A possible source of rising systemic risks for stock market
There has been a great deal of anger with Robinhood and other popular brokers decision to restrict trading of popular shorted stocks starting on 1/28/21 (GME AMC BB etc). There was an immediate outcry saying Robinhood was bowing to Citadel's pressure to ease their portfolio loss.
The real reason is actually much more complicated than that. And the real reason involves the Depository Trust & Clearing Corp.
It is important to pay attention to the DTCC. It is the entity that makes your trades actually happen. And it is a near monopoly, wielding a lot of power. If DTCC runs into cash flow or money guarantee problems, you can bet that the market will suffer something equivalent to a heart attack.
The crash of 2008 took off with the collapse of Lehman Brothers. It may turn out that the crash of 2021 starts with the collapse of DTCC.
Let's hope that it does not happen. But it behooves all of us to keep an eye on this story.
Below is a combination of excerpts from Bloomberg.com 1/29/21
The real reason is actually much more complicated than that. And the real reason involves the Depository Trust & Clearing Corp.
It is important to pay attention to the DTCC. It is the entity that makes your trades actually happen. And it is a near monopoly, wielding a lot of power. If DTCC runs into cash flow or money guarantee problems, you can bet that the market will suffer something equivalent to a heart attack.
The crash of 2008 took off with the collapse of Lehman Brothers. It may turn out that the crash of 2021 starts with the collapse of DTCC.
Let's hope that it does not happen. But it behooves all of us to keep an eye on this story.
Below is a combination of excerpts from Bloomberg.com 1/29/21
Why Robinhood and Other Brokerages Restricted Trading This Week
The rarely discussed role that clearing firms play in settling stock trades is at the heart of what caused Robinhood and other brokerages to restrict trading of some companies this week.
... The question is whether such critics will dig into the industry’s inner workings, where pressure mounted on Robinhood and other firms to limit certain trades. That would put a rare spotlight on arcane parts of the market designed to prevent catastrophe, such as the Depository Trust & Clearing Corp.
One key consideration for brokers, particularly around high-flying and volatile stocks like GameStop, is the money they must put up with the DTCC while waiting a few days for stock transactions to settle. Those outlays, which behave like margin in a brokerage account, can create a cash crunch on volatile days, say when GameStop falls from $483 to $112 like it did at one point during Thursday’s session.
“It’s not really Robinhood doing nefarious stuff,” said Bloomberg Intelligence analyst Larry Tabb. “It’s the DTCC saying ‘This stuff is just too risky. We don’t trust that these guys have the cash to be able to withstand settling these things two days from now, because in two days, who knows what the price could be, it could be zero.’”
The trouble on Thursday began around 10 a.m., when after days of turbulence, the DTCC demanded significantly more collateral from member brokers, according to two people familiar with the matter.
A spokesman for the DTCC wouldn’t specify how much it required from specific firms but said that by the end of the day industrywide collateral requirements jumped to $33.5 billion, up from $26 billion.
Larry Tabb, head of market-structure research at Bloomberg Intelligence, explains how the process works in a Q&A below.
Question: So what is the most important thing to understand here?
Tabb: The settlement process -- cash and securities officially change hands two days after a trade. During those two days, a lot of things can happen. The problem is, what happens when a trading counterparty and/or a firm cannot afford to pay for the securities they bought? If that occurred, and if the clearinghouse didn’t guarantee the other side of the trade, then the client would either not receive securities or not get paid, and the trade would have to be broken.
That is very bad. Not necessarily for a retail client buying 100 shares or so, but what if it was a big fund or a major player, like Robinhood or let’s say Lehman Brothers?
So if Lehman were to default (which it did) on all of its trades, then all of the folks on the other side of Lehman’s trades would send in their securities to Lehman, but wouldn’t get paid. Then the brokers who didn’t get paid wouldn’t be able to afford to pay for the securities that they bought. So you would have cascading failures.
So to ensure this doesn’t happen, they have clearinghouses. The clearinghouse takes the other side of the trade and guarantees settlement even if someone like Lehman goes bust. To do that, they have a waterfall of capital. First there is the securities in the client’s account (which support the broker and not the clearinghouse), then the margin provided by the broker , then there is capital provided by the clearing member, then there are IOUs by the big brokers to fund the clearinghouse, then there are central banks.
Question: Can you explain how high-flying stocks like GameStop and AMC make clearing firms require more margin collateral?
Tabb: So the amount of margin needed is determined by the riskiness of the securities that are bought. Most securities’ value stays pretty stable. However, given the volatility of these names and their overvalue, the problem is: Who knows what they are worth? And given that two-day lag, the clearinghouse can’t guarantee that the buyers will pay for their securities nor the sellers will come up with the securities to deliver.
Question: So if I’m a Robinhood customer, and I buy shares of GameStop or AMC or any of these wild Reddit stocks, what would prevent my counterparty from being able to deliver? I’m guessing if it’s a super-high short interest, the brokerage on the other side may struggle to find the stock to deliver?
