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. 

Updates: 

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. 

 

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