The GameStop Saga has exposed the Fragility…


of the proper functioning of the financial markets.

Some top securities regulators have called for “a halt in trading” so that markets can “cool down” (e.g. William Galvin, Secretary of the Commonwealth of Massachusetts, in an interview to Barron’s). Indeed, some brokerage houses have already stopped or limited trading of their own accord – angering retail traders and exposing themselves to lawsuits and investigations.

We disagree: halting or curbing trading deepens the uneven playing field at the expense of the “Davids” of the world and does nothing to address the systemic excessive risk-taking and business destruction practices by the “Goliaths”, the large financial players.

We concur with Chamah Palihapitiya, CEO of Social Capital (in an interview on CNBC):

 “If you start to gate decisions by individual people, all you are going to do is systematically lock in institutional ways of making money for institutional clients and I don’t think that is a solution.

If you want to go and address the solution, fix how risk-taking happens at the institutional level, fix the precondition: fix the ability for these stocks to be so massively shorted in the first place, change the business model of funds so they are not forced to be these small [..] highly-levered funds, change the leverage ratios.

[…] money is being made by retail and all of the sudden say: hey, they could and may be the bag-holders in the future so let’s make sure they can never participate. “

That’s exactly right: the fragility and unfairness of the system must be fixed by limiting over-exposure and excessive risk taking by  hedge-funds and other financial institutions.

How?

1. Limit the maximum short-interest percentage far below 100% (it was over 140% with GameStop (GME)!). One easy way to do so, is to give each regular share the right to loan out only half a share. That means that for each two shares you own, only one share can be loaned out for shorting – with the idea of preventing the short interest to ever increase over 50%.

2. Once a shared is loaned, it trades “without right”, i.e. cannot be loaned out again. The short seller compensates the new owner from the share being “sine right” by paying him a small fee. This will prevent the same shares being loaned out over and over again. 

3. Limit the privilege of “market makers” to escape or skirt around the requirement that in order for a share to be shorted, a share must be located and borrowed from an actual owner. While market-making should be allowed to function, the ability to short naked shares by market-makers should be controlled.

A simple, coordinated set of rules such as these, will prevent the pre-condition for fragility of the markets – an excessively high short-interest percentage – while still allowing shorting to occur and not gating retail players from participating

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