A week later Robinhood Markets tried to clear the air by explaining why it hit the controversial limits of hot stock trading, and Wall Street’s risks remain confused: how was the company so unprepared for a clear increase in collateral calls?
For the financial industry, forecasting collateral claims from hubs such as the Depository Trust & Clearing Corp., brokerage fee 101. Major firms assign teams to study the DTCC’s method, estimate its requests and make sure there is enough cash available . Everyone certainly grumbles, but they also know what happens when businesses fail: they skarrel for a lifebuoy or turn off. Robinhood has raised billions of supporters to keep it going.
“They obviously fell very, very short,” said David Weisberger, a market structure consultant who built trading systems at Salomon Brothers and Morgan Stanley. He said he was surprised by Robinhood, given what he calls the ‘known’ requirements of cleaning houses. “It was a franchise-threatening event.”
Silicon Valley launch has caused users to temporarily halt certain purchases at the height of January’s mania GameStop Corp. and other “meme stocks” that shot up too high. By the end of this week, while millions of customers were downloading the app to trade the fallen darlings and new ones, risk managers were still caught up on how Robinhood got into trouble.
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For a comment reached, a company spokesman referred to a Thursday blog post by Robinhood Securities president and chief operating officer Jim Swartwout.
“We grew fast. And sometimes we encountered challenges as we met the scale, ”Swartwout wrote, describing how the company’s growth and an increase in trading volume fueled collateral demands. ‘To say the increase in volume that Robinhood experienced last week was extraordinarily high would be a huge understatement. The boom was greater than the norm. ”
CEO Vlad Tenev linked the trade restrictions to an approximately $ 3 billion collateral call that arrived early January 28 from a section of the DTCC, which Robinhood said contributed to a 10-fold increase in the weekly requirement of deposits for shares. Although Tenev attributed to the DTCC that he was reasonable and eventually accepted $ 700 million, he sometimes portrayed the formulas as opaque and pointed out that they contained a ‘discretionary’ component.
“We do not have the full details” of how the DTCC came to the initial claim, Tenev told Elon Musk last weekend in an interview broadcast on the social club app Clubhouse. “Of course, it would be ideal if there was a little bit more transparency so we could plan better about it.”
The duplicate of managers in the industry: it’s just math.
‘Shame on them’
In interviews, more than half a dozen senior risk managers – some of Wall Street’s largest businesses – reacted with surprise to allegations that the scale of the DTCC’s claims could not be expected. They spoke on condition that they were not identified, in some cases because they were dealing with Robinhood.
They acknowledged that there were always complaints about the difficulty of finding out what the cleaning houses were looking for, and that things could go wrong. Some executives even recounted the times when, at short notice, they received millions in additional cash. But overall, the group said large, well-run businesses are not surprised by requests that threaten to empty their pockets.
One broker says Robinhood had to make sure he had enough capital or process the volatile stock trade. Charles Schwab Corp. ‘s TD Ameritrade, for example, started a day before Robinhood to limit bets on certain meme shares. The later restrictions of Robinhood were stricter and increased in the following week.
“There are some decades of improbability,” said Weisberger, who now runs cryptocurrency firm CoinRoutes. Self-certification firms like Robinhood need to know what potential claims they may have. “If they studied it and came up with an answer and it was wrong, the people who studied it should be sorry,” he said. “If they have not studied it, you should be ashamed of them too.”
Avoid surprises
The DTCC bases many of its deposit claims on elements including the concentration of a member in volatile shares, the volume of transactions, the imbalance between buying and selling and the financial condition of the business. The more a broker is exposed to volatile stocks, the more security he should place. The less capital a broker has available, the stricter its surcharge can be.
The aim is to protect the broader financial system from default. To make collateral calls predictable, the DTCC says it “provides reporting and other tools to our clearing members to help them meet their margin requirements for a specific portfolio.”
The nightmare that cleaning houses are designed to avoid is that a broker loses so much money before a transaction is completed that the business cannot hold the end of the transaction. Without a clearing house, the failure of one firm can fall through the financial system. To terminate only one transaction means that all subsequent transactions must be undone if the share has already been resold.
The collateral burden of a broker-dealer increases when it lends money to clients, and especially when they invest heavily in, for example, stocks that have recently multiplied in value, as GameStop and others did last month. If prices suddenly collapse – which also happened – it increases the risk that clients will not be able to repay their margin loans, so that the brokers can eat up their losses. Some of the recent decline in equities can be attributed to Robinhood liquidating their positions of clients to prevent the default on loans, according to risk managers on Wall Street.
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“Someone has to pay,” says Eric Budish, a professor of economics at the Booth School of Business at the University of Chicago. If you’re a broker, ‘you have the capital to deal with that existential risk. I was surprised that Robinhood did not have more capital for the scenario. ”
Margin lending was mid-20% of Robinhood’s $ 6.7 billion balance sheet. Robinhood used credit lines and raised about $ 3.4 billion from investors at the end of January.
Robinhood, founded in 2013, hired Wall Streeters to help integrate the startup into the more traditional financial system. The firm has hired former Securities and Exchange Commission member Dan Gallagher, Fidelity Investments’ Norm Ashkenas and Kelly Zigaitis, Wells Fargo & Co., in senior legal and compliance roles.
Robinhood’s prescription
This week Robinhood presented his own prescription to avoid future problems: the US stock market must abandon its two-day settlement system and move to a real-time process.
Moving the US stock market to immediate settlement is a big undertaking that will take years of work. Two components of trading are likely to need to be digitized: the securities and the cash to pay for them. It is not difficult to digitally represent a security such as a stock or bond, and a small-scale effort by Paxos Trust Co. to use blockchain to complete real-time stock trading in 2019 received a green light from the SEC.
The digitization of U.S. dollars to pay for shares is years off if that ever happens. Another hurdle is that all the banks, brokers, hedge funds and trading companies that buy and sell stocks need to update their systems to make the change. The transition would undoubtedly be expensive.
Australia launched a plan to do so in 2016, when Digital Asset Holdings entered into an agreement with ASX Inc. announced to rebuild the Australian Stock Exchange so that the trading time could be reduced from days to minutes. The project has been repeatedly expanded and is currently two years behind schedule.
Meanwhile, Robinhood is happy to have access to venture capital to get a tough impact, said Joanna Fields, founder of Aplomb Strategies, market structure adviser.
“There are companies with controls, management frameworks and processes, and that do not have the capacity to get that kind of capital input,” she said.
– With help by Jennifer Surane