Implications of "short squeezes" on financial market efficiency

Institutional Communication Service

Financial markets are often subject to sudden asset price surges and dips, most of the time due to the classic market dynamics of mismatched supply and demand. Market turbulence can however also be caused by speculation, with damaging effects for investors who find themselves on the 'wrong side'. These include the so-called short squeezes, which occur when bearish investors find themselves 'squeezed' by a sudden bull market, obliging them to buy back securities to cover their short positions, thus adding to the market turbulence. Short squeezes become problematic when it caused by high-risk (and often illegal) arbitrage. The USI Institute of Finance recently published two research papers on the phenomenon analysing the Porsche takeover of Volkswagen in 2008, and the GameStop incident that occurred in January 2021.

Porsche vs. VW

On 26 October 2008, in the midst of the global financial crisis, Porsche publicly and unexpectedly announced a plan to acquire the Volkswagen Group. The news triggered a sharp rise in the Volkswagen share price on the German stock exchange, to the extent that VW was - for a short period - the most valuable listed company in the world in terms of market capitalisation. Investors who had been betting on a fall in VW's share price (like many other stocks, given the context of the financial crisis) found themselves in a short squeeze valued at over 20 billion euros.

The GameStop incident

At the end of January 2021, a group of stocks listed on the US stock exchanges - including GameStop, the US retailer of video game and accessories - experienced sudden price surge. This created a sensational short squeeze event impacting large investors (investment funds, hedge funds, etc.) who, given the negative outlook on GameStop, held short positions on the stock, thus betting on its decline. The novelty in this incident is that the price surge of these stocks was the result of coordinated trading operations by small investors who discussed their strategies on trading platforms and social media, such as Reddit.

Regulation and enforcement

While stock price manipulations such as squeezes and corners have been outlawed in the U.S. since the Securities and Exchange Act of 1934, legal limitations have only been introduced in many European countries in recent years. In fact, the EU's Market Abuse Regulation (MAR) and the Directive 2014/57/EU of the European Parliament and of the Council of 16 April 2014 on criminal sanctions for market abuse (Market Abuse
Directive or CS MAD) were implemented in 2014 and came into effect in 2016. "In Germany, despite the EU-wide implementation of MAR and CS MAD, the lack of enforcement powers on the part of BaFin (the Federal Financial Supervisory Authority) has long been criticized, as the reason why there have been so few insider trading prosecutions", says Eric Nowak, Director of the USI Institute of Finance and financial regulation expert.

Analysis and policy implications

Prof. Nowak's analysis of the Porsche-VW affair - performed together with Prof. Franklin Allen (Imperial College, and Scientific Board Member of the Swiss Finance Institute), Prof. Angel Tengulov (Vanderbilt University) and Dr. Marlene Haas, and which will soon be published in the Journal of Financial Economics - is based on extensive hand-collected evidence publicly presented at court hearings and information reported in publicly available court documents in Germany, and is the first rigorous academic study of the Porsche-VW squeeze, showing also how it signicantly impeded market efficiency. "Preventing manipulation is important because without efficient securities markets, the EU's major project of the Capital Markets Union (CMU) cannot be successful", explains Prof. Nowak.
The GameStop case study, performed by Prof. Nowak and the same co-authors together with PhD student Matteo Pirovano, focuses on the 'novel' issue of the role of social media and online trading platforms. "Despite the possibility of easily observing, in real time, the information flowing on digital platforms, the GameStop incident revealed a certain inadequacy of financial market surveillance systems in the US, one of the most heavily regulated countries in the world, and the need to better understand the interconnections between social media, derivatives markets and stock markets", Pirovano explains.

The two research papers are available as part of the Swiss Finance Institute Research Paper Series (see Quicklink, top right).