Photographer: Alex Kraus / Bloomberg
Photographer: Alex Kraus / Bloomberg
Small investors and others watching the market swings around GameStop Corp. and other stocks have learned a long list of trading terms, including short squeeze, call options and range coverage. The decision to Robinhood Markets and other trading platforms to close the door on the most volatile stocks are introducing them to two others: clearinghouse and guarantee requirements. They are invisible parts of Wall Street infrastructure, except when things get wild.
1. What happened?
The Depository Trust & Clearing Corp., or DTCC, the main center of the United States stock markets, demanded large sums of guarantees from brokers, including Robinhood, which for weeks facilitated spectacular leaps in stocks like GameStop. In response, Robinhood and some other trading platforms have raised large sums of money to post on the DTCC to increase their protection against losses. They also controlled the risk for themselves by banning certain operations. Robinhood also moved to undo some customer bets, prompting customer protests.
2. What is a clearing house?
Clearing houses such as the DTCC act as intermediaries between buyers and sellers. They exist to protect investors and the markets, ensuring that participants, such as brokers, have the funds available to support the trades they conduct and to determine who will be paid in the event of default. Clearing companies charge fees on transactions.
3. What is compensation and what is guarantee?
Clearing is the business of managing and settling a transaction after a transaction has occurred. The guarantee is something of value – sometimes money, usually bonds – that is disclosed as protection against possible defaults. It is a requirement found in many types of transactions: for a mortgage, the property being purchased serves as a guarantee. In the financial markets, collateral generally represents a small part of the value of transactions. In the 2008 financial crisis, markets stopped when banks began to suspect that their counterparties would fail and that the guarantees they had deposited would be inadequate. Although the authorities subsequently enforced the rules related to clearing derivatives, clearing shares in cash was largely overlooked. In fact, the rule that defines the margin requirements for buying shares in cash, known as Reg-T, dates from 1974.
4. What kind of risks was the GameStop trading frenzy creating?
Some retail investors were trading with margin through brokers like Robinhood, a practice in which a buyer usually places between 50% and 90% of the amount needed to buy the shares, with the rest coming from the broker. Brokers, for their part, have to put money in the DTCC to support these negotiations during the few days needed for settlement. This becomes a major consideration in relation to volatile and bullish stocks like GameStop. Collateral disbursements can create a cash crisis on volatile days – say, when GameStop drops from $ 483 to $ 112, as it did on January 28.
5. What does this mean for DTCC?
Since the settlement of a stock trade occurs two days after the transaction, there is a risk that the broker will not have the money to pay for the shares that its clients bought at the time of the settlement. The volatility of GameStop shares – or others caught in the same commercial boom, as AMC Entertainment Holdings Inc. and BlackBerry Ltd. – the danger of losing value quickly increased. If the broker did not have enough funds to pay the shares at the highest original price because it allowed customers to borrow half the amount, the clearinghouse would be in trouble. If the guarantee is still not sufficient and the broker in question is no longer available to be requested, the clearing houses have a risk-sharing agreement with their member firms, which provide the necessary money.
6. What did the DTCC ask for?
On January 28, after days of turmoil, the DTCC demanded significantly more guarantees from member brokers in its GameStop negotiations. A DTCC spokesman did not specify how much he demands from companies in particular, but said that, at the end of the day, collateral requirements across the industry jumped to $ 33.5 billion, from $ 26 billion.
7. What was the reaction to the commercial bans?
Robinhood’s trade restrictions left virtually no one happy, except perhaps the hedge funds whose short sales were squeezed during the increase in purchases. Other companies have taken similar actions: TD Ameritrade by Charles Schwab Corp. restricted transactions at both companies, as well as Interactive Brokers Group Inc. and E * Trade from Morgan Stanley. In a surreal scene, political archenemies Alexandria Ocasio-Cortez and Ted Cruz found common ground in attacking the company’s decisions. Conspiracy theories surfaced online even after Robinhood and other platforms said they would allow limited trading of the affected stocks to resume.
The Reference Shelf
- AN Tracy Alloway’s QuickTake on “flows before professionals” – the clash between GameStop boosters and hedge funds.
- The DTCC’s website and a Bloomberg article about its role in the volatility of the repo market.
- AN booklet from the CFA Institute on clearing.
- AN history of the history of the central counterparty of the Federal Reserve Bank of Chicago.
- AN DTCC history.
- Bloomberg News article tracing the roots of the Reddit stock market revolt to Occupy Wall Street.