I’m fired up. I haven’t had much sleep. I’ve been following the Game Stop $GME story for only a few days. I wasn’t there at the beginning. I’m not a member of the reddit group, and I wasn’t aware of what was happening until it was big enough to hit every news outlet and even the ladies on The View had opinions on the matter.
But now I’m engaged in this drama, and I can’t look away.
First, a bit about my background so you know why this interests me so much. I’m a developer with a Computer Science degree, an entrepreneur with an MBA and two successful exits to public companies. I’m a poker player with a solid understanding of risk vs. reward. Before leading the Ravencoin development team, I was one of the early employees at tZero, now a venue for trading digital securities and a solution for naked short selling. I was hired as a developer. I learned quickly that Patrick Byrne had been in a clash with Wall Street shenanigans and had fought against the naked short selling of Overstock (OSTK), the company he founded. Overstock ultimately prevailed with most of the gains going to lawyers as is often the case.
In 2015, t0 (now tZero), was building a platform to help prevent naked short selling. With the introduction of Reg SHO, the short sellers are supposed to have a “locate” to ensure that they have access to buy the stock back after they’ve “borrowed” and sold into the market, pocketing the money.
Surprisingly, and despite Reg SHO, the SEC says that “naked short selling is not necessarily a violation of the federal securities laws or the Commission’s rules.” This means effectively that additional shares can be created. With supply vs. demand determining the price, this seems absurd to this engineer’s mind. And, as a guy who thinks in terms of systems, it immediately triggers thoughts of ways this can be gamed, manipulated, and abused. When the person doing the short benefits and is financially incentivized to have additional supply driving the price down, why wouldn’t they borrow more, and what prevents them from borrowing more than exists. The answer is supposed to be Reg SHO, but it is a super sloppy system.
Enter blockchain. Blockchain is not sloppy. It is like a CPA and a computer had a baby. It can track everything down to the 1/100,000,000 of a unit and there’s never a remainder or rounding error because it uses integer math in the bowels of the code. It does not sleep, it does not make mistakes, and it does not double-book.
So how can blockchain technology help fix the slop in the stock borrowing system? Well, for starters, it can document the borrowing. Short sellers would need proof of a locate. Then it can prevent double-borrowing using the same mechanism that Bitcoin uses to prevent double-spends. It solves the problem that “naked shorting continues to happen because of loopholes in rules and discrepancies between paper and electronic trading systems.” I helped build this system in 2015 and it went by the name Pre-borrow Assured Tokens or PAT for short.
Would that fix the problems we saw this week with the shorting of Game Stop $GME? Probably. It is my understanding that there were more shares borrowed than even exist. Now, I got my information from twitter, so it might not be 100% reliable, and sadly it could also be censored into oblivion depending on the whims of Twitter management, but that’s a different scary problem that I will address later.
If the short sellers could only borrow shares that were designated as borrowable (meaning the rightful owners allow borrowing), or a pension fund allows borrowing for a fee that ultimately goes back to the pension fund, then there would at least be a limit to the number of counterfeit shares trading. This doesn’t stop shorting of stock, but it at least limits it to double the number of real shares, and it promotes a more regular less-fragile system.
How is today’s system fragile? It isn’t a free market, and today proved that for lots of people when brokers (or platforms like Robinhood) suddenly and without prior warning prevented buying of specific public stocks including $GME, $AMC, and others. There are problems with the National Market System (NMS). I’ve known it for six years, and there’s insiders that know it, but many insiders take advantage of it, instead of fixing it. It takes someone of real character to see the flaws and loopholes, and instead of taking advantage of them, put their effort into fixing it. I was fortunate enough be part of a team established by such a man, and we built the solution to the naked short selling problem.
So what happened to PATs? I’m not sure. I left t0, involuntarily. That’s a whole other story. I then worked for another crypto-centric company headquartered in Hong Kong on an explorer for Open Assets, among other things. This added to my background and experience for architecting Ravencoin, so it worked out for the best.
Eight months later, I ran into Patrick Byrne again at a libertarian event held at my daughter’s school. Patrick wasn’t aware of the reason for my departure, and assumed I had left voluntarily. We talked, and I returned to work on a tZero project, but as a Medici Ventures’ employee. The corporate structure had changed and Overstock owned Medici Ventures which owned a majority share in tZero. I came in on the tail end of a project to issue digital shares on a private instance of Ethereum. My role as a crypto dev was to anchor hourly the block hashes from the private Ethereum nodes into the well-known and very secure Bitcoin blockchain. This ensured that the private Ethereum network could not be tampered with, despite lacking a large amount of hash power to secure the network. Any tampering would be evident if the linked block hashes ever didn’t match the anchored hash. These hashes exist in Bitcoin’s blockchain today. The OSTKP shares were issued on Dec 16, 2016 and now trade on tZero.
