Tuesday, February 2, 2021

Trading halts and game over

David Battan writing in the WSJ brings come clarity to Robin Hood's trading stop.  It raises some questions for me, however. Much of the problem seems to stem from two-day clearing and settlement, and brokers lending people money to trade. Instant settlement and at least separating the lending activity from the trading activity ought to help. The institutions are really stuck with relics of a pre-computer world, it seems. 

OK, first the facts, then speculation, and an invitation for commenters to correct me as I am not a master of these important plumbing issues. 

When clients trade, especially on margin, they use the broker’s money to play. Imagine a client buys 100 shares of GameStop for $400 a share, using $20,000 of his own money and borrowing $20,000 from Robinhood. If the stock drops from $400 to $120 (as it did on Jan. 28), the client’s position may be sold for $12,000 due to the margin violation, leaving Robinhood trying to collect an unsecured $8,000 debt from “u/Thicc_Ladies_PM_Me.” Good luck. Multiply this by hundreds or thousands of similar clients. Option trading is worse because the leverage is much greater. 

"Margin violation" means basically this: 

Even on the exchange, you don't immediately clear trades. It's really just a promise to deliver cash in the future. The exchange wants the broker to keep enough cash around to make good on all its losing trades, and so the broker wants to make sure you can pay it back. If your account heads to zero, as it does in this example, the broker may call and say, send money now to cover your losing position, or we sell out your trades and make sure we don't lose any more money. They do not want to hear your theory about how it will bounce back tomorrow. The same goes for short positions, which is how they got wiped out. 

"Option trading is worse because the leverage is much greater" is a bit misleading. The point of options is to give you great exposure without leverage. If you buy a call option, for say $10, and the stock goes up, you can get the same increase in value as if you had bought $100 of stock. If the stock goes down, you can only lose the initial $10 and no more. They are like buying on margin (with borrowed money) but in a way that painlessly closes your account when you lose the initial $10. Options trading ought to be great for speculation. That is likely why options were invented only a few years after stocks started trading in the 1600s. 

Trouble comes if you are so hot to trade that you borrow even the $10 to buy the call option. Or if you write the call option, in which case you get $10 but can lose unlimited amounts if the stock goes up. Those accounts have to be closed out just as above. 

A partial answer might be, let them all trade buying calls and puts, where you can't lose more than your individual investment. But someone has to write the calls and puts, and someone has to arbitrage the calls and puts back to the original stock. 

OK, back to Robin Hood

The broker’s risk is asymmetrical: If half its clients are winning big by buying during a short squeeze, while its short clients are suffering losses they can’t pay, the broker can’t offset these gains and losses, but must pay the winning clients while possibly eating the losing trades. It is rare, but brokers go bankrupt during market events like this.

Brokers therefore are subject to strict financial requirements, including that they maintain large security deposits at the clearinghouses. When risk rises, clearinghouses raise their requirements, even intraday. On Jan. 28, when GameStop dropped from $483 to $112, the clearinghouse DTCC raised requirements by an aggregate $7.5 billion. Brokers had to post that money to DTCC whether or not their clients had it.

Brokers facing liquidity crunches have two options: raise capital (which Robinhood apparently did) or reduce clients’ risky trading. This is a more plausible explanation for their actions last week than any desire to protect hedge funds. Brokers love their clients and want them to flourish. But they don’t want to go bankrupt.

In short, brokers who lend money to people to trade, as they all do, are a bit on the hook for their client's trades. They are also a bit on the hook since there is a two day settlement process. The exchange wants the broker to come up with the money no matter what. 

And regulation has a lot to do with it.  

The second factor possibly weighing on brokers’ minds is the prospect of eye-watering fines if clients engage in manipulative activity. Whereas social-media platforms are protected from liability for miscreant users, online brokerage platforms face opposite rules. Under federal anti-money-laundering regulations, firms must conduct “reasonable surveillance” for client fraud or criminality. The SEC and other regulators have fined banks and brokers (including E*Trade, Interactive and Schwab) hundreds of millions in total over recent years for failing to detect and prevent client misbehavior. While the legal standard is allegedly negligence (“reasonable surveillance”), regulators routinely employ 20/20 hindsight to second-guess broker due diligence of their clients after the fact, effectively imposing strict liability. To the regulators, fraudulent schemes are always perfectly obvious in retrospect.

