A while ago I wrote an article that talked about the mechanics of short squeezes. Perhaps the most high profile example of a short squeeze in recent times was what happened with GameStop. A situation arose where there was more short interest than there were available shares, which meant that people buying shares was able to initiate a rather large short squeeze.

If your only exposure to the financial markets is following headlines you might have missed how long the GameStop situation has been going on. The initial volatility of the squeeze was high with huge ups and downs in the share price, this naturally drew a large amount of attention to the stock.

GameStop had a moment of fame where a large number of people were talking about it, I wrote the first article in response to many people asking me about how it worked. Since then the mob interest has moved, I haven't had anyone outside of my finance friends mention GameStop in over a year. But the story is far from over and many extremely important developments have happened since. For the most part GameStop has disappeared from the mainstream news. Many people just would have assumed that there was a momentary move up in share price and that the price would have since dropped back down to some sort of level that represented the "fundamentals".

If you look at a recent chart you'll see that the price per share is lower:

However if you look back at an old chart it will say that the price of the shares used to be different:

So what's going on here?

GME had a stock split that was done a while back. This is much like what happened with Tesla. There was a time when Elon Musk publicly tweeted that Tesla could be taken private at $420 a share, in December of 2019 it got there.

Let's take a look at a current chart of Tesla stock:

You can see that in december 2019 on this chart the stock is around $24 and not the $420 that was in the article, what's happened here?

On just about every successful online charting platform they will retrospectively update the previous prices on the chart of a stock whenever a stock split happens. This way you can look back and see what one share at the current point in time would have cost in the past. However this is not what one share cost at that point in the past if the amount of shares in the company has changed in the interim.

Tesla had very publicly used stock splits multiple times as part of their overall strategy. This allowed them to raise a lot of money, it also probably had an influence in how TSLA short sellers got crushed at one point in time. This is partly because TSLA has had a very large amount of retail interest and splitting the stock meant that more people had access to buy single shares. Seeing these charts starts to reveal an important truth about how the markets really work, for the most part most market participants deal with the abstractions that the market works out without understanding the concrete implementation details that allows the markets to work. The chart itself is just a historical record of what levels trades occurred at. But buying a number of shares is far more complex than a transaction where you put in some money and get some number of shares, someone actually needs to sell for you to buy and that transaction has to settle somehow. The day to day operations of the market involve a rather large number of details, which many call "plumbing", that the average person never thinks about. In many cases the average retail investor doesn't even know these things exist.

Recently GME had issued a stock split as well. The way this was supposed to work was a stock split was to be distributed in the form of a dividend. However the plumbing matters because that's not what actually happened in this case. Many brokers split the stock in different ways which creates a number of issues.

A great write up covering what really happened can be found here

when things go wrong the plumbing of the markets matters.

GameStop is more than just a story about an individual company, it is a perfect case study into many of the important aspects of the markets that people rarely talk about. The word plumbing originally came from the Latin term for lead plumbum as lead piping was the first type of pipes used in the Roman era.

Markets in some senses remind me of cities. When times are good you don't care about the plumbing, but when your pipes block up and you have no water then suddenly everyone cares about plumbing and cares about it in a hurry. Plumbing has always been important but when times are good people are afforded the luxury of not having to care about it. When the plumbing goes wrong like it did in Flint Michigan the results can be catastrophic, whole systems can stop working entirely. The Flint water crisis shows a lot of lessons about the painful consequences of hidden infrastructure having problems, it also reminds us in a painful way that lead pipes can be highly problematic if not properly maintained. It also shows us a lot about the dynamics of how people can maneuver in the spaces such as this since hidden infrastructure gives the ability for large informational asymmetries to arise. The modern economy is very much like this in many very important regards.

Publicly tradeable stocks came into existence to make it easier for capital to be invested into companies. But these stocks are themselves a layer of abstraction. Say you start a private company of which you are the full owner, business decisions in a company like that are made by you. There's a very clear connection between who owns the company and the management decisions that are made on a more day to day basis in the running of that company. When the owners of the company are clearly in contact with management a lot of misaligned incentive problems just aren't possible at all. But when you start to scale the connection between the interests of the shareholders and the management decisions of the companies is far harder to discern. This of course can open up a number of avenues of abuse where actions by management can be done at the expense of everyone else, which we saw a great example of in the case of Enron's large scale accounting fraud. Enron was "America's Most Innovative Company" for six consecutive years by Fortune Magazine, but it turned out much of this creativity was basically directed towards unethical behavior. This sort of abuse has led to regulations such as the Sarbanes-Oxley act in 2002 which to attempt to constrain the actions of management while maintaining a system of fungible share ownership.

