BY GUY CARSON
The financial world has been gripped with the GameStop drama over the last few weeks. For those who haven’t heard, a group on the social media app “Reddit” called “wallstreetbets” orchestrated one of the most dramatic short squeezes ever seen. For a quick lesson a short is generally selling a stock that you don’t own. A short squeeze is when the price of a share rises dramatically and forces those shorting the shares to buy back the stock which in turn leads to further buying and further share price appreciation.
The stock in question here was GameStop, the world’s largest video game retailer with over 5,000 stores globally. Short interest in the company had risen to 114% in mid-January as hedge funds bet migration to downloading games online would continue to hurt their business. The short interest being this high indicated that this was clearly a crowded trade. The “wallstreetbets” group spotted this and started buying aggressively. This was remarkable as it is really the first co-ordinated attack on short sellers we have seen by retail investors. To top it all off, it was remarkably successful. Shares in GameStop surged from $18.84 at the beginning of the year to over $300. Since then, it has retraced to $90.
One side effect of this price action, that not many people saw coming, was the actions of Robinhood.
Robinhood is a commission-free stock trading platform designed to give retail investors free and quick access to financial markets. When the price of GameStop started to soar, Robinhood started to limit trading in the stock. The conspiracy theorists came out in force claiming that Robinhood was preventing the trading as a measure to protect the hedge funds. However, the real reason was that Robinhood’s solvency was at risk.
To understand why, it’s important to understand how Robinhood makes money. Traditionally, brokers would take commission but Robinhood doesn’t. They make money in two ways: through selling the order flow of their clients to large trading institutions who make money off trading it and via lending your stock out. Via the large institutions making money and essentially front running your orders, you end up paying a commission of sorts anyway. The second point is important because the default option when you set up a Robinhood account is that it will be a “margin” account as opposed to a “cash account”.
In a margin account, the client doesn’t actually own any securities, they own a promise from the broker. When you place an order to buy a stock through Robinhood, a lot of things happen behind the scenes. Despite everything in the world being instantaneous these days, stocks still settle on a “T+2” basis (i.e. two days after the trade). The transaction and the title for the stock goes through a company called DTCC (Depositing Trust and Clearing Corporation). Your money is sent through at the end of the day (netted off with all other clients at Robinhood) and sent through to the other party in a few days’ time. There is credit and counterparty risk involved and so DTCC requires a large balance sheet to facilitate the transactions. The title for the stock itself stays and DTCC maintains the registry.
Meanwhile, as you don’t own the shares, Robinhood is free to lend them out to short sellers. When a hedge fund goes to short sell a stock they go to their Prime Broker. If the Prime Broker doesn’t have those shares on hand, they come to a third party such as Robinhood. The shares which the client believes they own are then lent out and bought by someone else. This creates a security loan from Robinhood to the Prime Broker.
DTCC is recording the ownership chain and ensuring the cash flows through to the relevant parties. If one of those parties falls over, DTCC loses. To hedge against this risk, DTCC requires brokers to keep collateral on deposit with them in the form of cash and treasuries. The riskier the counterparty, the greater the deposit required.
When volatility in markets increases, the risk goes up. When a broker such as Robinhood sees a surge in GameStop activity and GameStop suddenly becomes the most volatile asset in the world, risk is clearly going up. Risk went up to the point where a $12.5bn hedge fund (Melvin Capital) had to be bailed out after falling 53% in January. Due to this risk increase, DTCC then had to go back to Robinhood and demand more collateral. Robinhood in turn had to go back to its investors and raise $3.4bn to meet these requirements and stay solvent.
The above explanation simplifies the process considerably. Adding extra complexity is the options market which provides significant leverage and is a key factor in why volatility increases risk.
Whilst Robinhood investors appear safe for now, this event highlights the importance of a strong custodian. In addition, investors need to know who owns their assets. In a margin account, they don’t own anything but a promise. When brokerage firms / custodians go into liquidation, the time to get assets out can be substantial and clients are the ones who bare the costs. A majority of the banks and custodians we work with are non-lending Private Banks with well capitalised balance sheets. We look to mitigate the risk through our due diligence on our partners. Whilst we can’t offer zero brokerage accounts, we can offer security of your assets.
Disclaimer: The above contains the opinion of the author and is for information purposes only. It is not intended to be investment advice. Seek a duly licensed professional for investment advice