There is also the broker's and exchanges regulations for capital, liquidity, and so forth, which I hope commenters will help out with. 

Robin Hood had to do it. 

Now, for the question. Would this not all be solved by two simple changes. First, nearly instantaneous clearing. The crypto crowd has been saying for a while that stocks and other financial contracts can be moved to instant settlement by blockchain. Even without blockchain, it seems computers are a lot better now than in the 1970s. Why this two day process? The markets are still pretty much at the stage where for a whole day we throw slips of paper on the floor, then add up gains and losses at the end of the day, make one net payment, and hope that the losers can come up with their share. (Metaphorically. There used to literally be trade slips on the floor, now it's in the computer.) Why not settle immediately? 

Second, it seems the business of lending people money to trade, monitoring their accounts, and keeping track of collateral they have against the value of their accounts, could be more separate from the business of trading. People who want to trade long-only, without borrowing the money to trade, should be able to. It's not clear why a broker has to slow down all trading. 

The answer really would seem to be more trading via options and single-stock futures, that don't require margin, no? 

I will be glad to hear if this is wrong, or other suggestions on how to cure these hiccups in trading mechanics. 


Robin Hood is raising capital. More capital is the answer to everything. 

I forgot to add a good point I saw on twitter and now can't locate the source. We are seeing a lack of liquidity, a lack of people willing to take the other side of bets that are clearly doomed to fail eventually though they might get worse in the short run, causing margin calls. Owen made this point in our interview (previous post), and we have seen many glitches in markets over the last decade or so with wild price swings and not enough arbitrage capital -- really risk-bearing capital -- to profit from them. Adding a transactions tax or other restrictions will hurt more than help. The transactions tax will be a tiny cost of doing business to the basement-dwelling day-trader, but will further get in the way of institutions trying to smooth markets by arbitraging them out. The transactions tax remains the favorite answer in search of a question. 



  1. Does RH have increased risk from selling fractional shares? Any insight to fractional share mechanics?

  2. Does RH have increased risk from trading fractional shares? Do they wait for customer buy/sell orders to aggregate to a whole number before executing?

  3. John,

    "People who want to trade long-only, without borrowing the money to trade, should be able to. It's not clear why a broker has to slow down all trading."

    With margin buying and selling of shares essentially the broker is trying to create debt from an equity instrument (which is the exact opposite of where this country needs to head - more equity and less debt).

    Instead, why not rely more on equity swaps? Client wishing to engage in trading swaps shares of one company for shares in another.
    He can then sell the shares he has "borrowed" hoping to buy them back later.

    Would it make sense to adjust tax policy to make swaps and direct share for share exchanges (without intervening money or debt) tax free? Should barter exchange be exempt from taxation?

  4. I'm also not an expert on the plumbing, but I think you've explained well the reason why brokers would set the margin requirements such that you can't borrow money to trade GME.

    The thing is, I don't think anybody (even the WSB boys) was saying that brokers should be forced to lend money to buy GME. But, for a broker to disallow you from using your own money to purchase a valid asset, while giving no warning, has to be some sort of failure on their part.

  5. Simple solution - eliminate the taxation on barter exchange.


    If you don't use the "government's money" in an exchange, there is no reason for you to pay taxes in the "government's money".

  6. I worked by a broker in Europe that last year go bankrupt during the pandemic market crash due option sells of our clients.

    The main problem is, given a short option position, you must provide a margin based on volatility models of the underlying. But prices are not normal distributed and there always exists a higher probability than anyone want to account of a "black swan" event, than can blow up any margin provision.

    For example, int the day of oil crash, WTI futures price went from nearly $0 to -$63 in a few minutes and liquidity of the market went to 0, making impossible to close positions. Interactive Brokers reported $8 million losses from costumers

  7. Some notes.

    Margin calls exist not because of settlement, they exist because you borrowed money with the stock as collateral and if the value of the collateral drops below the amount you owe, the broker is in the red. Margin calls happen on unrealized losses with no settlement involved.

    Leverage does not necessarily imply borrowing. Leverage is, basically, the ratio between changes in your P&L and changes in the value of the underlying asset. Borrowing some money (e.g. on the margin) is a way to get leverage, but not the only one. Options typically have built-in leverage without any borrowing (but it changes depending on the moneyness of the option, see the concept of delta).

