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Staff Report on Equity and Options Market Structure Conditions in Early 2021: After nine long months the SEC has finally released its report on the GameStop Reddit drama of January 2021. The 45 page document does a good job of explaining the environment that precipitated such a sharp rise in GME shares & how market structure handled the shock, but offers little in the way of policy changes or opinion. The SEC effectively said “We know this happened, everything more or less worked as intended, and we’ll study some new things as a result.” They even tried to stress that GameStop traders were buying a business and not a meme, which is technically true but in reality shows how out of touch the regulator may be. Below was by far my favorite quote from the report:
“Those who bought GameStop became co-owners of a company through a system of mutual trust and participation that sustains our economy.”
There was one conclusion the SEC made that I think is worth noting, which answers the question “What really caused GME to spike nearly +2,000% in two weeks?”. There are multiple theories that try to explain the magnitude of the increase, including:
A short squeeze - because GameStop’s short interest was so high (over 100% of total shares outstanding were sold short at one point) even a small amount of net buying was enough to cause massive amounts of short covering which accounted for most of the price spike.
A gamma squeeze - A wave of deep OTM call buying in GME forced market makers to buy the underlying to hedge their exposure. When this buying pushed GME’s price up, the delta of those OTM call options increased, forcing market makers to buy even more stock to remain hedged. This vicious cycle caused most of GME’s spike.
A combination of 1 and 2.
The SEC report touched on both these theories & concluded that neither explained the majority of GameStop’s rise. To refute the short squeeze theory, the SEC noted that short-covering volume was only a small percentage of total buy volume in the stock during the week of January 27. Many people were buying GameStop stock that week, but it not with the intent to cover an outstanding short position.
To tackle the gamma squeeze theory the SEC examined GME options market maker activity and found that a) more puts than calls traded that week and b) market makers were net buyers of call options when hedging their GME exposure, suggesting the opposite dynamic to that of a gamma squeeze.
If a short squeeze didn’t cause GameStop to spike, and a gamma squeeze didn’t cause GameStop to spike, what did? In the SEC’s words - “bullish sentiments of individual investors [via] social media” was the main culprit. This is an important conclusion that to me confirms how powerful coordinated retail activity in a stock can be.
Bitcoin Comes to the Big Board: The internet is abuzz with victory laps, bold predictions & plenty of opinions about the first Bitcoin ETF to launch in the US. The impacts of a Bitcoin ETF are notable - crypto-averse investors can now be exposed to the asset class through their normal brokerage apps, Bitcoin in retirement accounts moves closer to reality, and a precedent is set for future crypto products to be approved by the SEC. What intrigues me most about this launch, however, is the downstream impact on futures exchanges linked to these ETFs - mainly CME.
The NYSE-listed ProShares Bitcoin ETF is a product that takes customer assets & exposes them to Bitcoin by buying & continuously rolling Bitcoin futures on the CME. Because retail interest in this product is expected to be substantial, the ETF is expected to be quite active in the futures markets on a daily basis & account for a notable amount of volume. This is a very bullish development for CME - a new source of large, price-insensitive, passive order flow is now interacting with & improving the overall health of its market. Volume, open interest & revenue capture for Bitcoin futures should all start to see healthy increases over time & begin to contribute meaningfully to the exchange’s bottom line.
Timing of this ETF approval is also a bullish sign for CME given competitive pressure from FTX and Coinbase as they begin to enter the futures space. If CME controls a large share of the ETF order flow it will be very difficult for competing futures exchanges to match its liquidity or revenue capture even with market makers on board. I continue to hold my shares of CME and look forward to management’s thoughts on the ETF launch & crypto more broadly during upcoming earnings.
Cboe Agrees to Acquire ErisX, Entering Digital Asset Space with Spot, Derivatives and Clearing Platform: Speaking of the crypto futures space… CBOE feels left out! They announced a deal to buy ErisX this week for an undisclosed (likely very small) sum. ErisX launched a crypto exchange & clearinghouse in mid 2018 with backing from TD Ameritrade, Virtu, DRW, Susquehanna, and CBOE, but never gained significant traction in volumes or market share. The deal gives CBOE a set of licenses to build out its own set of crypto derivatives and, in their words, “push the boundaries of digital asset innovation and unlock its next phase of growth.”
To be completely honest, I don’t understand the rationale behind this deal. CBOE first showed crypto interest in 2017 when it proudly launched one of the first Bitcoin futures contracts in the US. A year after trading began CBOE decided to sunset the product & rethink their broader crypto strategy, ceding dominance to CME’s cash-settled Bitcoin future. After multiple years of “rethinking their broader crypto strategy”, CBOE’s ErisX purchase puts them right back where they were in 2017. The only difference between now & then is CBOE comes into a more mature & crowded market as the clear underdog. How are they going to beat out exchange rivals with more experience & focus in crypto, deeper pockets, and better liquidity?
This deal also adds to the long list of companies CBOE has purchased in the last year including dark pools, Asian equities platforms, market data businesses & European clearinghouses. I think it’s good to try and grow within multiple industries & asset classes, but with crypto added to the list CBOE may now be juggling one too many strategic expansions. The exchange mentioned near the bottom of its announcement that ErisX won’t reach profitability for another 2-3 years, adding more short term burden to the expense base. I remain skeptical that any exchange can upset CME’s Bitcoin futures network effect, and question yet another CBOE purchase that doesn’t come with much likelihood of success.
My latest paid post is live - The House that Sam Built: Part II takes a deep look at the history, strategy & business model of FTX amid its recent push into the US. Subscribers get immediate access to this post and a deep archive of past exchange & market structure research.
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Other Stories I’m Reading
Chart of the Week
ICE’s Bakkt crypto SPAC finally began trading on the public markets this week under ticker symbol $BKKT. If we recall their initial investor deck, Bakkt had expected to end 2021 with ~9 million active users, a lofty goal by all stretches of the imagination. A few days ago @TangoGrenada tweeted a Bakkt short thesis that to me seems pretty convincing. In it he argues that Bakkt will miss their 2021 user & revenue targets by ~90% which will likely cause their stock to crater in response. After monitoring Google search trends, social media sentiment & management’s prior activity in crypto, @TangoGrenada believes Bakkt is a classic case of a SPAC money-grab gone wrong that will correct itself as earnings are digested.
I’ve re-posted his excerpt below so you can read for yourself:
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Disclaimer: I am not a financial advisor. Nothing on this site or in the Front Month newsletter should be considered investment advice. Any discussion about future results or projections may not pan out as expected. Do your own research & speak to a licensed professional before making any investment decisions. As of the publishing of this newsletter, I am long ICE, CME, TW, NDAQ, COIN and VIRT. I am also long Solana.