Let’s get back to the Game Stop story that is in-progress as I write this.
So first let’s address whether the Game Stop trading was market manipulation. The answer is “Yes!”. If you can borrow and sell more stock than the float, then it is clear market manipulation. Here’s a simple example with numbers we can all wrap our heads around. Let’s say there are 10 shares each representing one tenth of a company. Now let’s say those shares belong to individuals, companies, pension funds, etc. Now let’s say for the sake of argument that EVERYONE wants to loan out their shares and get some interest on them. Now this is never true, but for the sake of our example, we’ll make it best case for the hedge funds wanting to short the stock. So they borrow all of the shares, and sell them. So now there’s owners of 10 NEW shares that shouldn’t really exist because the original owners think they own theirs, and the new owners think they own theirs, so there’s 20 in the supply, each representing 1/10 of the company — WHAT?!?. How? The hedge funds shorting the stock owe 10 shares, but they are hypothecated (pledged, not real). So the amount in the market (supply) is 20 shares because the hedge funds sell their borrowed shares immediately. That’s pretty bad to have extra shares when the price is set on where supply and demand meet. Now, let’s look at what really happened (if you believe twitter, which isn’t my default mode). It’s like 14 shares were borrowed (40% more that should be able to be borrowed — double-dipping). Now there’s 24 shares of supply, when 10 is the real number. If you think that stocks are tracked better than that, then you should read the Dole Pineapple case. What limits the supply? Reg SHO from 2005? Apparently not. What prevents that number from being 200%, 500%? I don’t know. It seems like the slop allows excess borrowing, so where’s the limit? To make it even worse, there is a financial incentive for the shorts to have excess supply in the market so they can buy and return the shares while the price is lower due to excess supply. Wow, what happens when a whole bunch of people on the interwebs figure this manipulation out, and also figure out a way to benefit as supply is forced back down?
Well, we got to see first hand, and in living color what happens. First the price goes up as investors realize or are educated as to what could happen and buy shares even above what might be considered future earnings of the company. As the price goes up, the exposure to the hedge funds, who must return the borrowed $GME shares, goes up. The exposure is unlimited. This is one of the risks you take when you short stocks. When you’re short, you’re obligated to return the shares, which is only fair, you borrowed shares that don’t belong to you and sold them and kept the money. So now you must buy shares and the price can keep going up. If you are long (regular stockholder), then the worst that can happen is the shares go to $0.00 and they are worthless. If you are short, the price can keep going up beyond your ability to buy the shares back and return them to the lender. That’s what happened as the reddit readers on r/wallstreetbets bought more $GME shares. The redditors don’t set the price, the market supply and demand does that, and to be fair, the market is stacked against the redditors because there are more shares outstanding than there should be until the shorts buy and return theirs.
What’s the best case scenario? In my opinion it would be if the hedge funds learned a powerful lesson about excessive borrowing of shares, and the money they lose gets transferred to the redditors who took a risk with their own money and learned a lot about investing and made some easy money. Score one for Main Street investors.
Another outcome that isn’t all bad and is the most likely, is that some redditors win, and some latecomers to the reddit party lose. The hedge fund covers their shorts, and barely survives to fight another day. The early redditors that win will watch for more similar opportunities. The ones that lose will get something more valuable than money and that is a visceral lesson on risk, reward, and the importance of timing. We need more people in our society that understand the relationship between risk and reward.
The worst outcome, by far, and it is looking more likely given the events today, is if the system changes the rules and goes against the redditors. There’s already the perception that the game is rigged, and that’s before the rules of the game are changed mid-game. With TD Ameritrade, Robinhood, and WeBull restricting the sale of $GME and a few select other stocks, it sends a message that the game is rigged against the Main Street investor.
What should be done? To me, it’s obvious. Let this play out. It’s a giant game of chicken where a lot of Main Street investors are playing against a few sophisticated hedge funds . I think the hedge fund should capitulate before they learn the painful lesson of the power of the people, but that’s up to them. But if they are called, or force liquidated because they’re over-leveraged and represent a risk to the broker allowing that leverage, they lose. The redditors and the hedge fund learns a valuable lesson about the power of large crowds of like-minded individuals with internet platforms, and the brokers reduce the amount of buying power they’ll extend in the future. If, on the other hand, the redditors lose, it means that each individual made their own decision on when to capitulate. There might be some “diamond hands” that lose, but they played hard, took a bigger risk, and lost the game of chicken. Most of the Main Street investors can only go to 0, and lose what they risked and that seems like a good way to learn. I don’t know who will win this game of chicken. What I do know is that there is far more systemic risk if the rules are changed on-the-fly because then the lessons learned aren’t valuable economic lessons, but rather lessons in how the system is indeed rigged.