    And futures certainly require margin, as does writing options. Note that futures and options are *contracts*. You have limited downside only when you're long puts and calls; people thought that being long futures limits your downside to 100% but they were proved wrong when oil futures traded at significant negative prices last year.

  8. I have been moderately amused by the behavior of people engaged in moralizing the events surrounding the GME short squeeze: one side saying the "Davids" rebelled against Goliath; the other side saying they are criminals hell bent on manipulating markets.

    It's amusing and predictable, but it's not exactly very productive. There is a lot of great work done on the design of exchanges and financial regulations and their impacts on liquidity and price discovery, so it's not like there isn't enough material to have a serious conversation.

    Yet, serious public conversations are scarcer still than short squeezes. I'm almost surprised the usual suspects didn't come out yet claiming one side or the other are white supremacists, though we did get Ocasio-Cortez accusing Cruz of attempting to have her murdered.

    Fortunately, we've all had some great commentary on this blog. I'm looking forward to hearing from people with more expertise in market microstructure to weigh in on this problem.

    1. I suspect it is because there is implicit reliance on asymmetrical financial literate, and similar asymmetric access to market securities. This facilitates "the few" being able to gain disproportionate and supernormal profits. That same "few", are then able to wield their considerable power and influence to keep financial literate low, and keep the market barriers high.

      I've always wondered what the world would be like if the basics of interest rates and bonds were taught as part of the school curriculum, and if Joe Public could readily (and directly) access the likes of corporate bonds - which *should*, in theory, be absolutely possible with today's technology - and 'fraction' math, of course.

      As John remarks, securities transactions shouldn't take two days to clear - but they do. Whilst the technology and literate lags behind, it allows others to benefit.

      (I feel I should reassure everyone that I am not a communist or "Reddit-er": I think it is my growing cynicism commiserate with my mid-thirties)

    2. Financial literacy is very heterogeneously distributed. Even though financial markets have a very complicated structure, it might be worthwhile for the general population to have a sense of the basics.

    3. BazzyUK,

      "I've always wondered what the world would be like if the basics of interest rates and bonds..."

      Okay, here are the basics of interest rates and bonds.

      1. What is an interest rate? An interest rate is the cost of time (not the cost of money or the cost of borrowing as a lot of people may believe).

      This is demonstrated in a barter economy. I have an apple orchard and you make airplanes. I will trade you 10,000 apples delivered today for one airplane delivered today. Oh wait, it will take you 2 years to build me an airplane? Fine then I will only give you 8,000 apples now for an airplane delivered to me two years from now.

      In the deal I describe (my apples now for your plane delivered two years from now), is either one of us using money - no. Is either one of us lending our goods to the other - no - we are engaging in a trade separated by a period of time.

      Am I charging you interest in this trade? Absolutely. I am offering fewer apples for a plane delivered two years from now than I would if you could deliver the plane to me today. And I do this for all the same reasons that a bank charges you interest on a loan - you could walk away from the agreement, you could die before the plane is built, I could die before I receive the plane - it's called default risk and it is not limited to lending arrangements.

      It is because we each have a limited lifespan that time has a cost associated with it. If we all lived forever (or if there are frictionless intergenerational transfers), this will reduce what economists call the "natural rate of interest" simply because more time is available to each of us (in the case of living forever, an infinite amount of time).

      2. What is a loan or what is meant to lend?

      To lend means to transfer a good from one party to another with the expectation that the good will be returned at some point in the future. Obviously when you borrow money (say ten $100 bills), you are not expecting those exact same $100 bills to be returned because money is fungible. If I lend you my car (a 2017 Chevy Volt) I expect you to return my car (not a 2004 Ford Taurus).

      Notice that in my apples / airplanes example neither of us is actually lending, even though some time may elapse between when I deliver apples and you deliver an airplane.

      3. What is a bond? A bond in finance is a securitized form of loan. In essence it is a loan where all of the terms of the loan are written down, signed by both parties, and constitute a legally binding contract. You and I could agree to a loan - I will lend you $50 as long as you pay me back next Friday (a verbal or gentlemen's agreement), but that would not constitute a bond.

