The battle between amateur investors and the financial establishment has transfixed Wall Street and Washington this week around GameStop (GME), which has seen its stock price swing wildly and had trading of its stock restricted by online brokerage Robinhood.
Other than Robinhood itself, perhaps the one thing less popular in Washington this week has been short sellers and the hedge funds that usually employ them, which had, until recently, been making money by betting against the struggling video game retailer.
House Financial Services Chairwoman Maxine Waters called out “funds engaging in predatory short selling” while announcing Congressional hearings coming soon. Short sellers also have plenty of enemies in the business community, with figures like Tesla (TSLA) CEO Elon Musk cheering for their demise.
But what if what we all need right now is actually more shorting?
Georgetown University finance professor James Angel made that case during an appearance on Yahoo Finance Live on Friday.
“One of the problems is we don't have enough people who can go short at a time like this,” he said. Short-sellers may get blamed, he added, but “they are a vital part of the ecosystem: they protect us from overpriced stocks, they protect us from pump and dump actions.”
“Whenever you have these stock prices that go far beyond economic reality, you are baking in losses for future investors,” says Angel, noting that the losses can extend to people who never bought GameStop directly, but have unknowingly purchased shares as part of their 401(k) plans.
Angel is not the only expert warning of the dangers of GameStop’s overpriced stock. “Eventually, it will end and it will end very badly for some folks,” Ric Edelman of Edelman Financial Engines said during another Yahoo Finance live appearance this week.
How short sellers make money
It’s unclear whether more short sellers would be a check on traders driving up the price of a stock. Short selling is already prevalent in the U.S., with those betting on declines in the stocks making $344 billion in profit when the market sold off in March, according to data from S3 Partners cited by Reuters. And in recent days, short sellers’ interest in GameStop has skyrocketed to where, as of Friday, it sits as the third most shorted stock by value behind Tesla and Apple (AAPL).
For his part, Angel said Washington should encourage even more people to bet on stock declines to serve as a check on stock prices via SEC rule 204, which concerns how short sellers can operate.
Short sellers bet against a company by paying a fee to borrow stock they believe will go down and then selling it. When the price dips, the short seller buys back the stock at the lower price — but then returns the stock and gets to pocket the amount that stock dropped. If the stock doesn’t go down as they expected, then short sellers can lose, and they can lose very big.
SEC rule 204 regulates what are known as close out requirements — ie, when a short seller is on the hook to actually buy a stock they borrowed. Currently, short-sellers are forced to deliver on their short sale transaction “by no later than the beginning of regular trading hours on the settlement day following the settlement date.”
‘Monitoring the situation’
Both the House Financial Services Committee and the Senate Banking Committee hearings have planned to examine Robinhood’s decision to halt buying of GameStop and other heavily shorted stocks such as AMC (AMC) and Bed Bath & Beyond (BBBY). Senator Elizabeth Warren also wrote a letter to the U.S. Securities and Exchange Commission on Friday asking the regulator to “identify gaps in existing securities laws and rules and ways in which the Commission can improve its enforcement capabilities.”
White House press secretary Jen Psaki has said that Treasury Secretary Janet Yellen “is monitoring the situation” and referred further questions to the SEC.
The Commission has only offered a bit more detail so far. An SEC statement Friday echoed that language and said they are “closely monitoring and evaluating the extreme price volatility of certain stocks’ trading prices over the past several days.” The statement didn’t promise specific actions beyond working to protect investors and ensure orderly markets.
Ben Werschkul is a writer and producer for Yahoo Finance in Washington, DC.