Tabb: Yup. And the problem is, if I am a hedge fund and I am short GME at $30, I have to buy it back at $500 or pay some astronomical fee to borrow it.
Question: So firms like Citadel Securities, which execute trades for brokerages like Robinhood, have nothing to do with this?
Tabb: No.
Question: So a clearing firm somewhere got concerned, and called Robinhood and said this has all gotten out of hand, we need more money in your account?
Tabb: So Depository Trust & Clearing Corp. -- actually National Securities Clearing Corp., which is owned by DTCC -- upped the capital that is needed to guarantee those trades. Now the broker can’t guarantee those trades with the clients’ cash -- a la MF Global -- the broker needs to pledge their own capital. And given the massive trading in GameStop, AMC, the amount of capital was really substantial. And Robinhood and a few others just didn’t have the capital. So Robinhood needed to borrow $1 billion to cover their clients’ settlement.
... The question is whether such critics will dig into the industry’s inner workings, where pressure mounted on Robinhood and other firms to limit certain trades. That would put a rare spotlight on arcane parts of the market designed to prevent catastrophe, such as the Depository Trust & Clearing Corp.
One key consideration for brokers, particularly around high-flying and volatile stocks like GameStop, is the money they must put up with the DTCC while waiting a few days for stock transactions to settle. Those outlays, which behave like margin in a brokerage account, can create a cash crunch on volatile days, say when GameStop falls from $483 to $112 like it did at one point during Thursday’s session.
“It’s not really Robinhood doing nefarious stuff,” said Bloomberg Intelligence analyst Larry Tabb. “It’s the DTCC saying ‘This stuff is just too risky. We don’t trust that these guys have the cash to be able to withstand settling these things two days from now, because in two days, who knows what the price could be, it could be zero.’”
The trouble on Thursday began around 10 a.m., when after days of turbulence, the DTCC demanded significantly more collateral from member brokers, according to two people familiar with the matter.
A spokesman for the DTCC wouldn’t specify how much it required from specific firms but said that by the end of the day industrywide collateral requirements jumped to $33.5 billion, up from $26 billion.
Larry Tabb, head of market-structure research at Bloomberg Intelligence, explains how the process works in a Q&A below.
Question: So what is the most important thing to understand here?
Tabb: The settlement process -- cash and securities officially change hands two days after a trade. During those two days, a lot of things can happen. The problem is, what happens when a trading counterparty and/or a firm cannot afford to pay for the securities they bought? If that occurred, and if the clearinghouse didn’t guarantee the other side of the trade, then the client would either not receive securities or not get paid, and the trade would have to be broken.
That is very bad. Not necessarily for a retail client buying 100 shares or so, but what if it was a big fund or a major player, like Robinhood or let’s say Lehman Brothers?
So if Lehman were to default (which it did) on all of its trades, then all of the folks on the other side of Lehman’s trades would send in their securities to Lehman, but wouldn’t get paid. Then the brokers who didn’t get paid wouldn’t be able to afford to pay for the securities that they bought. So you would have cascading failures.
So to ensure this doesn’t happen, they have clearinghouses. The clearinghouse takes the other side of the trade and guarantees settlement even if someone like Lehman goes bust. To do that, they have a waterfall of capital. First there is the securities in the client’s account (which support the broker and not the clearinghouse), then the margin provided by the broker , then there is capital provided by the clearing member, then there are IOUs by the big brokers to fund the clearinghouse, then there are central banks.
Question: Can you explain how high-flying stocks like GameStop and AMC make clearing firms require more margin collateral?
Tabb: So the amount of margin needed is determined by the riskiness of the securities that are bought. Most securities’ value stays pretty stable. However, given the volatility of these names and their overvalue, the problem is: Who knows what they are worth? And given that two-day lag, the clearinghouse can’t guarantee that the buyers will pay for their securities nor the sellers will come up with the securities to deliver.
Question: So if I’m a Robinhood customer, and I buy shares of GameStop or AMC or any of these wild Reddit stocks, what would prevent my counterparty from being able to deliver? I’m guessing if it’s a super-high short interest, the brokerage on the other side may struggle to find the stock to deliver?
Tabb: Yup. And the problem is, if I am a hedge fund and I am short GME at $30, I have to buy it back at $500 or pay some astronomical fee to borrow it.
Question: So firms like Citadel Securities, which execute trades for brokerages like Robinhood, have nothing to do with this?
Tabb: No.
Question: So a clearing firm somewhere got concerned, and called Robinhood and said this has all gotten out of hand, we need more money in your account?
Tabb: So Depository Trust & Clearing Corp. -- actually National Securities Clearing Corp., which is owned by DTCC -- upped the capital that is needed to guarantee those trades. Now the broker can’t guarantee those trades with the clients’ cash -- a la MF Global -- the broker needs to pledge their own capital. And given the massive trading in GameStop, AMC, the amount of capital was really substantial. And Robinhood and a few others just didn’t have the capital. So Robinhood needed to borrow $1 billion to cover their clients’ settlement.