      Bonds have various optional features. They can be marketable / resalable or they can be non markable / resalable. They can be fixed or floating rate. They can be coupon paying or zero coupon / accrual. They can offer simple or compound interest.

      I think part of the problem is that even the basics are misconstrued. Listen to any financial reporter and see how many of them refer to interest as the cost of money. It is a convenient short hand, but is factually inaccurate.

    4. Thanks, I enjoyed reading the reply!

      I was imagining a hypothetical world where all that participate in the market by either buying/selling/renting products, services and assets are also able to access all types of security, where there are instant transactions, without the need for a clearing house.

      This, coupled with a basic financial curriculum so that Joe Public are better equipped to understand the threats and opportunities to their savings, mortgages and investments.

      I believe such am alien world could only be a loss for Wall St and 'The City'. And the reason for my cynicism of why I think some technology seems to lag in Finance for purposeful reasons.

    5. BazzyUK,

      "I was imagining a hypothetical world where all that participate in the market by either buying/selling/renting products, services and assets are also able to access all types of security, where there are instant transactions, without the need for a clearing house."

      The reason for a clearing house and interest is......time. It is easy to conceive of an electronic barter economy in today's world where no actual money is exchanged. The problem is time. I can't snap my fingers and build an airplane and I can't build a bunch of airplanes in advance hoping to sell all of them as soon as they are built.

      And no, blockchain technology (despite it's promise) cannot will goods into existence to be immediately sold on a market.

      For that, we will need the Nutri-Matic from Hitchhiker's Guide to the Galaxy (one of my all time favorite books) :-)

    6. " I'm almost surprised the usual suspects didn't come out yet claiming one side or the other are white supremacists"

      That was attempted. I suspect this accusation fell into disfavour as it was discovered that most of the RH traders are young lefties with a weirdly woke agenda. I think the grass-roots support of Bernie Sanders and AOC implies a pretty big populist segment of the left.

  9. Considering most brokerages allow naked put writing (on margin) the losses with options may be limitless in certain trades.

  10. Two day clearing can generate a liquidity crunch even where the broker extends zero margin. For example: imagine a Robinhood user bought 1 GME share (solely for cash, no margin) at 9:30am on January 28th when the price was $265, then sold that same share at 10am when the price had risen to $469 and immediately cashed out his account. Let's further assume the sale was to another Robinhood user who also bought solely for cash, just for the sake of simplicity. All seems fine for Robinhood, right?

    Well not entirely, because it will take these trades 2 days to clear and Robinhood must post collateral with the DTCC clearinghouse in the meantime. So although Robinhood has lost no money whatsoever, it does have a liquidity issue to manage. Normally this is fine... brokers are in the business of managing exactly this sort of thing, and do it quite well. The trouble is when the DTCC notices that dramatic 30 minute price move, gets freaked out, and suddenly increases the collateral brokers need to post (with little/no warning) on GME shares. That can be a (2 day) liquidity problem that requires raising money from your shareholders. No margin is necessary to get yourself into trouble in this scenario.

    This is what likely caused with the Robinhood trade halt. Note the margin issue you discussed is related-but-separate and, critically, isn't helped one bit by a trading halt (you just stop offering margin and forcibly close out positions that are too thin, which Robinhood did).

    1. I think it is as you describe. But as I understand it, the other issue that makes this problematic, even when no one is trading on margin, is that RH can't use (by law) customer funds committed to a purchase for the collateral RH needs to post with NSCC. So that regulatory requirement re the treatment of client funds creates an essentially artificial liquidity problem for RH pending settlement.

    2. This is a key point. Thanks, I was not aware. It doesn't make a lot of sense that if I post $10 collateral for my trade, the broker can't pass the same collateral and same trade on to the market.

    3. I'm going to guess those rules are more geared towards preventing either (1) use of customer FLOAT for collateral with a clearinghouse, or (2) using the same funds to simultaneously satisfy both customer-broker margin requirements and broker-clearinghouse collateral requirements.

      Full disclosure: I'm no expert, that's just what the rules sound like from what I've seen in the media coverage.

    4. I don't think one is allowed to cash out immediately in the manner you describe. One needs to wait for the trade to settle before one's broker will allow one to withdraw the funds.

  11. I read the institutions were short on 140% of GameStop shares. Huh?

    Can someone explain?

