GameStop-ped Up Robinhood’s Plumbing
The vertigo inducing story of GameStop ramped it up to 11 yesterday, with a furore over Robinhood’s restriction of trading in GME to liquidation only, and the news that it had sold out of its customers’ positions without the customers’ permission. These actions are widely perceived as an anti-populist capitulation to Big Finance.
Well, they are in a way–but NOT the way that is being widely portrayed. What is going on is an illustration of the old adage that clearing and settlement in securities markets (like the derivatives markets) is like the plumbing–you take it for granted until the toilet backs up.
You can piece together that Robinhood was dealing with a plumbing problem from a couple of stories. Most notably, it drew down on credit lines and tapped some of its big executing firms (e.g., Citadel) for cash. Why would it need cash? Because it needs to post margin to the Depositary Trust Clearing Corporation (DTCC) on its open positions. Other firms are in similar situations, and directly or indirectly GME positions give rise to margin obligations to the DTCC.
The rise in price alone increased margin requirements because given volatility, the higher the price of a stock, the larger the dollar amount of potential loss (e.g., the VaR) that can occur prior to settlement. This alone jacks up margins. Moreover, the increase in GME volatility, and various adders to margin requirements–most notably for gap risk and portfolio concentration–ramp up margins even more. So the action in GME has led to a big increase in margin requirements, and a commensurate need for cash. Robinhood, as the primary venue for GME buyers, had/has a particularly severe position concentration/gap problem. Hence Robinhood’s scramble for liquidity.
Given these circumstances, liquidity was obviously a constraint for Robinhood. Given this constraint, it could not handle additional positions, especially in GME or other names that create particularly acute margin/liquidity demands. It was already hitting a hard constraint. The only practical way that Robinhood (and perhaps other retail brokers, like TDAmeritrade) could respond in the short run was trading for liquidation only, i.e., allow customers to sell their existing GME positions, and not add to them.
By the way, trading for liquidation is a tool in the emergency action toolbook that futures exchanges have used from time-to-time to deal with similar situation.
To extend the plumbing analogy, Robinhood couldn’t add any new houses to its development because the sewer system couldn’t handle the load.
I remember some guy saying that clearing turns credit risk into liquidity risk. (Who was that guy? Pretty observant!) For that’s exactly what we are seeing here. In times of market dislocation in particular, clearing, which is intended to mitigate credit risk, creates big increases in demand for liquidity. Those increases can cause numerous knock on effects, including dislocations in markets totally unrelated to the original source of the dislocation, and financial distress at intermediaries. We are seeing both today.
It is particularly rich to see the outrage at Robinhood and other intermediaries expressed today by those who were ardent advocates of clearing as the key to restoring and preserving financial stability in the aftermath of the Financial Crisis. Er, I hate to say I told you so, but I told you so. It’s baked into the way clearing works, and in particular the way that clearing works in stressed market conditions. It doesn’t eliminate those stresses, but transfers them elsewhere in the financial system. Surprise!
The sick irony is that clearing was advocated as a means to tame big financial institutions, the banks in particular, and reduce the risks that they can impose on the financial system. So yes, in a very real sense in the GME drama we are seeing the system operate to protect Big Finance–but it’s doing so in exactly the way many of those screaming loudest today demanded 10 years ago. Exactly.
Another illustration of one of my adages to live by: be very careful what you ask for.
Margins are almost certainly behind Robinhood’s liquidating some customer accounts. If those accounts become undermargined, Robinhood (and indeed any broker) has the right to liquidate positions. It’s not even in the fine print. It’s on the website:
If you get a margin call, you need to bring your portfolio value (minus any cryptocurrency positions) back up to your minimum margin maintenance requirement, or you risk Robinhood having to liquidate your position(s) to bring your portfolio value (minus any cryptocurrency positions) back above your margin maintenance requirement.
Another Upside Down World aspect of the outrage we are seeing is the stirring defenses of speculation (some kinds of speculation by some people, anyways) by those in politics and on opinion pages who usually decry speculation as a great evil. Those who once bewailed bubbles now cheer for them. It’s also interesting to see the demonization of short sellers–whom those with average memories will remember were lionized (e.g., “The Big Short”) for blowing the whistle on the housing boom and the bank-created and -marketed derivative products that it spawned.
