The events of the past week or so in the “real world” have been interesting enough (vaccine nationalism, a Myanmar coup, just the odd example of geopolitical sabre-rattling…). However, if one has a taste for the baroque and enjoys a little financial excitement, the GameStop/Robinhood/Melvin Capital/et alios saga, with its additional cast from a Reddit sub-thread, certainly provided an object lesson in how, more often than one might expect, the financial markets “lose it”; and brought back nostalgic memories of the demise of Long Term Capital Management (LTCM) in 1998.
After all, GameStop was generally seen as a failing “bricks and mortar” retailer, which had missed the shift in gaming to the internet and cloud, and so was ultimately doomed to go bankrupt, or at best undergo a lengthy re-structuring. As a result, it was one of the most heavily shorted stocks, with some hedge funds, particularly Melvin Capital, having unusually large positions. Unfortunately for the “shorts”, we all witnessed one of the most violent “short squeezes” ever, that overwhelmed the resources of Melvin Capital (which reportedly lost 53% of its value in January) and, as collateral damage, forced the Robinhood trading platform to seek billions of dollars in emergency capital, not once but twice.
While one might say: “But why does any of this matter to the (re)insurance market?”, we think there are a few points worth making:
– The market price of GameStop moved to levels that bore no conceivable relationship to the company’s intrinsic value, and one, relatively insignificant stock suddenly became one of the most highly-traded on any exchange. Just because you think that something is ludicrous, or irrational, does not mean it cannot happen. As the saying goes: “The market can remain irrational longer than you can remain solvent”
– Avoidance of ruin has to be at the core of any risk management strategy. The right side of the distribution is important for long term value creation, but only if the left side is contained
– One needs to be aware of how important interconnectedness is, and understand the intricacies of the markets’ “financial plumbing”. The Great Financial Crisis (GFC) provided evidence of that. In this case, Robinhood’s obligations to a key US central clearing house(the National Securities Clearing Corporation, NSCC) grew so rapidly that NSCC reportedly made a demand to Robinhood for USD 3BN in collateral to enable the company to continue using its services, and then agreed to USD 700MM
– Capital and liquidity matter! Always. Forgetting that is abiding sin of those who believe that they are smarter than everyone else
– The explanation for a disruptive event is usually deemed “obvious”- in hindsight
– One needs to have decision-making processes in place ex ante that can manage the rapidity with which your environment can go from “stable” to chaotic. The onset of the pandemic gave a reminder of that
So, while the continuing GameStop saga may seem an amusing diversion for the industry and “happening to other people”, that would be a misguided response.
We wonder when Michael Lewis will write the book, and who will option it to produce the film, following in the footsteps of “The Big Short” or “Rogue Trader”?!
The Awbury Team