    1. The same individual share was lent 1.4 times (on average). Same thing as fractional reserve banking, except replace lending dollars with lending shares.

  12. Yellen paid $800k from Citadel. Citadel Portfolio Manager is Jeffrey PSAKI.
    Biden Press Secretary is Jen PSAKI.

    I wonder who rang Robinhood from the White House to stop Citadel from going bankrupt??


    1. Jewel,

      Not only that. Janet Yellen was paid large sums of money by Citadel for speaking engagements. See:


    2. Citadel was never in danger of going bankrupt from GME.

  13. The collateral that DTC required clearing firms (like Citadel) to cover trades passing through their hands before they clear was raised from 1% to 100% on the morning selling was halted by Robinhood and others. This was put in place by DTC due to increased risk of being left holding the bag if traders/brokerages/hedge funds became insolvent.

    At the very least it does not look good when Citadel & partners loaned Melvin Capital $2 billion but won't cover the increased collateral requirements on buy trades coming through their system. That down trading day made it much easier for Melvin to unwind their trade, helping their investment in Melvin work out.

  14. The answer to both questions is: "It's complicated."

    A Day-trader is required to have a margin account with his broker. With a margin account, settlement is not constrained to two-day settlement period, as it would be with a cash trade in a cash-account or a margin account that is not a day trading account. Margin requirements are set by the brokerage, or FINRA, which ever is the more stringent (restrictive). The broker sets his margin requirements ("rules-based requirements, 'RBR') according to a risk assessment of the collateral in the account that supports the broker's loan, and the margined security's characteristics (type, price, sector, volatility, etc.) In a day-trader's margin account, the broker settles the client's trades instantly in-house. Doing so facilitates the day-trader's 'trading pattern'. The broker has a two-day window to settle trades with his alter-egos through the clearing house. We can see here that there is an analogy with a business account holder and a commercial bank, where the business account does multiple transactions with his commercial banker in the course of a business day, and commercial bank settles the banker's accounts with his counterparts in other commercial banks at the federal reserve bank in his region.

    In the case of a cash account, the broker has only a trade brokering relationship with the account holder. Consequently, the two-day settlement requirement is imposed to provide for orderly transactions in the clearing house. The broker does not act as a principal in the transaction.

    The margin account creates a borrower-lender relationship. The collateral supporting the loan must represent an ownership interest. Options and futures are not eligible as collateral. Because of this, and the nature of trading in stocks and bonds and derivative securities, it is unlikely that the trading relationship can be separated (severed) from the lender-borrower relationship. The two functions are intertwined and interdependent.

    For details on margin requirements at Fidelity Investments see:

  15. The WSJ article was a bit disingenuous, implying that Robin Hood blocked trading of GME and other meme stocks on margin, because they didn’t want to take the credit risk. In fact, if you followed WSB at all when the blocks first took effect, it was obvious that people posting were saying their trades were blocked even when they had cash in their accounts to cover the transaction.

    However, as another commenter alluded to, and as I have read elsewhere, it appears that the brokerages are on the hook for posting a clearing deposit with the NSCC, and the brokers can’t use client cash to cover it, which means regardless of whether the buyer is using margin or cash to make the stock purchase, it still affects the clearing deposit the brokerage is required to meet using their own capital.

    This Twitter thread gives some good details on how the clearing deposit is calculated. This is the best explanation I have found, but I welcome other sources.

    The calculation relies on many factors (and volatility is a factor), but it appears there is a “Margin Liquidity Adjustment Charge” that the DTCC has wide latitude to set – could potentially be as high as 100% of the cost of the GME shares at purchase. There was no transparency how the DTCC/NSCC arrived at the increased clearing deposit requirements for RH and other brokerages. But the fact that RH and NSCC negotiated and reduced requirement from $3 billion down to ~$1.4 billion indicates that they have a pretty wide range of discretion. I think it’s fair to ask whether some other Wall Street entities could have influenced the NSCC’s decision. Or at least if they want to avoid that appearance, they could be more transparent about how the decision was reached and how the calculation was made.