There are a lot of economic issues to sort through in the midst of the GME frenzy. There will be in the aftermath. Unfortunately, and perhaps not surprisingly given the times, virtually everything in the debate has been framed in political terms. Politics is all about distributive effects–helping my friends and hurting my enemies. It’s hard, but as an economist I try to focus on the efficiency effects first, and lay out the distributive consequences of various actions that improve efficiency.
What are the costs and benefits of short selling? Should the legal and regulatory system take a totally hands off approach even when prices are manifestly distorted? What are the costs and benefits of various responses to such manifest price distortions? What are the potential unintended consequences of various policy responses (clearing being a great example)? These are hard questions to answer, and answering them is even harder in the midst of a white-hot us vs. them political debate. And I can say with metaphysical certainty that 99 percent of the opinions I have seen expressed about these issues in recent days are steeped in ignorance and fueled by emotion.
There are definitely major problems–efficiency problems–with Big Finance and the regulation thereof. Ironically, many of these efficiency problems are the result of previous attempts to “solve” perceived problems. But that does not imply that every action taken to epater les banquiers (or frapper les financiers) will result in efficiency gains, or even benefit those (often with justification) aggrieved at the bankers. I thus fear that the policy response to GameStop will make things worse, not better.
It’s not as if this is new territory. I am reminded of 19th century farmers’ discontent with banks, railroads, and futures trading. There was a lot of merit in some of these criticisms, but all too often the proposed policies were directed at chimerical wrongs, and missed altogether the real problems. The post-1929 Crash/Great Depression regulatory surge was similarly flawed.
And alas, I think that we are doomed to repeat this learning the wrong lessons in the aftermath of GameStop and the attendant plumbing problems. Virtually everything I see in the public debate today reinforces that conviction.
It’s political since the conflict over GME is a part of a larger class war: see the closing of wallstreetbets accounts by big tech monopolies. This coordination between big finance and big tech is not an accident.
We no longer have an efficiency problem since there are two broad classes at war: insiders and outsiders. All big tech, big finance, big eduction and big government work to dispossess and destroy the political power of the middle class.
Re: liquidation of accounts: Robinhood closed out unmargined positions, too.
Comment by Krzys — January 29, 2021 @ 4:13 pm
Whaddya expect in Creepy Joe Biden’s America?
(Dear Prof, is there any way in which this comment of mine can be automated, at least until Dear Old Joe falls off his perch?)
Comment by dearieme — January 29, 2021 @ 5:55 pm
This is a great post. I think Single Stock Futures could have been an escape valve for this situation. I am not as familiar with long stocks or long options and margin. Never traded that stuff on margin. I was always under the impression that you had to post 50% margin in stocks/options but having no experience I am not educated enough to have a thought on it-which is why I appreciate this post more. I am familiar with long futures and margin. Even if you are long futures and the market is rising and you have equity in the trade, you have to post more margin. For sure, you have an unlimited risk being naked short, or short premium in the options market.
Comment by Jeffrey Carter — January 29, 2021 @ 6:36 pm
This makes complete sense in the futures world, but how does this apply to RH when almost none of their customers are buying on margin? Shouldn’t they have had all the collateral (or at least most) from their customers already? I assume I am missing something here.
Comment by Matt — January 29, 2021 @ 6:36 pm
Hi professor, this is a terrific primer to the issues at hand. It makes it crystal clear how this is a financial chain reaction first and foremost, and not some politically partisan act by Robinhood.
I happen to know almost all the facts you laid out – I am a former plumber – and for that I appreciate it even more! You see, I have, talking to skilled tradesmen from other construction branches over the last 48h, that the plumbing knowledge which I take for granted was barely familiar to these other tradesmen. So your article is a perfect gift of knowledge. I can stop talking like a missionary forcing conversions and just forward links to your article.
Thank you and keep up the insightful work!
