A week later Robinhood Markets tried to clear the air by explaining why it set controversial limits on major stock trading. Risk professionals on Wall Street are still baffled: how was the company so ill prepared for an obvious increase in collateral calls?
For the financial sector, anticipating demands for guarantees from centers such as the Depository Trust & Clearing Corp. it is Brokerage 101. The main companies designate teams to study the DTCC methodology, estimate their requests and ensure that there is enough money available. Everyone complains, of course, but they also know what happens when companies fall short: They tour for a lifeline or shutdown. Robinhood has gathered billions of sponsors to keep it going.
“They obviously fell very, very little,” said David Weisberger, a market structure consultant who built trading systems at Salomon Brothers and Morgan Stanley. He said he was intrigued by Robinhood, given what he called “well known” requirements for clearing houses. “This was an event that threatened the franchise.”
The Silicon Valley startup made users furious by temporarily restricting certain purchases at the height of the January craze over GameStop Corp. and other “stockpiles of memes” that were in the middle of a spike. At the end of this week, while millions of customers were downloading their app to exchange fallen and new darlings, risk managers still didn’t know how Robinhood ended up in this difficult situation.
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Obtained for comment, a company spokesman referred to a Thursday blog post by Robinhood Securities president and chief operating officer, Jim Swartwout.
“We have been growing rapidly. And sometimes we encounter challenges as we adapt to meet this moment, ”wrote Swartwout, describing how the company’s growth and an increase in the volume of negotiations fueled demands for guarantees. “To say that the nightly increases in volume that Robinhood experienced last week were extraordinarily high would be a great understatement. The increase was of magnitudes higher than normal.
Chief Executive Vlad Tenev linked the trading restrictions to a $ 3 billion guarantee call that came in early January 28 from the DTCC, which Robinhood said contributed to a 10-fold leap in demand requirements. weekly deposits from the stock clearinghouse. Although Tenev credited the DTCC for being reasonable and accepting $ 700 million, he sometimes portrayed his formulas as opaque, noting that they include a “discretionary” component.
“We don’t have all the details” of how the DTCC reached its initial demand, Tenev told Elon Musk last weekend in an interview broadcast on the Clubhouse social chat app. “Obviously, it would be ideal if there was a little more transparency so that we could plan better around that.”
The replica of industry executives: it’s basically just math.
‘What a shame’
In interviews, more than half a dozen senior risk executives – some of the biggest Wall Street companies – reacted with bewilderment to any claim that the magnitude of DTCC’s demands cannot be predicted. They spoke with the condition of not being identified, in some cases because they interact with Robinhood.
They acknowledged that there are always complaints about the difficulty of identifying what clearing houses will look for and that things can go wrong. Some executives even reported occasions when they were pressured by millions of additional cash in the short term. But overall, the group said that large, well-run companies are not surprised by orders that threaten to empty their pockets.
A broker executive said Robinhood should have ensured it had enough capital or stopped processing volatile stock trades. TD Ameritrade of Charles Schwab Corp., for example, started limiting bets on certain meme stocks the day before Robinhood. Robinhood’s later restrictions were more severe, gradually decreasing over the following week.
“Once every decade, more or less, there are improbabilities,” said Weisberger, who now runs the cryptocurrency venture CoinRoutes. Automatic clearing firms, like Robinhood, need to know what potential demands they can face. “If they studied and gave an answer and it was wrong, well, what a shame for the people who studied,” he said. “If they haven’t studied, well, what a shame.”
Avoiding surprises
The DTCC bases a large part of its deposit demands on elements that include the concentration of a clearing member on volatile stocks, the volume of trades taking place, imbalances in the purchase and sale and the financial condition of the company. The more a broker is exposed to erratic actions, the more guarantees it has to offer. The less capital a brokerage firm has in hand, the more severe its surcharge may be.
The aim is to protect the broader financial system from trading patterns. To make collateral calls predictable, the DTCC says it provides “reports and other tools for our clearing members to help them anticipate their margin requirements for a specific portfolio”.
The nightmare that clearing houses must avoid is that a broker loses so much money before a deal is completed that the company cannot handle the end of the transaction. Without a clearing house, a company’s bankruptcy can spread through the financial system. Undoing just one trade means undoing all subsequent transactions if that stock has already been resold.
A broker’s collateral burden increases if it lends money to clients, and especially if they bet heavily on, say, stocks that have recently multiplied in value, as GameStop and other companies did last month. If prices fall suddenly – which has also happened – there is an increased risk that clients will be unable to repay their margin loans, leaving the broker to eat their losses. Some of the recent stock declines can be attributed to Robinhood liquidating clients’ positions to avoid defaulting on loans, according to Wall Street risk managers.
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“Someone needs to pay,” said Eric Budish, professor of economics at the University of Chicago’s Booth School of Business. If you are a broker, “you have capital to deal with this existential risk. I was surprised that Robinhood had no more capital for this scenario. “
Margin loans made up about 20% of Robinhood’s $ 6.7 billion balance sheet in mid-2020. Robinhood took advantage of credit lines and raised about $ 3.4 billion from investors at the end of January.
Robinhood, founded in 2013, has hired Wall Streeters to help integrate the startup into the more traditional financial system. The company appointed former Securities and Exchange Commission member Dan Gallagher, Norm Ashkenas of Fidelity Investments and Kelly Zigaitis of Wells Fargo & Co. to senior compliance and legal positions.
Robinhood prescription
This week, Robinhood offered his prescription itself to avoid future problems: The United States stock market must abandon its two-day settlement system and move to a real-time process.
Transferring the US stock market to instant settlement is a gigantic task that would require years of work. Two trading components would probably need to be digitized: the bonds and the money to pay for them. Digitally representing a security as a stock or security is not difficult, and a small-scale effort by Paxos Trust Co. to use blockchain to settle stock trades in near real time received a green light from the SEC in 2019.
Digitizing US dollars to pay for shares will take years, if that happens. Another obstacle is that all banks, brokers, hedge funds and brokers that buy and sell shares would need to update their systems to make the change. The transition would undoubtedly be expensive.
Australia embarked on a plan to do just that in 2016, when Digital Asset Holdings announced an agreement with ASX Inc. to redo the Australian Stock Exchange so that settlement times could be reduced from days to minutes. The project has been repeatedly extended and is currently two years behind schedule.
Meanwhile, Robinhood is fortunate to have access to venture capital to face a difficult period, said Joanna Fields, founder of market structure consultancy Aplomb Strategies.
“There are companies that have controls, governance structures and processes, and that don’t have the capacity to get that kind of capital injection,” she said.
– With the help of Jennifer Surane