    This is part of the reason the WSJ article irritated me. I would hope the WSJ would be capable of providing this level of analysis of the situation. I personally would like to see WSJ explain the situation thoroughly, raise relevant questions, and attempt to answer them. Questions like, “What drove RH’s decision to block and then limit purchases of GME and similar stocks?” It appears to be the significantly increased clearing deposit requirements - fine. Then, “how did the entities that apparently forced RH’s hand (i.e. the NSCC) handle the situation behind the scenes? Who/What, if anything, influenced them in setting the deposit requirements? Why no transparency?” But alas, I have to look to Twitter for any analysis whatsoever of NSCC clearing deposit requirement calculations/factors. And then to think there might be any investigative reporting to get someone from the NSCC to talk on or off the record about what went on, well… maybe that’s just asking too much.

    Perhaps we shouldn’t be surprised. Part of what’s driving the Redditor sentiment is videos like this one, an old video of Jim Cramer talking about how he used to manipulate stock prices of companies that he had a short or long position in when he was a hedge fund manager. He mentions how he would use the financial media to do this (“you’d call The Journal and you’d get the bozo reporter…” he says at 3:25 in the video). So articles like this one from the WSJ, which purport to show the truth behind the situation, start to leave the impression that they’re actually intentionally leaving important stones unturned to provide cover for someone or something more nefarious…

  16. "The answer really would seem to be more trading via options and single-stock futures, that don't require margin, no?"

    Futures trading is done on margin - as commitments to buy or sell in the future, they're designed to give you the exposure without the cash outlay, hence margin is required to cover losses. Most options trading, too, although it's true that vanilla puts and calls can be held long and paid in full, so without risking margin calls.

  17. Firms that self clear or are members of the Options Clearing Corp are guarantors to the market place. To avoid traders invading firm capital, margin rules and risk managers will either liquidate positions, call for cash or close accounts. In times of high volatility, margin may go to 100% for long positions, all cash, and as much for as 1600% for short positions. In 1978, On the CBOE, where I was a market maker, traders who shorted straddles, strangles, ratio writes and naked calls were squeezed into bankruptcy when the market rallied. The firm through whom I cleared was nearly bankrupted guaranteeing counter party profits. I was asked to delay taking money from my account until financing was secured. I did along with others who in effect became creditors. It helped and the firm survived.

  18. 1/ Legacy technology could be adapted to T+0 settlement. And in some markets that is already being done. But gross settlement of every trade (rather than netted at the end of the day) would increase risk rather than reduce it. Also, T+0 settlement would not change the fact of margin calls in the chain: clearing house - brokers - clients.

    2/ Are you suggesting that RobinHood set up a separate legal entity for those clients who commit to never trading with leverage? Or dual accounts for all clients, one in each legal entity? I think it would get messy on an operational level between RH and clients and also for clients, whichever way you'd do it. It also would be inefficient use of equity capital. More importantly, the issue originated between DTCC and RH, not between clients and RH. Furthermore, shorts are by nature leveraged positions (stocks or options).

    Note: In a discussion of clearing and settlement, there is nothing misleading about the statement "Option trading is worse because the leverage is much greater." In relation to the price of the underlying, there is a non-linearity. But from a clearing and settlement perspective, it is just a more volatile financial asset. Also note that a stock price doesn't go below zero either.

  19. The governments takes a cut of lotteries. They should take a cut of market transactions. Maybe exempt the tiny fraction that actually involves allocation of capital. ( Yes there is the probably vain, probably painful, attempt to store wealth in the financial markets, like a massive bitcoin, good luck)

    1. Jim and Linda,

      That is certainly one way to go about things, it's called a Tobin Tax (named after economist James Tobin). See:


      "A Tobin tax was originally defined as a tax on all spot conversions of one currency into another. It was suggested by James Tobin, an economist who won the Nobel Memorial Prize in Economic Sciences. Tobin's tax was originally intended to penalize short-term financial round-trip excursions into another currency. By the late 1990s, the term Tobin tax was being, contrary to its original use, used to apply to all forms of short term transaction taxation, whether across currencies or not. Another term for these broader tax schemes is Robin Hood tax, due to tax revenues from the (presumably richer) speculator funding general revenue (of whom the primary beneficiaries are less wealthy)."

      John C. on occasions has recommended that a tax be assessed on short term debt taken on by banks. But John refuses to provide clarification on what he means by short term (overnight, one week, one year?) and what is and is not a bank (is a broker dealer like Robin Hood a bank?).