Comment by Ioana — January 29, 2021 @ 6:43 pm
I wonder if anyone here can comment on K. Denninger’s take, on how we could’ve seen short positions in excess of the # of available shares:
> … I can buy a $20 PUT on some stock. This gives me the right to PUT that stock on the other person for $20/share up until expiration. IF the price is under $20 I of course have every reason to do that — I can buy the shares for $10 and make you pay me $20! Who doesn’t like that deal?
Likewise, the *market maker* never wants that directional bet either, since on the short side of an options trade you’re obligated to perform, if demanded by the long side.
Nobody would stay in business being a market maker, if this sort of thing could happen to them, so as soon as they take the opposing side, they execute a balancing trade on the other side. In short if you’re a market maker you always want to be neutral on every security you make a market in; you make a (very) small profit on each transaction, but you never, ever want to be exposed directionally, because the amount you get paid is tiny compared to the risk, and one mistake will bankrupt you.
Therefore if you’re a market maker, you can short without locating first, for this explicit reason. This doesn’t lead to a problem generally, because nobody in their right mind as a market maker wants a directional exposure, ever. As a result the failure to locate is transient, and does not accumulate; you will lay that risk off and remove the imbalance if you have to, since you can construct synthetic positions that perform financially the same as real ones.
So how do you get 130% of the available shares short? It would seem impossible and is, unless someone *cheats*.
There are some players in the market who have “market maker” status, but *also trade their own* books, or have cross-interests with those who do. Allegedly there are “Chinese walls” between those pieces (or interconnected entities.). Quite obviously that is a load of crap, because otherwise what you’ve seen would be impossible, but it clearly not only has happened before, but is still happening to this day.
These entities are how you wind up with short sales, where the *locate and borrow* hasn’t happened first, and the position remains open across time. This is supposed to be *illegal*, but other than a few hand-slaps in the futures markets for physical commodities, I’m not aware of any criminal prosecution for doing it.
And let’s be clear here: This practice is counterfeiting…. <
From https://market-ticker.org/akcs-www?post=241454 .
Comment by aNanyMouse — January 29, 2021 @ 8:50 pm
That’s it. I completely blanked on the margin effect of T+3 settlement. I am officially senile.
Posted ton the wrong article, sorry
Comment by sotosy1 — January 30, 2021 @ 5:09 pm
The analogy of a toilet backing up is particularly apt for what we’re seeing.
There’s good liquidity and bad liquidity, and the institutional side of things is getting a pipeline of the yucky stuff. And they can’t turn the flow off at the faucet! If they can’t swing things their way soon they’re going to have to mop it all up with pallet-loads of currency (fortunately those can be produced on demand, for the ‘right’ kind of people).
The plumbing aspect of the mess is interesting. Like the rest of our 21st-century society, the infrastructure is built for efficiency, so that when a deluge comes it is at risk of not be sufficiently robust to handle the flood.
It’s cold comfort to know that the administrators can’t claim they weren’t warned. Maybe you’ll have to work on what these days they call your ‘influencing skills’, Prof 😉
Comment by Ex-Global Super-Regulator on Lunch Break — January 30, 2021 @ 5:41 pm
Wait until that mephitic Waters holds hearings. More rank toilet overflow.
Comment by Richard Whitney — January 30, 2021 @ 7:46 pm
Thanks for the insightful post, professor. What’s your take on what’s causing all the bubbles in the financial markets (Tesla, Bitcoin, now WSB). Is it only me or do these bubbles seem to persist longer than ever?
Comment by aaa — January 30, 2021 @ 10:01 pm
and lol @ “minus any cryptocurrency positions”
RobinHood is perfectly happy to let its customers trade cryptos but is unwilling to accept them as collateral.
Comment by aaa — January 30, 2021 @ 10:01 pm
Can anyone make sense, of how more shares could get shorted, than the original firms have issued?
Here’s Karl Denninger’s take:
> … the *market maker* never wants that directional bet either, since on the short side of an options trade you’re obligated to perform, if demanded by the long side.
