A week later Robinhood Markets tried to clear the air by explaining why it has exceeded controversial limits on trading hot stocks, but Wall Street’s risk professionals are still perplexed: How was the company so ill-prepared for a marked increase in collateral calls?
For the financial sector, anticipating collateral demands from hubs such as the Depository Trust & Clearing Corp. Brokerage 101. Large companies assign teams to study the methodology of the DTCC, estimate the requests and ensure that sufficient funds are available. Everyone grumbles, of course, but they also know what happens when companies fall short: them to rinse together for a lifeline or closed. Robinhood collected billions from lenders to keep it going.
“They were clearly very short,” said David Weisberger, a market structure consultant who built trading systems at Salomon Brothers and Morgan Stanley. He said he was puzzling about Robinhood, given what he called clearing house “known” requirements. “This was a franchise-threatening event.”
Silicon Valley start-up left users furious by temporarily restricting certain purchases at the height of January’s mania GameStop Corp. and other “meme” stocks that were in the midst of the skyrocketing rise. By the end of this week, when millions of customers downloaded the app to trade the fallen darlings and new ones, risk managers were still trying to get Robinhood into the predicament.
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A company spokesperson was reached for comment, referring to a Thursday blog post from Robinhood Securities president and chief operating officer Jim Swartwout.
“We have grown quickly. And we have faced challenges from time to time as we scaled up to address this moment, ”wrote Swartwout, describing how the company’s growth and a surge in trading volume fueled demand for collateral. To say that Robinhood’s nightly volume surges were extraordinarily high last week would be a huge understatement. The increase was much higher than the norm. “
Chief Executive Officer Vlad Tenev has linked the trading restrictions to a collateral call of approximately $ 3 billion that came in early January 28 from a section of the DTCC, which Robinhood has said contributed to a tenfold jump in weekly clearinghouse deposit requirements for shares. While Tenev has credited the DTCC as reasonable and eventually accepted $ 700 million, he has at times portrayed the formulas as opaque, noting that they contain a “discretionary” component.
“We don’t have the full details” of how the DTCC met its original demand, Tenev told Elon Musk in an interview aired on the social conversation app Clubhouse last weekend. “It would of course be ideal if there was a little more transparency, so that we could plan around it better.”
The reply from industry executives: It’s really just math.
‘They should be ashamed’
In interviews, more than half a dozen senior risk executives – some of Wall Street’s largest firms – responded in dismay to all the claims that the magnitude of the DTCC’s demands cannot be foreseen. They spoke on the condition that they were not identified, in some cases because they interacted with Robinhood.
They recognized that there are always complaints about the difficulty of determining what clearinghouses are looking for, and that things can go wrong. Some executives even mentioned the times when they had to ask for millions of extra cash in the short term. But overall, the group said that large, well-run companies aren’t surprised by requests that threaten to empty their pockets.
A brokerage officer said Robinhood should have made sure it had enough capital or stopped processing volatile stock trades. The TD Ameritrade of Charles Schwab Corp. For example, the day before Robinhood began to limit bets on certain meme stocks. Robinhood’s later restrictions were tougher and gradually slipped into the week that followed.
“There are improbabilities once every ten years,” said Weisberger, who now runs cryptocurrency firm CoinRoutes. Self-clearing firms like Robinhood need to be aware of the potential demands they may face. “If they studied it and came up with an answer and it was wrong, then be ashamed of the people who studied it,” he said. “If they haven’t studied it, shame on you.”
Avoid surprises
The DTCC bases many of its deposit requirements on elements such as a clearing member’s concentration in volatile stocks, the volume of transactions taking place, imbalances in purchases and sales, and the company’s financial condition. The more a brokerage is exposed to erratic stocks, the more collateral it has to post. The less capital a brokerage has on hand, the heavier the surcharge can be.
Its purpose is to protect the wider financial system from defaults. To make collateral calls predictable, the DTCC says it “provides reporting and other tools to our clearing members to help them anticipate their margin requirements for a particular portfolio.”
The nightmare clearing houses should avoid is that a brokerage loses so much money before a transaction is completed that the business cannot hold up the end of the transaction. Without a clearinghouse, a company’s failure could run through the financial system. If you undo just one trade, all subsequent trades will be canceled if that stock has already been resold.
A broker-dealer’s collateral burden rises when he lends money to clients, and especially when they bet heavily on, say, stocks that have recently multiplied in value, as GameStop and others did last month. If prices suddenly crash – which has also happened – there is a risk that clients will not be able to repay their margin loans, forcing the brokerage to eat up their losses. According to Wall Street risk managers, some of the recent stock declines can be attributed to Robinhood’s liquidation of clients’ positions to avoid loan defaults.
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“Someone has to pay,” said Eric Budish, a professor of economics at the University of Chicago’s Booth School of Business. If you’re a brokerage, “you have capital to deal with that existential risk. I was surprised Robinhood didn’t have more capital for that scenario. “
Marginal loans made up about 20% of Robinhood’s $ 6.7 billion balance sheet by mid-2020. Robinhood took advantage of lines of credit and raised approximately $ 3.4 billion from investors at the end of January.
Founded in 2013, Robinhood hired Wall Streeters to help integrate the startup into the more traditional financial system. The company has appointed Dan Gallagher, a former member of the Securities and Exchange Commission, Norm Ashkenas of Fidelity Investments and Kelly Zigaitis of Wells Fargo & Co. appointed to senior legal and compliance roles.
Robinhood’s recipe
This week, Robinhood offered his own recipe to avoid future problems: the US stock market must abandon its two-day settlement system and switch to a real-time process.
Moving the US stock market into immediate settlement is a huge undertaking that would take years of work. Two components of the trade should probably be digitized: the securities and the money to pay for them. Digitizing a security such as a stock or bond is not difficult and a small-scale attempt by Paxos Trust Co. Using blockchain to settle stock transactions in near real-time was given the green light by the SEC in 2019.
Digitizing US dollars to pay for stocks is years away, if it ever happens. Another hurdle is that all banks, brokers, hedge funds and trading firms that buy and sell stocks will need to update their systems to make the change happen. The transition would no doubt be expensive.
Australia began a plan to do just that in 2016 when Digital Asset Holdings announced a deal with ASX Inc. to rebuild the Australian Stock Exchange so that settlement times could be reduced from days to minutes. The project has been extended several times and is currently two years behind schedule.
Meanwhile, Robinhood is lucky enough to have access to venture capital to get through a rough patch, said Joanna Fields, founder of market structure consultancy Aplomb Strategies.
“There are companies that have controls, governance frameworks, and processes that are unable to get that kind of capital injection,” she said.
– With help from Jennifer Surane