with total call option volume exceeding 100,000 contracts and had not hedged the position.
In the primary example, within 1 week, “Man-like-Citadel” would have been in a deficit position of 300% of notional derivative amount as Game Stop ended at $325. Remember “Man-like-Citadel” had on 31 Dec 2019, equity derivative notional of about $400 billion, with $200 billion on the asset side and $200 billion on the liability side.
“Man-like-Citadel” could still be holding hundreds of billions notional derivatives on all sorts of equity derivatives. I think it is this worry that if “Man-like-Citadel” goes down, it will drag a lot of other folk down with them because suddenly banks will find themselves “unbalanced” in terms of risk exposure.
(Actually they were never balanced in the first place – such is the lies that the media feeds on these bankers being able to manage trading books with notional derivatives in the trillions. It always has and will be a House of Cards, they want the fees, the politician want the retirement perks, you get the drift.).
So I think folk are scared that if “Man-like-Citadel” goes down, a lot of things become unbalanced and there is another Lehman like moment. A $70 billion hit in 1 month to a small group of hedge funds is not something any highly leveraged industry can sustain.
That is my guess why so many politicians have suddenly become so scared and are trying to protect their hedge fund buddies such as Men-like-Citadel. They must have got a call from the Federal Reserve to speak up, I guess.
In the end, the bankers need not worry. Power is in the hands of the elite. They may even come up with a nice little chant that goes like this:
The moral of the story can be best summarized by this post from Bloomberg.
When in doubt, blame Risk!
( Our best estimate is that GMN will do a secondary issue to take advantage of this massive price spike . All they need to do is to time it for when the stimulus checks come in )