U.S. SEC praises equity market structure, absolves short sellers in GameStop report

By Katanga Johnson and Chris Prentice

WASHINGTON, Oct 18 (Reuters) - The U.S. markets functioned well during January's GameStop volatility, while short selling was not the main cause of the unprecedented rise in the 'meme stock,' according to a long-awaited Securities and Exchange Commission (SEC) report.

The report published on Monday provides a post-mortem into how amateur traders using commission-free retail brokerages drove shares in GameStop and other popular meme stocks to extreme highs, squeezing hedge funds that had bet against them.

Amid the intense volatility, several brokerages restricted trading in the affected stocks, curbing the rally, infuriating retail traders, sparking outrage from policymakers, and leading to a Congressional hearing.

Despite the extraordinary series of events, the SEC concluded that the basic plumbing of the market remained "sound," an SEC official said. The report also found that positive sentiment on video game retail company GameStop rather than dislocations caused by short selling was the main driver of GameStop's stock spike.

Short sellers borrow shares from brokers and then sell them into the market, with the agreement that they will buy the shares back and return them to the lender at a later date. If the price has fallen, the short seller can buy the shares back at a lower price than they paid for them, locking in a profit.

When a heavily shorted stock soars, short sellers are forced to buy the shares back at higher prices to close out their positions, pushing the stock even higher - known as a "short squeeze."

The SEC found, however, that "it was the positive sentiment, not the buying-to-cover, that sustained the weeks-long price appreciation of GameStop stock."

It also rebutted a popular theory, sparked by the unusually high volume of short selling in GameStop, that some hedge funds were 'naked' shorting the stock - selling without arranging to borrow the shares. The SEC said it found no evidence of this.

The report does not address several outstanding questions, including whether bad actors manipulated social media to whip up positive sentiment in GameStop, or whether hedge funds tried to pressure retail brokers to restrict trading in GameStop, something that all parties concerned have denied.

An SEC official said it could not discuss in the report misconduct that could result in a potential enforcement action.

The agency's chair Gary Gensler told Congress earlier this year that the agency would address other issues raised by the saga, including short selling disclosures, game-like trading prompts used by brokers, and brokers' practice of sending customer orders to wholesale market makers for a fee.

"January's events gave us an opportunity to consider how we can further our efforts to make the equity markets as fair, orderly, and efficient as possible," Gensler said in a Monday statement.

(Reporting by Katanga Johnson and Chris Prentice in Washington Editing by Michelle Price and Rosalba O'Brien)