Who Stopped the Buying?
The DD on which east coast elites’ heads should end up on sticks
If you follow the financial markets or are active on the internet, you probably woke up and checked your phone and were immediately confused by the trending column on twitter this Thursday (Jan 28, 2021). Even the most seasoned stock jockeys might not fully know what happened during today’s chaotic market hours, and it’s going to be a while before Michael Lewis writes a book explaining it all, so hopefully this article will provide some desperately needed clarification in the interim.
(The main focus of this piece will be the logistics of the Robinhood-GameStop situation, not the ethics. I think it goes without saying that if (and only if) hedge funds can do this sort of manipulation, Redditors should be able to as well. This article has a great discussion on the broader market implications if you’re interested.)
Part 1: Background Info:
In the past few months, a bunch of rich hedge fund guys on the east coast used stupid amounts of leverage to open a bunch of naked short positions (really hoping Margot Robbie explains this part in the movie) on struggling brick and mortar retailers (GameStop) like the soulless ghouls that they are.
This reckless shorting led to 140% of the outstanding shares being sold short. (If you think that’s stupid, you’re right. It is.) This in turn triggered both a short squeeze and a gamma squeeze when Reddit’s retail investors (plus financial wizard christian bale) started buying in. This made the price go really high in the past few days. To the moon, even.
Then, the hedge funds that were short GameStop (among others) started hemorrhaging money and working people on reddit starting making money. This, of course, is not A.O.K. on Wall Street. Rule number one is that the house always wins, and to this end, the buying of GameStop stock (and a bunch of other stocks where the same thing was happening) was halted on Thursday.
“Wait, don’t you mean trading of gamestonk was halted? No. You heard right. Only buying was halted. In other words, hedge funds were losing money because too many people were buying the stock and pushing the price up, so they resorted to literally making it impossible to buy. One could only sell shares on most brokerage platforms for the majority of the day on Thursday, which cratered prices and gave hedge funds some much needed breathing room.
Part 2: Who is They, Exactly?
This is where things start to get tricky. You see, when you try and buy a share of stock on Robinhood, you’re not actually buying it from the nice folks at Robinhood proper. The arcane process through which you end up with a share of stock after pressing “submit order” involves a whole host of other entities: market makers, HFTs, clearing houses, the Federal Reserve Bank of the United States, OTC markets, dark pools, the DTCC, the NSCC, etc... I’ll explain the gist of it here, but you’re going to want to follow this link if you want a more in-depth guide.
Essentially, Robinhood sells your buy/sell orders to firms like Citadel, Wolverine, etc… (read all about it here), who frontrun and fill them or send them to other market makers who actually fill them. But remember that US equities are nothing new; the NYSE was founded 228 years ago. What this means is that the system used to finalize these contracts between people buying and selling shares of stock is archaic, and despite the fact that information now moves at the speed of light, all equity trades still take 2 days (T+2)to settle.
So how do brokers (firms like citadel, not Robinhood) deal with this settlement period? The answer is: with clearing houses. These firms process trades for brokers and reduce counterparty risk, but require fees and margin (insurance on the aforementioned counterparty risk). As you can see in these videos(pt. 1, pt. 2) and this Bloomberg article, firms like Robinhood and WeBull were forced to stop sending buy orders for $GME, $AMC, $BB, etc, simply because the orders became too expensive for their intermediary brokers to clear. The executing brokers then told the client facing brokers (Robinhood, WeBull, etc…) that they would not accept additional GME buy orders, hence the Thursday buy restrictions.
Part 3: Why did clearing become so expensive?
The answer is that the gamma on the options used by brokers to delta hedge their exposure to the “meme stocks” was at an all time high because of the incredible surge in volatility on those few stocks, which makes clearing theoretically more expensive due to the associated rise in risk premium. This situation was made worse by the massive amount of $GME float being shorted by hedge funds in the months leading up to Thursday.
In English, clearing trades got risky, and liquidity got thin, so clearing houses started charging much higher premiums and hiking margin requirements to protect themselves, and most brokerages couldn’t afford it.
So all of these firms are at fault? Not quite… All of these firms go through the DTCC, which maintains a ledger of all the custodial owners for each share of stock listed on the exchanges, and the NSCC, a wholly-owned subsidiary of the DTCC which manages the continuous net settlement process used to match up the balances of all parties involved.
The DTCC margin requirements seem to be the ones that were altered which resulted in the trade clearing becoming prohibitively expensive. This is because DTCC margin requirements essentially act as insurance on trades being cleared, and the insurance got too expensive.
Part 4: Ok, so who goes to jail now?
Well, that depends on a few things. If the DTCC raised it’s insurance prices in a consistent manner, then probably no one’s going to jail. However, it’s not totally out of the question that there was some hedge fund-DTCC collusion here (the DTCC sets it’s own insurance prices, so massive changes to the price should be somewhat suspect). The DTCC is a private entity regulated by the SEC and the Federal Reserve Bank of New York, ran by Michael Bodson, an ex-wall-street-banker. The DTCC could have at say, Steven Cohen’s request, drastically and arbitrarily hiked margin rates to cause a breakdown in the clearing process for a select few stocks that were becoming problematic for hedge fund executives.
While I think this is highly unlikely, and am NOT promoting any conspiracy theories, the fact that these answers are not immediately clear and google-able is itself deeply problematic. There should absolutely be more transparency and regulation here, and the fact that there is not is a fault of the SEC.
Part 5: Conclusions.
This whole situation could’ve been avoided if hedge funds weren’t allowed to recklessly open naked shorts. Shorting is stupid financial magic. This is the practice that reddit exploited. No sketchy shorting, no sketchy squeezing. Simple as that. This is a textbook financial-history-repeats-itself situation à la Long Term Capital Management’s implosion in 1998. Read more about it here.
Additionally, his situation could be made more easily navigable by all investors if there was more transparency in the order routing process. This whole thing is currently a total mess and expecting all retail investors to understand these complex, potentially liquidity-erasing risks is not realistic.
TLDR:
Robinhood relies heavily on other clearing firms to place trades. These firms told Robinhood they couldn’t take any more GameStop buy orders because the cost of clearing with the DTCC was too high, and Robinhood had no recourse. The situation could’ve been easily avoided if hedge funds couldn’t do stuff like shorting 140% of a stock’s float.