When you hold a stock you are holding a promise that you have some stake of ownership over that company. But in reality when people are trading stocks this is often not so simple, in many cases people think they are the owner of shares but in fact don't own anything tangible at all that has that companies name on it. For example many online brokers deal with contracts for difference for their share trading. This is an arrangement where as a client you are effectively making a bet that the stock price goes up or down with whoever the broker is. In such a situation you never get any ownership of the company, as no shares are ever held in your "street name".

The first extremely public example of the plumbing breaking with GME was when they literally shut off the buy button on some brokers while allowing unrestricted selling at the same time. The abstractions of the market were directly violated here and it forced people to look into the plumbing. Much like when you get a blocked sewage pipe and the plumbers dig it up showing you the disgusting contents, people did not like what they saw here when they were exposed to the plumbing of the financial markets and how these often interacted in very messy ways with retail finance platforms. What people saw was a system that was deeply unfair, any veneer of fairness was shattered, and brokers were clearly exposed as taking from the poor to give to the rich. Platforms like "Robinhood" actually removed the ability of their clients to buy the shares while allowing them to sell, immediately making me think that the name of the platform was Kafkaesque. If they changed the app name to something like "Sheriff of Nottingham trading" I might be less appalled.

This behavior by platforms painfully highlighted a reality of the plumbing of the modern financial systems to many retail investors, which is that many people don't actually own shares in their own names. Going further though there are a lot of situations where people work with brokers who invest heavily in misinforming their clients on exactly this details. On many platforms retail clients think they are holding shares but in reality they don't hold the title to these shares. There's a number of reasons for why this is so, mostly that the whole idea of "day trading" can't actually work on apps if you have to wait for the title to fully change names. Settlement of the shares into someone's name can take a few days for the full process to complete. This means that if full settlement of shares into the new name were needed then the fastest frequency with which trading could occur would be a few days. There's a lot of groups out there that would like to trade faster than this so having that settlement be a requirement would be a limitation to them.

Many retail trading platforms are unfortunately using the non-transparency of these arrangements very deliberately to make their customers think they are able to trade shares multiple times a day in their own names. Generally speaking what allows such an offering is hidden deep in the plumbing and is therefore usually not visible to the retail traders. This makes it possible to get away with a selling a not-completely-honest-story to retail traders about how those shares are actually being held and traded. Much like the multiple building materials scandals that have come up in recent years flammable cladding materials were discovered somewhat earlier than other defective components, since these materials were on the surface and were easier to investigate. I think we are in the middle of a massive counterparty risk bubble at the moment and one of the major drivers of this is large scale trading done on underlying assets where the street names of those assets aren't held by who people think are holding them.

Bringing this all back to GameStop for a moment, a large part of what allowed there to be more short interest than there were available shares was that many market participants who hold shares on behalf of their customers also engage in the practice of leasing out those same shares to short sellers. This is a rather profitable scheme if you can get away with it. This became a frustration to many of the retail traders who were trying to buy up shares in GameStop to reduce the amount of open float available for those wishing to cover their short positions. Imagine for a moment that you are someone who thinks "For me I just like the stock" and think that GME is undervalued and that there's more short interest than can possibly be reasonable so you decide to buy some shares to remove shares out of the pool for the short sellers. If your intention is to buy shares for this reason it will be very annoying if your broker buys some shares but then uses those same shares to allow someone else to close their short position. This is exactly the sort of customer hostile behavior that could happen if the trader doesn't actually hold the GME shares in their own street name. This has created a massive movement in the crowd pushing the GME short squeeze to change the registration of the shares to be directly registered in their own names and not under the custody/bailment of a 3rd party platform. Interestingly we see the exact same dynamic in many commodities at the moment, there's an enormous amount of derivatives chasing a far smaller amount of actual tangible assets. What allows this entire system to work is a large number of investors who think they are getting exposure to the underlying assets being deceived into buying derivatives. As a result those buyers have far less power over the actual spot price of those commodities than they think they are, because whenever someone buys paper derivatives they don't impact the open float in the case of stocks or the warehouse/production claims in the case of commodities.

It would be rather easy to set up a system whereby the name of all share owners was tracked but that would upset certain interest groups that wish to run shell companies and other types of structures. Improving this area of the market is a difficult thing because despite all the bad things about the opaque structuring there's some upsides too.

In very many important regards what we see on the market is an idealized system that has many important aspects of plumbing that must run smoothly to allow us to maintain the illusions of the simpler system. When things are running smoothly it is easy to fall into the trap of thinking that the situation is less complex than it really is. But the underlying complexity never go away and when markets break down having an understanding of that plumbing becomes increasingly more important. As the GameStop situation shows massive gains and losses are realized when the assumptions of the simpler system break down.