Why did Robinhood stop them?
You don't think about it much, but every stock trade involves an extension of credit. You see a price on the stock exchange and push a button and instantaneously get back a confirmation that you bought some shares of stock, but you actually get the shares, and pay the money for them, two business days later. This is called "
T+2 settlement," and it might seem a little silly in an age when a "share of stock" is an entry in an electronic database and "money" is also an entry in an electronic database. Why not just update the databases when you push the button? T+2 settlement feels like a vestige of the olden days, when traders agreed to trades on the stock exchange but then had to go back to their vaults to dig up stock certificates to hand over in exchange for sacks of cash. Back when I worked on Wall Street it was T+3. These days it is not hard to find people who want to talk to you about moving to instantaneous settlement on the blockchain. Bitcoin trades settle immediately. But U.S. stocks, for now, settle T+2.
This means that the seller takes two days of credit risk to the buyer.[4] I see a stock trading at $400 on Monday, I push the button to buy it, I buy it from you at $400. On Tuesday the stock drops to $20. On Wednesday you show up with the stock that I bought on Monday, and you ask me for my $400. I am no longer super jazzed to give it to you. I might find a reason not to pay you. The reason might be that I'm bankrupt, from buying all that stock for $400 on Monday.
The way that stock markets mostly deal with this risk is
a system of clearinghouses. The stock trades are processed through a clearinghouse. The members of the clearinghouse are big brokerage firms—"clearing brokers"—who send trades to the clearinghouses and guarantee them. The clearing brokers post collateral with the clearinghouses: They put up some money to guarantee that they'll show up to pay off all their settlement obligations. The clearing brokers have customers—institutional investors, smaller brokers—who post collateral with the clearing brokers to guarantee
their obligations. The smaller brokers, in turn, have customers of their own—retail traders, etc.—and also have to make sure that, if a customer buys stock on a Monday, she'll have the cash to pay for it on Wednesday.[5]
This is not stuff most people worry about most of the time. Generally if you buy a stock on Monday you still want it on Wednesday; even if you don't, we live in a society, and you'll probably cough up the money anyway because that's what you're supposed to do. But at some level of volatility things break down. If a stock is really worth $400 on Monday and $20 on Wednesday, there is a risk that a lot of the people who bought it on Monday won't show up with cash on Wednesday. Something very bad happened to them between Monday and Wednesday; some of them might not have made it. You need to make sure the collateral is sufficient to cover that risk. The more likely it is that a stock will go from $400 to $20, or $20 to $400 for that matter,[6] the more collateral you need.
Anyway why did Robinhood (and other retail brokers) shut down purchases of GameStop (and other meme stocks)? Here is a good explanation
from Bloomberg News:
One key consideration for brokers, particularly around high-flying and volatile stocks like GameStop, is in the money they must put up with the DTCC while waiting a few days for stock transactions to settle. Those outlays, which behave like margin in a brokerage account, can create a cash crunch on volatile days, say when GameStop falls from $483 to $112 like it did at one point during Thursday's session.
"It's not really Robinhood doing nefarious stuff," said Bloomberg Intelligence analyst Larry Tabb. "It's the DTCC saying 'This stuff is just too risky. We don't trust that these guys have the cash to be able to withstand settling these things two days from now, because in two days, who knows what the price could be, it could be zero.'"
The trouble on Thursday began around 10 a.m., when after days of turbulence, the DTCC demanded significantly more collateral from member brokers, according to two people familiar with the matter.
A spokesman for the DTCC wouldn't specify how much it required from specific firms but said that by the end of the day industrywide collateral requirements jumped to $33.5 billion, up from $26 billion.
Brokerage executives rushed to figure out how to come up with the funds. Robinhood's reaction drew the most public attention, but the firm wasn't alone in limiting trading of stocks such as GameStop and AMC Entertainment Holdings Inc.
In fact, Charles Schwab Corp.'s TD Ameritrade curbed transactions in both of those companies on Wednesday. Interactive Brokers Group Inc. and Morgan Stanley's E*Trade took similar action Thursday.
And here is
the Wall Street Journal:
At least three brokerages said the trading restrictions stemmed from mandates from their clearing firm, which process the securities on the back end after a user executes a trade with their brokerage. Webull Chief Executive Anthony Denier said his platform's clearing firm, Apex Clearing Corp., notified him Thursday morning that Webull needed to shut off the ability to open new positions in certain stocks. Otherwise, Apex wouldn't be able to settle the trades, he said. ...
Mr. Denier at Webull said the restrictions originated Thursday morning when the Depository Trust & Clearing Corp. instructed his clearing firm, Apex, that it was increasing the collateral it needed to put up to help settle the trades for stocks like GameStop. In turn, Apex told Webull to restrict the ability to open new positions in order to prevent trades from failing, Mr. Denier said.
DTCC, which operates the clearinghouses for U.S. stock and bond trades, is a key part of the plumbing of financial markets. Usually drawing little notice, it facilitates the movement of stocks and bonds among buyers and sellers and provides data and analytics services.
In a statement, DTCC said the volatility in stocks like GameStop and AMC has "generated substantial risk exposures at firms that clear these trades" at its clearinghouse for stock trades. Those risks were especially pronounced for firms whose clients were "predominantly on one side of the market," a reference to brokers whose customers were heavily betting for stocks to rise or fall, rather than having a mix of positions.
Robinhood
drew down "at least several hundred million dollars" from its bank credit lines
and "said on Thursday that it was raising an infusion of more than $1 billion from its existing investors." The volatility of those stocks is approaching infinity as their trading volume increases, so the traditionally mild and technical credit risk around settling trades has become real and scary. Brokerages have to put up more money to guarantee against that risk, and also think about ways to prevent the risk from coming true. "Stop buying super volatile stocks" is one obvious way. It has become expensive and risky to be a broker for the meme stocks, so some of them tried to stop.[7]
There are conspiracy theories floating around, because this
feels weird, but it is actually pretty normal?
Byrne Hobart writes:
In a way, WallStreetBets' GameStop experience is the culmination of efforts to give retail investors an institution-quality experience. As Josh Brown points out,
WallStreetBets is a scaled-up version of an idea dinner. It might seem more raucous than how financial professionals behave, but
competitive hyper-bullishness and hyper-boorishness are not restricted to reddit and Discord. Most individual investors don't lever up enough, or get into crowded enough trades, that their broker raises collateral requirements at the most inconvenient possible moment, but this does happen to institutions. And professional investors often develop somewhat conspiratorial instincts—the more research you've done before a trade, the more losing money on it feels like the result of sinister forces trying to thwart you. After many layers of indirection, WallStreetBets and Robinhood have given retail investors a version of the professional experience.