      At the bottom of the article, John has added that Robin Hood is raising more capital (presumably through the sale of equity shares though he doesn't say so) and bemoans a transaction tax.

      Ironic that the nickname for the tax you describe (Robin Hood Tax) is also the name of the broker dealer.

  20. John,

    I see you have added a notation that Robin Hood is raising additional capital (presumably through the sale of equity shares).

    Question: Why can't Robin Hood offer shares in itself as collateral to the DTCC (preferred dividend paying stock?) rather than using client funds or going through the rigamarole of trying to schedule equity sales on short notice to meet DTCC collateral requirements?

  21. Good post and comments on this topic. The key problem is that the fat tail event (aka 'Black Swan') was incompatible with RH business model. They ran into a capital requirement problem and were forced to raise capital. I did not see any mainstream brokers halt trading in GME and certainly this was the case with my brokerage as I did not see any messages that there were limits on the trading of any security. Black Swan events are disruptive as we saw with the 2008 banking problem which led to increased capital requirements on banks post-crisis.

    A lot of years ago I lost a gain by taking the points in Super Bowl 3 when you could get 18 points taking the NY Jets over Baltimore. Jets win and the local bookmaker is caught in a short squeeze. He disappeared from town and my winnings were gone. Too bad there wasn't a regulatory option to get my $50.

    1. It wasn't just Robinhood: eTrade, Interactive Brokers, and TDAmeritrade also imposed restrictions on various "meme stock" trades on or around January 28th.

      The reason for all the focus on Robinhood is that there's a silly* conspiracy theory floating around that Citadel influenced the trading halt to protect its investment in Melvin Capital. You can even see a version of this a few posts up. That's put Robinhood firmly in the spotlight.

      *Silly in hindsight, no offense intended to those who had already posted days ago. We now know that Melvin Capital had already closed its short position in GME by January 27th (before the Robinhood trading halt happened).

  22. "First, nearly instantaneous clearing. The crypto crowd has been saying for a while that stocks and other financial contracts can be moved to instant settlement by blockchain. ... Why this two day process? Why not settle immediately?

    1. Please appreciate that the clearance and settlement procedure involves netting the transactions of each participating broker in the system.

    Ignoring for the moment margin accounts, Brokers must maintain a number of shares of each security that its customers own equal to the total number owned by all customers. Shares held by the broker are not tagged or segregated by customer, but are held as a fungible mass.

    Assume that Brokerage B has two customers. One owns 1000 shares of Apple, the other has a free cash balance of $2M. If on a given day, one customer sells 1000 shares of Apple and the other customer buys 2,000 shares, the settlement at NSCC has B receive 1,000 shares. If the price for both is $1,000 per share, B must deliver $1,000,0000. B then credits the account of the first customer with $1M and debits it for 1000 shares and debits the account of customer 2 for $2M and credits it for 2,000 shares.

    This is vastly over simplified, but it is a decent first order approximation.

    Please appreciate that NSCC guarantees the settlement of all cleared transactions.

    Think of netting as providing a set of shock absorbers in the system. Between the customers trading among themselves are capitalized and regulated entities, the brokers and NSCC. they allow the market to function anonymously and rapidly.


  23. 2. The old paper based system (before the 1960s) was not T+2 it was T+5 and it did not have a central depository for stocks (DTC) or a central clearance and settlement. Little old men (mostly retired cops and firemen) shuffled around Wall Street with ratty old briefcases full of stock certificates and checks. It was replaced in steps and stages over the the next 50 years. T+5 was replaced by T+3 in 1995. T+2 was legislated in 2017.

    There have been major stock market breaks in recent years. Two of the biggest were the Panic of 2008 and the chaos of last March (isn't it still March?). In 2008 several major houses went under. Not just Bear Stearns and Lehman, but also Wachovia (bought out by Wells Fargo) and Citibank (bought out by Morgan Stanley). Last spring there was utter chaos in the market. In neither event did any firm fail because of problems with clearance and settlement.

    3. In the clearance and settlement system, both the brokers and NSCC go back thorough the days transactions and make sure that the books balance. Believe or not, brokers make mistakes, --digits are swapped, wrong symbols are entered, and on and on. This is inevitable as long as the system begins and ends with humans articulating their wills. Most mistakes them are caught and corrected in the clearance process. But, time must be allotted The settlement process is fairly simple after the clearance. The transition to T+2 was estimated to have cost abut $550M, but to save about $195M/yr.

