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You may have heard the story about the folk-hero Robinhood, who stole from the rich to give to the poor. However, in this true story, Robinhood is an 8 billion dollar online brokerage that has been portrayed over the last few days as Robinhoods evil twin who steals from the poor to give to the rich. But, is this true?
Tl;dr – On January 28th, 2021, Robinhood restricted the purchasing of specific stocks including $AMC, $BB, $BBBY, $EXPR, $GME, $KOSS, $NAKD, and $NOK in an attempt to protect two major Wall Street hedge funds; i.e, Citron Research and Melvin Capital after WSB Reddit investors (Wall Street Bets) launched a chaotic short squeeze attack to increase the price GameStop (GME). Robinhood also locked up investors’ funds in orders that would not go through and cannot be canceled.
THE BIG QUESTION – WERE THEY WRONG?
Robinhood is a private company that does not owe investors market access. If the market environment becomes significantly volatile where it does not make financial sense, they reserve the right to pause the trading of any product. The same is for any brokerage, and what occurred with other brokerages such as WeBull, and TD Ameritrade. They did not do anything wrong or illegal.
When dumb money by the WSB and the retail community started piling into GME (one-way margin trading), Robinhood had to post a significantly larger margin to the clearinghouse using their funds. At a certain point, they had to shut down the trading of the volatile assets due to the margin requirements of the clearinghouse. Investors could have purchased GME at other brokerages that were passing the clearing costs, but retail investors wanted to purchase for FREE (no fees) on Robinhood, WeBull, etc. The result – collateral and margin calls across markets sent overnight funding rates to the moon and required FDIC intervention as hot money and dumb retail risk became a systemic and stability threatening force.
LET’S BREAK IT DOWN
Robinhood does not execute stock orders themselves. Instead, they sign up customers, route their orders to executing brokers, and keep track of who owns what. Robinhood is also its own clearing broker, so they directly settle and custody their clients’ securities.
Citadel, Robinhoods largest customer, pays Robinhood to handle executing some of its order flow (approximately 15%). This is not as nefarious as it sounds – Citadel Equity Securities is paying to execute retail orders.
Robinhood customers buy and sell stocks. Those trades do not settle (closing, the exchange of cash for security) until two days later. But, the Buyer’s and Seller’s brokerage accounts generally reflect the transactions immediately – behind the scenes, there is lending. Therefore, depending on the net of buys and sells, Robinhood is on the hook to pay or receive that net cash. That is “counterparty credit risk.
If you bought GME with your Robinhood margin account this is what happens behind the scenes:
- You buy the GME stock
- At day’s end Robinhood nets all the money it needs to send to DTCC
- If Robinhood is a net sender, they generally borrow that money cheaply via interbank lending, and sends it to DTCC
- DTCC then sends the net proceeds to brokers due to receive
- Formal settlement happens within 2 days
More on the DTCC below.
The National Securities Clearing Corporation (NSCC) is the entity that takes that credit risk and matches the net buyers and sellers, post-trade, and handles the exchange of cash for security. To mitigate the credit risk if one of the clearing brokers fails, they demand the brokers post a clearing deposit with them.
The NSCC is required to do this by SEC rule, tracing to Dodd-Frank. Everyone posts, and if a broker fails, then the NSCC takes any losses out of that broker’s deposit, then some from NSCC, then from everyone else (the other brokers). This is a post-crisis idea encoded in Dodd-Frank, that making everyone post collateral reduces the credit risk and systemic risk.
So how does the NSCC clearing deposit get calculated? Learn more here. They set the framework, but it is spelled out in Dodd-Frank that they have to do so by law. These deposits are held in the Clearing Fund at the NSCC. Financials are here. As of September 30th, 2020, they had 10.5 billion in the Clearing Fund.
This is the regime post-Dodd-Frank. The NSCC updated its rules in 2018 to improve the value at risk (VaR) calculation and to add the Gap Risk Measure.
How did this impact Robinhood?
Well, let’s say Robinhood had 20 billion of client assets starting 2021 and those customers trade 1 billion a day, what is the context for Clearing Deposit?
