Streetwise Professor

Shuttling between FUBARs, it’s back to GameStop!

Last week there were House hearings regarding the GameStock saga. As is usual with these things, they were more a melange of rampant narcissism and political posing and outright stupidity than a source of information. Everyone had an opportunity to identify and then flog their favorite villains and push their favorite “solutions.” All in all, very few constructive observations or remedies came out of the exercise. I’m sure you’re shocked.

Here are a few of the main issues that came up.

Shortening the securities settlement cycle. The proximate cause of Robinhood’s distress was a huge margin call. Market participants post margins to mitigate the credit risk inherent in a two day settlement cycle. Therefore, to reduce margins and big margin calls, let’s reduce the settlement cycle! Problem solved!

No, problem moved. Going to T+0 settlement would require buyers to stump up the cash and sellers to secure the stock on the same day of the transaction. Almost certainly, this wouldn’t result in a reduction of credit in the system, but just cause buyers to borrow money to meet their payment obligations. Presumably the lenders would not extend credit on an unsecured basis, but would require collateral with haircuts, where the haircuts will vary with risk: bigger haircuts would require the buyers to put up more of their own cash.

I would predict that to a first approximation the amount of credit risk and the amount of cash buyers would have to stump up would be pretty much the same as in the current system. That is, market participants would try to replicate the economic substance of the way the market works now, but use different contracting arrangements to obtain this result.

I note that when the payments system went to real time gross settlement to reduce the credit risk participants faced through the netting mechanism with daily settlement, central banks stepped in to offer credit to keep the system working.

It’s also interesting to note that what DTCC did with GameStop is essentially move to T+0 settlement by requiring buyers to post margin equal to the purchase price:

Robinhood made “optimistic assumptions,” Admati said, and on Jan. 28, Tenev woke up at 3:30 a.m. and faced a public crisis. With a demand from a clearinghouse to deposit money as a safety measure hedging against risky trades, he had to get $1 billion from investors. Normally, Robinhood only has to put up $2 for every $100 to vouch for their clients, but now, the whole $100 was required. Thus, trading had to be slowed down until the money could be collected.

That is, T+0 settlement is more liquidity/cash intensive. As a result, a movement to such a system would lead to different credit arrangements to provide the liquidity.

As always, you have to look at how market participants will respond to proposed changes. If you require them to pay cash sooner by changing the settlement cycle, you have to ask: where is the cash going to come from? The likely answer: the credit extended through the clearing system will be replaced with some other form of credit. And this form is not necessarily preferable to the current form.

Payment for order flow (“PFOF”). There is widespread suspicion of payment for order flow. Since Robinhood is a major seller of order flow, and since Citadel is a major buyer, there have been allegations that this practice is implicated in the fiasco:

Reddit users questioned whether Citadel used its power as the largest market maker in the U.S. equities market to pressure Robinhood to limit trading for the benefit of other hedge funds. The theory, which both Robinhood and Citadel criticized as a conspiracy, is that Citadel Securities gave deference to short sellers over retail investors to help short sellers stop the bleeding. The market maker also drew scrutiny because Citadel, the hedge fund, together with its partners, invested $2 billion into Melvin Capital Management, which had taken a short position in GameStop.

To summarize the argument, Citadel buys order flow from Robinhood, Citadel wanted to help out its hedge fund bros, something, something, something, so PFOF is to blame. Association masquerading as causation at its worst.

PFOF exists because when some types of customers are cheaper to service than others, competitive forces will lead to the design of contracting and pricing mechanisms under which the low cost customers pay lower prices than the high cost customers.

In stock trading, uninformed traders (and going out on a limb here, but I’m guessing many Robinhood clients are uninformed!) are cheaper to intermediate than better informed traders. Specifically, market makers incur lower adverse selection costs in dealing with the uninformed. PFOF effectively charges lower spreads for executing uninformed orders.

This makes order flow on lit exchange markets more “toxic” (i.e., it has a higher proportion of informed order flow because some of the uninformed flow has been siphoned off), so spreads on those markets go up.

And I think this is what really drives the hostility to PFOF. The smarter order flow that has to trade on lit markets doesn’t like the two tiered pricing structure. They would prefer order flow be forced onto lit markets (by restricting PFOF). This would cause the uninformed order flow to cross subsidize the more informed order flow.

The segmentation of order flow may make prices on lit markets less informative. Although the default response among finance academics is to argue that more informative is better, this is not generally correct. The social benefit of more accurate prices (e.g., does that lead to better investment decisions) have not been quantified. Moreover, informed trading (except perhaps, ironically, for true insider trading) involves the use of real resources (on research, and the like). Much of the profit of informed trading is a transfer from the uninformed, and to the extent it is, it is a form of rent seeking. So the social ills of less informative prices arising from the segmentation of order flow are not clearcut: less investment into information may actually be a social benefit.

There is a question of how much of the benefit of PFOF gets passed on to retail traders, and how much the broker pockets. Given the competitiveness of the brokerage market–especially due to the entry of the likes of Robinhood–it is likely a large portion gets passed on to the ultimate customer.

In sum, don’t pose as a defender of the little guy when attacking PFOF. They are the beneficiaries. Those attacking PFOF are actually doing the bidding of large sophisticated and likely better informed investors.

HFT. This one I really don’t get. There is HFT in the stock market. Something bad happened in the stock market. Therefore, HFT caused the bad thing to happen.

The Underpants Gnomes would be proud. I have not seen a remotely plausible causal chain linking HFT to Robinhood’s travails, or the sequence of events that led up to them.

But politicians gonna politician, so we can’t expect high order logical thinking. The disturbing thing is that the high order illogical thinking might actually result in policy changes.