  24. 4. Transition from T+2 to T+1 would cost something. But, it would save some money, and it might be worthwhile. T+0 (i.e. netting, clearing, and settling on the same day) strikes me as very difficult because it may not allow enough time for book balancing. A direct settlement system (going back to the eighteenth century) creates all kinds of problems with credit risk, error correction, and anonymity, among others.

    5. Blockchain is the second most overhyped technology in IP these days. (AI being first). Blockchain is a method of maintaining a database that embeds a lot of security and error detection. Its virtue is also its vice. It requires a lot of processing overhead to maintain. So much that Bitcoin (the first implementation of blockchain) has been estimated to use the equivalent of a medium sized first world country in electricity.

    Proposals have been made to have all stock registers currently maintained by banks and DTC with blockchain. Companies like Apple and Amazon have upwards of a billion shares, millions of stockholders and millions of shares changing hands everyday. Putting all of that data on a blockchain and having it reprocessed every time shares change hands would just choke computers.

    Disintermediating the securities transfer system in order to have transaction be settled continuously would replace the capital invested in the clearance and settlement system with incredible costs in computing and electricity (so much for net zero).

    6. Please respect that the existing system is the product of a very long evolution. It is not perfect, but I don't see scrapping it as a solution.

    1. Fat Man here has a deeply important point about financial market structure. The safest way to transact is to clear every transaction. I buy 100 shares of stock at $1 per share at 10 AM, I pay you $100. You buy the shares back from me at $1.01 per share at 10:05 AM, you pay me $101. But with any cost at all of delivering money, it is much easier to sit down at the end of the day and net all the gains and losses, and only deliver the difference - if you have the money, which is where margin etc. come in.

      Most retail transactions are netted. If you send me a check for $100 and we have the same bank, they just flip a switch on your and my accounts, and no actual money goes anywhere. If bank A owes bank B $1000 and bank B owes bank A $999 at the end of the day, they just send $1.

      Netting is much more efficient, even with blockchain. And just a little bit less safe. This is a fact of life that designing payment and trading systems have to face.

  25. instantaneous settlement is inconvenient.. T+2 settlement convention allows to separate trading decisions from settlement decisions which are in many situations quite different... settlement consequences of trades done at T with T+2 settlement are taken care of the next day by repo/swap desks with T+1 settlement of near leg of repo/swap... to take care of price risk for the period between trade and settlement dates clearing houses require from brokers and brokers require from their clients collateral of 20-70% of the value of trade which is sufficient 99.99% of time... now to real world examples... in my country we have an unusual fx market.. we have liquid market for usd/russian ruble for settlement today (almost instantaneous but not quite) and for settlement tomorrow (t+1).. and guess market preference? of course in open competition delayed settlement wins big... turnover is 5x higher for T+1 settlement... local stock exchange used instantaneous settlement from its founding back in the mid 1990s but switched to T+2 settlement in 2013.. this is because partial collateral (20-70% of trade value in money) and t+2 settlement set up works much much better than 100% collateral (in money for purchases and in securities in case of sale) with immediate settlement setup.. in fact there is no way to sell the stock short unless u first finance it with repo trade (get 100% on ur account) which might look unnecessary in a couple of hours and which u will have to reverse or will be quite difficult to achieve because nobody has a clue about their position at the end of trading day...

    1. KP,

      "...in fact there is no way to sell the stock short unless you first finance it with repo trade."

      Yes there is. Bank or other financial firm offers it's own shares in a swap for shares that it wants to sell short. And so shares of bank A are swapped for shares in company B owned by firm C. Bank A then sells shares of company B into the market hoping to buy them back at a cheaper price. The swap after some time period is then reversed. Bank A buys back shares of company B, returns them to firm C, and A receives it's own shares back from firm C

      With a repo trade, the downside risk lies with the shorting firm (in my case Bank A). With a swap, the downside risk / upside reward is shared by both the shorting firm and the owner of the shares being shorted.

      Why would firm C in my example do this? To raise cash through a dividend payment on shares in bank A while retaining control of shares in company B.


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