- Say 2 days it is a little unbalanced and it is 1.2 billion buys and 0.8 billion sells. That is probably around a 12 – 20 million deposit.
- If they take in 600 million of new deposits and say 400 million want to buy GME, plus, of their 20 billion existing, say there is 400 million of GME buys over the past 2 days, then the picture could look like 2 billion buys and 1 billion sells, which might normally be 30 million deposit. But the volatility went up significantly.
- Now 99% 2 day VaR is much higher. It should be 20x higher for their net portfolio, but the formula will smooth it out. Maybe it’s ~4x bigger. So just on VaR, they have to post 120 million now – that they should have.
The Gap Risk Measure is what kills them.
If GME is over 30% of their net unsettled portfolio, then they are required to post 10% of all the GME buys. So if that is 800 million, they have to post another 80 million. And there is no limit to it. As long as their clients are up P&L (profit and loss), the mark-to-market covers it.
But if Robinhood takes in 500 million of new money and 300 million buys GME, then at a minimum they are looking at posting 30+ million from just that exposure at NSCC. They cannot use client money – Robinhood has to use their own resources to post; and if GME stock drops, they have to post the loss pre-settlement.
This would also explain why Robinhood drew its credit lines and said vague things about clearing requirements.
The policy goal here is to avoid the central plumbing entities from taking credit risk. In reality, such regulations raise costs and create barriers to entry. It raises profits for entities like Depository Trust and Clearing Corporation (DTCC) (which owns NSCC and is itself owned by Wall Street)
Robinhood offered to open up stock market investing more broadly, and they succeeded. But the regulations did not change – there are still pro-Wall Street, pro-incumbent rules, and capital requirements. It is one of the most highly regulated industries in the United States.
Congresswoman Alexandria Ocasio-Cortez was right to ask how can it be that Robinhood stopped its clients from buying certain securities. And what she will find is that the reason is that Dodd-Frank requires brokers like Robinhood to post collateral to cover their clients’ trading risk pre-settlement.
And it is not the Fed or SEC who sets the rules. It’s the Wall Street owned central clearing entity itself, DTCC, that makes its own rules. So when the retail masses decided to squeeze the short-sellers, in the middle of crushing them, it was government regulations that tripped them up.
Robinhoods real customer is not you. They are the buyers of order flow; the largest of whom is Citadel. You are the product. Just because you are not their real customer does not mean that they do not care about you. They need you to be happy and active in order to continuously sell you to Citadel. Citadel et al get a sneak peak at Robinhoods order flow (ie, pending trade activity) and use that to “provide you liquidity” (ie, front-run your trade).
So you now own GME stock in your margin account. Actually, no you do not. Robinhood owns the stock and simply passes through many of the rights of ownership to you, crediting them with quasi-ownership.
This is important because if Robinhood failed, you would not “own” your stocks, per se. You would be a creditor with a claim against Robinhood. This is a key risk of margin accounts. Remember Lehman Brothers?
When you signed your customer agreement and terms of service, you gave Robinhood the ability to take the stock you bought and lend it out to others to short. Depending on how “hard to borrow” that stock is, Robinhood gets paid a variable rate for this stock loan. The devil is always in the details.
While many brokers share the proceeds of stock lending with clients, Robinhood does not. Robinhood keeps it all. This is a critical way Robinhood gets paid. This payment can be VERY large on hard to borrow names.
Lending MSFT, which is easy to borrow, pays very little. Lending GME, which is very hard-to-borrow may pay 50-100% (or more) per year. The “borrow rate” is set by the market and is frustratingly opaque. The rate gets reset daily as the difficulty of borrow goes fluctuates.
As a retail investor, the odds are not in your favour if you want to play on Wall Street, and it is critical to understand the difference between gambling and investing, and the associated risks. Diving headfirst into a pump and dump without any financial knowledge is a recipe to get REKT!
All of this strengthens the case for bitcoin and decentralized finance, where everyone can participate. Many unbelievers of bitcoin and decentralized technologies have become believers after the smoke has cleared. Centralized exchanges (CExes) can always block, stop, and seize because of regulatory requirements.
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