After a week Robinhood Markets tried to clear the air by explaining why it exceeded the controversial limits on trading hot shares, Wall Street risk professionals are still puzzled: How was the company so ill-prepared for an obvious increase in collateral calls?
For the financial industry, anticipating collateral requests from hubs such as Depository Trust & Clearing Corp. is Brokerage 101. Major firms assign teams to study the DTCC methodology, to estimate its demands, and to ensure that cash is available. Everyone gropes, for sure, but I also know what happens when companies fail: They brawl for a save or close line. Robinhood has raised billions from funders to continue it.
“Obviously they have fallen very, very short,” said David Weisberger, a market structure consultant who has built trading systems at Salomon Brothers and Morgan Stanley. He said he was puzzled about Robinhood, given what he called the “well-known” requirements of clearing centers. “This was an event that threatened the franchise.”
Silicon Valley startup lets users smoke, temporarily restricting certain purchases to January heights GameStop Corp. and other growing “meme stocks”. By the end of this week, while millions of customers were downloading their app to replace fallen loved ones and new ones, risk managers were still stuck with how Robinhood got into trouble.
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Arriving for comments, a company spokesman referred to a Thursday blog post by Robinhood Securities President and Chief Executive Officer Jim Swartwout.
“It simply came to our notice then. And sometimes we faced challenges as we expanded to reach this moment, “wrote Swartwout, describing how the company’s growth and increased trading volume have fueled warranty claims.” To say that growth “Overnight of the volume experienced by Robinhood last week was extraordinarily large would be a vast understatement. The increase was by magnitudes larger than normal.”
Executive Director Vlad Tenev linked trading restrictions to a $ 3 billion collateral call that came in early January 28 from a side of the DTCC, which Robinhood said contributed to an increase of 10 billion. or weekly stock filing requirements. While Tenev credited the DTCC with being reasonable and eventually accepted $ 700 million, he sometimes presented his formulas as opaque, noting that they included a “discretionary” component.
“We don’t have the full details” of how the DTCC came to the original request, Tenev told Elon Musk last weekend in an interview on the Clubhouse social conversation app. “It would obviously be ideal if there was a little more transparency, so that we can plan better in this regard.”
Industry executives reply: it’s basically just math.
‘Shame on them’
In interviews, more than half a dozen high-risk executives – some from the largest Wall Street firms – reacted with amusement to any claim that the scale of DTCC’s demands cannot be anticipated. They spoke on the condition that they not be identified, in some cases because they interact with Robinhood.
They acknowledged that they always complain about the difficulty of identifying what the clearing houses will look for and that things can go wrong. Some executives even recounted the times when they were pressed for millions of extra money at short notice. In general, the group said that large, well-run companies are not surprised by the demands that threaten to empty their pockets.
A brokerage executive said Robinhood should have made sure it had enough capital or stopped processing volatile stock transactions. Charles Schwab Corp.’s TD Ameritrade, for example, began limiting bets on certain meme stocks the day before Robinhood did. Subsequent Robinhood restrictions were more severe, slowing down the following week.
“Once every decade or so, there are unlikely things to happen,” said Weisberger, who now runs the cryptocurrency company CoinRoutes. Self-compensation companies such as Robinhood need to know what potential requirements they may face. “If they studied it and came up with an answer and it was wrong, shame on those who studied it,” he said. “If they haven’t studied it, then it’s a shame for them.”
Avoiding surprises
The DTCC bases a large part of its deposit requirements on items, including the concentration of a clearing member in volatile shares, the volume of transactions taking place, imbalances in buying and selling and the company’s financial condition. The more exposed a brokerage is to irregular actions, the more guarantees must be registered. The less capital an intermediary has, the more severe his surcharge may be.
The aim is to protect the wider financial system from implicit transactions. To make collateral calls predictable, The DTCC says it provides “reports and other tools to our clearing members to help them anticipate margin requirements for a particular portfolio.”
The nightmare that clearing houses are designed to avoid is that a brokerage loses so much money before completing a transaction that the company cannot maintain the end of its transaction. Without a clearinghouse, a company’s failure could fall through the financial system. Carrying out a single transaction means canceling all subsequent transactions if the share has already been resold.
The collateral burden of a broker-dealer increases if he lends money to clients and, especially, if he bets a lot on, say, shares that have recently multiplied in value, as GameStop and others did last month. If prices fall sharply – which has also happened – there is an increased risk that customers will not be able to repay the loans on the margin, leaving the brokerage to eat their losses. Some of the recent declines in equities can be attributed to the liquidation of Robinhood’s customer positions to eliminate loan defaults, according to Wall Street risk managers.
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“Someone has to pay,” said Eric Budish, a professor of economics at the Booth School of Business at the University of Chicago. If you are an intermediary, “you have the capital to deal with this existential risk. I was surprised that Robinhood didn’t have more capital for this scenario. ”
The margin loan accounted for about 20% of Robinhood’s $ 6.7 billion balance sheet in mid-2020. Robinhood operated 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 firm has named former member of the Securities and Exchange Commission Dan Gallagher, Norm Ashkenas of Fidelity Investments and Kelly Zigaitis of Wells Fargo & Co. in legal and compliance functions.
Robinhood’s prescription
This week, Robinhood offered it own prescription to avoid future problems: the US stock market should give up the two-day settlement system and move to a real-time process.
Moving the US capital market to instant settlement is a huge undertaking that would require years of work. Two components of trading should probably be digitized: securities and cash to pay them. The digital representation of a guarantee as a share or an obligation is not difficult and a small-scale effort made by Paxos Trust Co. to use blockchain to settle stock transactions almost in real time received a green light from the SEC in 2019.
The digitization of the US dollar to pay for the shares is free years, if it ever happens. Another hurdle is that all banks, brokerages, hedge funds and trading companies that buy and sell shares should upgrade their systems to make the change. The transition would undoubtedly be costly.
Australia committed to doing just that in 2016, when Digital Asset Holdings announced an agreement with ASX Inc. for the recovery of the Australian Stock Exchange, so that settlement terms can be reduced from days to minutes. The project has been extended repeatedly and is now two years old.
Robinhood, meanwhile, is fortunate to have access to venture capital to withstand a difficult challenge, said Joanna Fields, lead founder of Aplomb Strategies Market Structure Consulting.
“There are companies that have controls, governance frameworks and processes and do not have the capacity to obtain this type of capital infusion,” she said.
– With the assistance of Jennifer Surane