Short changed

On Thursday morning, at about 10am New York time, the Depository Trust & Clearing Corporation (DTCC), which guarantees American stock trades, told its member brokers to post a great deal more collateral.^{1Fortune (Bloomberg)Robinhood raised $1 billion from investors amid client revolt, collateral demands29 Jan 2021} By the end of the day industry-wide requirements had risen from $26bn to $33.5bn.^{1Fortune (Bloomberg)Robinhood raised $1 billion from investors amid client revolt, collateral demands29 Jan 2021} Later that day the customers of Robinhood, a free-trading app, found that they could no longer buy GameStop shares.^{3RobinhoodKeeping Customers Informed Through Market Volatility28 Jan 2021} That sequence, and not the story that was soon being told about it, is the one worth keeping.

GameStop, a video-game retailer, had become the object of a contest between those betting on its failure and those who had noticed. On Thursday its shares swung from $483 to $112 at one point in the session.^{1Fortune (Bloomberg)Robinhood raised $1 billion from investors amid client revolt, collateral demands29 Jan 2021} Robinhood restricted transactions in certain securities to position closing only and raised margin requirements for some.^{3RobinhoodKeeping Customers Informed Through Market Volatility28 Jan 2021} They included GameStop and AMC Entertainment, a cinema chain.^{1Fortune (Bloomberg)Robinhood raised $1 billion from investors amid client revolt, collateral demands29 Jan 2021} It said after the close that it planned to let “limited buys” resume.^{1Fortune (Bloomberg)Robinhood raised $1 billion from investors amid client revolt, collateral demands29 Jan 2021} TD Ameritrade had curbed both stocks the previous day, and Interactive Brokers and E*Trade followed on Thursday.^{1Fortune (Bloomberg)Robinhood raised $1 billion from investors amid client revolt, collateral demands29 Jan 2021} Robinhood raised more than $1bn from existing investors and drew at least several hundred million dollars from bank credit lines; its lenders, Bloomberg reported, include JPMorgan Chase and Goldman Sachs.^{1Fortune (Bloomberg)Robinhood raised $1 billion from investors amid client revolt, collateral demands29 Jan 2021}

The popular reading is that Wall Street changed the rules to rescue its friends. We think the plumbing is a better suspect. Robinhood’s chief executive, Vlad Tenev, said it was “not negotiable for us to comply with our financial requirements and our clearinghouse deposits”.^{1Fortune (Bloomberg)Robinhood raised $1 billion from investors amid client revolt, collateral demands29 Jan 2021} A broker whose customers have bought volatile shares on credit must post collateral against the risk that those customers cannot pay. The clearing house sets the sum. When the sum soars, a broker with thin capital can either find the money or stop taking on more risk. Robinhood did both.

This explains the episode without excusing it. The collateral is needed because a trade is not finished when the customer clicks. Until it settles, it is an IOU, and the clearing house must be protected against the chance that it is not honoured. The longer that gap, the more collateral the system demands, and the more it demands when prices go wild. An app built for instant gratification sits on top of machinery that is not instant.

There is a fair case for caution against retail investors. Prices that move by several hundred per cent in days can expose people to heavy losses, as the Securities and Exchange Commission (SEC) noted on Friday: “extreme stock price volatility has the potential to expose investors to rapid and severe losses”.^{2US Securities and Exchange CommissionStatement of Acting Chair Lee and Commissioners Peirce, Roisman, and Crenshaw Regarding Recent Market Volatility29 Jan 2021} The commission also said that the core market infrastructure “has proven resilient under the weight of this week’s extraordinary trading volumes”.^{2US Securities and Exchange CommissionStatement of Acting Chair Lee and Commissioners Peirce, Roisman, and Crenshaw Regarding Recent Market Volatility29 Jan 2021} Both statements are true, and they sit uneasily together. The infrastructure survived because brokers were allowed to pull up the drawbridge on their own customers.

That is the difficulty. A market in which buying is restricted does not look neutral to the buyers, whatever the clearing house’s reasons. The SEC has promised to “closely review actions taken by regulated entities that may disadvantage investors”.^{2US Securities and Exchange CommissionStatement of Acting Chair Lee and Commissioners Peirce, Roisman, and Crenshaw Regarding Recent Market Volatility29 Jan 2021} It should, and it should look past the brokers to the rules that leave them so exposed. Faster settlement is the pro-market reform: it shrinks the collateral that needs to be posted, and so the temptation to ration access. Rationing retail trading would be the opposite.

Robinhood promised to democratise finance. It has found that democracy needs a clearing house that settles on time.