The crucial role played by clearing houses in financial markets has been thrust into the spotlight after contentious moves by US brokers such as Robinhood and Charles Schwab to restrict retail investors’ bets on stocks at the heart of the Reddit-fuelled trading boom.
Customers reacted angrily on Thursday as brokers moved to stop them opening new positions in certain red-hot stocks, accusing them of unfair treatment or even a Wall Street establishment plot. But the brokers gave a more mundane explanation: the extra volatility in share prices meant they had to hold more capital at the institutions that clear their trades.
What do clearing houses do?
These unobtrusive venues normally sit in the background of daily market activity but they can become the centre of attention during periods of volatility when they require more cash — or “margin” — from their members to ensure that deals are honoured as customers expect.
An equities trade that has been executed can take up to two days to be legally settled, creating a risk of it failing if either side of the trade defaults. A clearing house stands between the two sides to manage the risk to the market if that happens.
Each day members of the clearing house, which range from small brokers like Robinhood to big Wall Street banks such as JPMorgan and Citigroup, are required to put up margin as insurance for their trades.
The amount is calculated by the clearing house and is based on the amount of trading carried out by each member, as well as the volatility of the individual securities traded. Margin is generally collected at the start of the trading day, although there can be intraday calls in frenzied periods, in an attempt to protect the wider market from sudden trade failures.
The clearing member often has limited time to make up the shortfall and the margin typically has to be an asset that is highly liquid, such as cash, US government bonds or shares. In the middle of the market volatility last March, one US bank was required to find $9.6bn of margin for derivatives trades within an hour.
How do brokers such as Robinhood fit into this?
In common with rivals such as Schwab and ETrade, Robinhood clears its own trades and is a member of the main US equities clearing house, run by DTCC.
While self-clearing saves on the fees that would otherwise go to another clearing broker, it also means Robinhood takes on the risk that an executed trade does not settle, and needs to have more cash on hand to cover shortfalls. It also faces higher costs if the clearing house raises margin requirements in volatile periods to protect against a member default.
“The extreme volatility is a big factor behind this,” said Andy Nybo, managing director at Burton-Taylor International Consulting. “They need to make sure they are able to meet cash requirements, whether it is for clearing or to investors that are owed money due to trading activity.”
As Robinhood said in a blog post on Thursday, the requirements “can be substantial in the current environment.” It declined to comment further.
Between Wednesday and Thursday, the margin call from DTCC across the US equities market rose from $26bn to $33.5bn, the clearing house confirmed.
DTCC said the frenzied trading in shares such as GameStop and AMC Entertainment “generated substantial risk exposures at firms that clear these trades . . . particularly if the clearing member or its clients are predominantly on one side of the market.”
How did brokers respond?
Safety mechanisms built into the market’s infrastructure across Wall Street led to periodic halts in trading activity on Thursday. In order to ensure they had enough money to cover margin and capital requirements, Robinhood and others such as Schwab and TD Ameritrade raised margin for trading on some of the names at the heart of the volatility, which required more cash be set aside after each trade.
This limited its margin needs from escalating further. By allowing users to close positions, it was still permitting trades that would reduce its immediate need for cash.
Robinhood also raised the margin requirements for customers that had not paid for the total value of their trading up front, having cut its margin requirements in December in an attempt to drive more trading activity. That meant some customers suddenly needed to come up with cash to cover trades.
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Behind the scenes, Robinhood moved to raise a fresh $1bn in capital from its existing investors, which it announced ahead of trading on Friday. The company said the fundraising was a “strong sign of confidence from investors that will help us continue to further serve our customers”.
Anthony Denier, chief executive of Webull, another company that was forced to restrict trading in some shares, said in an interview with Yahoo Finance that its clearing firm “simply could not afford” the cost of entering into new trades.
“This has nothing to do with a decision or some sort of closed, cigar smoke filled room of Wall Street firms getting together to the dismay of the retail trader,” he said.
This article has been amended to clarify that platforms did not halt trading, but raised margin requirements.