Today, January 29, shares of GameStop (GME) were up 68%. And the market as a whole fell hard with the Standard & Poor’s 500 down 1.93% at the close and the Dow Jones Industrial Average off 2.03%. The NASDAQ Composite dropped 2.00% and the NASDAQ 100 tumbled 2.09%. The Russell 2000 small cap index was lower by 1.26%. And the iShares MSCI Emerging Markets ETF dropped 2.52%.
Is there a connection between the runaway rally in GameStop and the drop in the market as a whole?
Yes, but it’s not the one that might first come to mind. The jump in GameStop, as extreme as the valuation may now be (and as wrong as many believe it to be) is not threat to the market as a whole. GameStop is another indicator that this market is at or near a top and that valuations are too “generous” but what else is new. This market has been in this territory for a while.
No, instead it’s what the trading halt in GameStop by RobinHood and other no-commission, on-line only brokerage apps that has spooked the market. The worry is that the trading halt revealed a systemic weakness in part of the market and some brokerage companies that could indicate more widespread problems and that could catch-up other financial firms.
You see–despite the rhetoric from Robinhood and competitors–this trading halt had nothing to do with “protecting” individual investors or damping a speculative blow off.
All the evidence is that Robinhood was in danger of running out of money.
According to the New York Times, on Thursday Robinhood drew on a line of credit from six banks amounting to between $500 million to $600 million to meet higher margin requirements from its central clearing facility, the Depository Trust & Clearing Corporation, created by the huge volume of trades in GameStop and similar “rally” stocks. And then Robinhood raised $1 billion from existing investors such as venture capital firms Sequoia Capital and Ribbit Vsital to provide the capital it needed to meet the cash demands from all the trading. (Brokerage companies need cash to pay customers who are owed money from trades and have to post additional margin cash to that central clearing facility to insulate trading partners from potential losses if Robinhood couldn’t come up with the cash when it came time to settle a trade.)
In other words, Robinhood, one of the largest online trading apps, didn’t have the capital to meet the cash demands created by the huge volume of trades its customers were making. And it had to limit trades to gain time to raise the cash it needed.
Now, Robinhood running low on cash to meet its obligations to customers and to trading partners isn’t the same thing as, say Goldman Sachs running low on cash and having to halt trading. That would send financial markets into a nose dive of major proportions. But Robinhood is a major player in the new world of FinTech and financial online apps. It’s not clear to anyone that these new companies are sufficiently regulated or that the Federal Reserve is holding them to tight enough standards.
So, yes, the GameStock “event” has been enough to move some worries from nagging back of mind niggles to closer to front of mind concern. Remember that in the last two decades we’ve had plenty of financial “corrections” start in relatively obscure corners of the market–Long Tern Capital and the sub-prime mortgage disaster are two examples that come to mind.
In a market priced to perfection and that’s counting on a big recovery in earnings (and no disruptions) the trading halt at Robinhood is a disconcerting reminder that it’s the things that you aren’t watching that can go wrong and bite you.