Nobody would stay in business being a market maker, if this sort of thing could happen to them, so as soon as they take the opposing side, they execute a balancing trade on the other side. In short if you’re a market maker, you always want to be neutral on every security you make a market in; you make a (very) small profit on each transaction, but you never, ever want to be exposed directionally, because the amount you get paid is tiny compared to the risk, and one mistake will bankrupt you.
Therefore if you’re a market maker, you can short without locating first, for this explicit reason. This doesn’t lead to a problem generally, because nobody in their right mind as a market maker wants a directional exposure, ever. As a result the failure to locate is transient, and does not accumulate; you will lay that risk off, and remove the imbalance if you have to, since you can construct synthetic positions that perform financially the same as real ones.
So how do you get 130% of the available shares short? It would seem impossible and is, unless someone *cheats*.
There are some players in the market who have “market maker” status, but *also trade their own* books, or have cross-interests with those who do. Allegedly there are “Chinese walls” between those pieces (or interconnected entities.). Quite obviously that is a load of crap, because otherwise what you’ve seen would be impossible, but it clearly not only has happened before, but is still happening to this day.
These entities are how you wind up with short sales, where the *locate and borrow* hasn’t happened first, and the position remains open across time. This is supposed to be *illegal*, but other than a few hand-slaps in the futures markets for physical commodities, I’m not aware of any criminal prosecution for doing it.
And let’s be clear here: This practice is counterfeiting…. <
From https://market-ticker.org/akcs-www?post=241454 .
Comment by aNanyMouse — January 30, 2021 @ 10:25 pm
Dark Pools owned by the biggest names on Wall Street – such as Goldman Sachs’ Sigma X2, JPMorgan Chase’s JPM-X, UBS’ UBSA, Morgan Stanley’s MSPL, and Credit Suisse’s Crossfinder — have been making tens of thousands of trades in the shares of GameStop on an ongoing weekly basis. FINRA, Wall Street’s highly compromised self-regulator, reports the Dark Pool data on a stale basis, two to three weeks after the trading has occurred. It is then lumped together for the whole week, rendering it useless in terms of monitoring price manipulation. The chart above is taken from the latest available information from FINRA. (See our previous reporting on Dark Pools in Related Articles below.)
It’s a fair guess that you haven’t heard a peep about Dark Pools on the evening news. The fact that you haven’t is a perfect commentary on why mainstream media is failing the American people when it comes to exposing Wall Street’s serial looting of the little guy.
But when a bunch of quixotic posters on a Reddit message board can be parlayed into the exciting narrative of a Robinhood band taking on the evil hedge funds, it goes viral on the evening news – sucking in hundreds of thousands more unsophisticated retail investors.
(From SlopeofHope.com comments)
Comment by Jeffrey Carter — January 31, 2021 @ 6:05 pm
BTW, check out Bitnomial.com, will be the first futures exchange to settle in physical crypto
Comment by Jeffrey Carter — January 31, 2021 @ 6:06 pm
I’m an alien, a bit like 50% of the US population at present. I’m used to trading an account in which I must have the funds to buy an equity position otherwise no trade. It officially takes 3 days for settlement here, giving the stockbrokers time to transact and remit. I have no knowledge of RobinHood. It does not sound like a traditional stockbroker, i.e. no funds, no buy. So what instruments are they trading, is it CDF’s with their intrinsic margin requirement or what?
I see RobinHood claims to be a zero commission broker. How then do they make money? Is it like FX where the broker sets the bid/ask and creams off a slice? I’ve said for years “when you get something for nothing then there has to be a sociopath involved somewhere and you will end up getting nothing for something.” Behind ever great fortune lies a great crime, the trick is to find it. Seems some organisations are making it very visible.
Comment by Alessandro — January 31, 2021 @ 7:03 pm
@Jeffrey Carter, the term “physical crypto” is a rather jarring oxymoron. Maybe a phrase like settling “on-chain”, “to a non-custodial wallet”, or (to really catch a cypherpunk vibe) “via a trustless protocol” is more consistent with crypto parlance.
@Aleessandro, RobinHood, like most no-fee brokers, makes it money the way most “free” internet services do: by selling data on their customer…er…um…users.
Comment by M. Rad. — February 1, 2021 @ 1:39 pm