Europe: the world’s next big short squeeze?

A European Commission law could leave European companies vulnerable to becoming the next GameStop.

, by Devin Sean Martin

Europe: the world's next big short squeeze?
Credits: Gamestop/Blubberboy92, Creative Commons, https://i.imgur.com/ws2kAA0.png

GameStop has drawn global headlines in the past month due to its dramatic rise and fall in stock price.

Largely caused by a surge in investments from Reddit users, the video game company’s stocks have made armchair investors millions while leaving some of the world biggest hedge funds out billions.

While many are eyeing US stock exchanges for the next opportunity to make a quick profit, a European Commission law may leave European companies particularly vulnerable to the “short squeeze” GameStop experienced.

What happened with GameStop?

Several large institutional investors and hedge funds saw GameStop, the brick and mortar video game retailer whose service has largely been rendered obsolete by downloadable content, as vulnerable to go bankrupt. Therefore, these institutions placed shorts on GameStop’s stock, meaning they bet its stock price would go down.

Shorting a stock is a high-risk, high reward scheme where being successful can result in hefty payouts, but being wrong can result in even more massive losses. To short a stock, an investor must first borrow a stock from a broker and then sell it to a third party at the price the stock was when they borrowed it. Then, they wait for the stock’s price to go down, pay back the broker at the stock’s lower value, and pocket the profit.

The problem with shorting, though, is that if the stock price goes up, the investor must then buy back the stock they borrowed in full.

In January, users from the Reddit forum WallStreetBets collectively began buying up GameStop stock, driving its price up. This forced the hedge funds, which held millions of short positions on its stock, to start buying their borrowed stocks back. Because GameStop stock was heavily shorted and several companies were buying back millions of shares at once, the stock price shot up even more, which forced even more buy-backs, resulting in what is called a short squeeze.

The entire ordeal has proven how influential casual investors can be as they were traditionally considered minnows of the market compared to the sharks of Wall Street. Now, the world has seen the kind of waves the minnows can make, and many are searching for the next company to short squeeze in order to make a quick profit.

Europe’s vulnerability

In the wake of the 2008 global financial crisis, a handful of hedge funds made billions after shorting the housing market, profiting off of millions of people losing their jobs and livelihoods. In response, countries worldwide scrambled to pass short selling disclosure laws that would force institutional investors to disclose if they held short positions above a certain percentage of a company’s floated stock. In the United States, that threshold is 5 per cent, meaning institutional investors must publicly declare if they short more than 5 per cent of any company’s floated stocks. In Europe and the UK, though, the threshold is only half a per cent.

This gives amateur investors, like the ones that caused the GameStop short squeeze, far broader insight into what company’s stocks are being shorted, and by how much. With an influx of armchair investors around the globe getting into the stock market due to the GameStop craze, European companies are increasingly vulnerable to short squeezes as investors can more easily identify overly shorted stocks and exploit them.

Companies such as Evotech have already seen this happen to them. The German-based Biotech firm saw its stock price shoot up 23 per cent from January 25 to January 28 before falling back down.

Melvin Capital, the hedge fund that lost over a billion euro shorting GameStop, recently disclosed that it was shorting 6 per cent of Evotech’s shares, which is the largest single short against any European company.

German battery manufacturer Varta also saw a squeeze it late January, with its stock rocketing 39 per cent between January 22 and January 28. CD Projekt, the Polish video game developer, saw its stock rise 47 per cent in the same window. Melvin Capital held shorts in both Varta and CD Projekt, illustrating how market minnows have targeted Melvin Capital’s short positions and forced squeezes.

What this means for market regulations

Just as American trading services like Robinhood and E-Trade have seen an unprecedented surge in users in the past month, Europe’s services have too.

The UK based investment app Interactive Investor reported a 368 per cent increase in users in January, compared to the same time last year. Free-Trade, another UK based trading app, saw 40,000 new users join in just one day in late January.

The majority of these new investors are under the age of 25, according to reports from both companies. The infusion of youth in the stock trading world may sound like a positive, but it has also pressured the EU stock market regulators to restrict uninformed and unseasoned investors from spending recklessly in the market.

Myron Jobson, a personal finance campaigner at Interactive Investor, told the Financial Times that investment platforms carry the responsibility of helping young investors. He added that young people have shown a propensity to follow volatile market trends, like GameStop, which can lead to the overall detriment of the market.

Restricting the freedom of investors to put their money where they want is a controversial subject. US trading platforms like Robinhood received international backlash after briefly banning users from buying shares in volatile stocks like GameStop, and later only allowing new users to purchase a certain amount of shares. The move sent GameStop’s stock into freefall during the afternoon of January 28 with investors accusing the platforms of illegal market manipulation.

Europe’s stock market regulatory organization, the European Securities and Markets Authority (ESMA), have not shown their hand at any specific future regulations, but have acknowledged the emergence of an increasingly volatile market caused by young investors.

“We’re closely monitoring these new developments and are assessing whether any further supervisory actions are needed,” said Steven Maijoor, chairman of the ESMA.

If the ESMA does impose stricter rules on young investors and short selling, it would be the continent’s first major market legislation since European Commission regulation number 236, which was passed in 2012 in response to the 2008 financial crisis.

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