Clogged Pipes on Wall Street? Inside the Infrastructure of a Trade.

“We are concerned about the ability of the market and the clearing systems, through the onslaught of orders, to continue to provide liquidity. And we are concerned about the financial viability of intermediaries and the clearinghouses.”

These concerns were expressed by Interactive Broker Chairman Thomas Peterffy, as he explained the move to curb trading in certain stocks.

My takeaway — we may have a bit of a plumbing problem in our financial markets. 

The GameStop fiasco has prompted many to take a deeper look at the inner-workings of financial transactions. A certain brokerage being slammed in the media for how they dealt with the massive volume and volatility of GameStop and several other public companies, but many other brokerages did the same (including some prime brokers who serve institutional investors). The purpose of this article is not to create an escape hatch for large financial institutions, rather, I hope this provides a little information on what occurs behind the scenes every time you push that buy or sell button. 

The Key Players

• Retail Investors — non-professional, individual investors
• Institutional Investors — an institution that pools money to invest (pension funds, mutual funds, endowment funds, hedge funds, etc.)
• Publicly Traded Company — companies generally decide to go public to raise money to fund future growth
• Depository Trust & Clearing Corporation (DTCC) — provides clearing and settlement services for the financial markets
• Options Clearing Corporation (OCC) — provides a similar service as DTCC but for options

The Process

Many traders use margin accounts (as opposed to cash accounts). While I won’t get into all the details of a margin account it’s important to note that practically speaking, the client doesn't own securities in the margin account, they own a promise from their broker. 

When the decision is made to buy a security and that button is pushed, the buyer doesn't know who the seller is, so a third-party has the important role of matching the transactions, or clearing (transferring ownership from one broker to another broker); that’s where DTCC comes in. Trades must be settled two business days after the trade, known as T+2, but most trades reflect immediately on the investor’s account. This difference is due to lending occurring in the background, and anytime there is lending there is also credit risk. 

DTCC utilizes its balance sheet to guarantee settlement. Since the balance sheet isn’t massive, they must very tightly manage counterparty risk to ensure settlements are accurate and timely. When business is happening, as usual, there is little risk, but when things go haywire as we saw recently, things can get a little buggy. 

Typically, DTCC maintains the “physical title” to the stock, which speeds up the settlement. With the high-frequency trading of digital platforms and to comply with the SEC’s T+2 rule, this just makes things simpler. As necessary they simply assign that title from one client (broker) to another, thus clearing the transaction. 

Let’s take a look at a stock  purchase:

1. You choose the security and hit that buy button
2. At the end of the day, the broker nets out all trades from that day(buys and sells) and determines if they are net senders or receivers
3. If they are a net sender they borrow that money (using inter-institution short-term borrowing) and send it to DTCC
4. DTCC then sends money to those brokers that are net receivers
5. Formal settlement occurs within 2 days

Where’s the Risk?

There are several times when credit risk might come into play:

1. Between the time the trade is executed until the end of the business day (when the broker nets with DTCC).
2. Between DTCC sending net proceeds and formally settling the transaction
3. When the selling broker allows the selling client access to the funds from the sale before the trade has settled
4. Between the sell and when DTCC settles with the selling broker at the day’s end

There are a lot of other things going on behind the scenes that make this plumbing system even more complicated (selling order flow, short interest, price correlation, etc.) but for the sake of simplicity, we’ll revisit that another time.

Since DTCC plays a huge role in ensuring smooth transactions across a massive financial system, they require brokers to keep collateral on deposit at DTCC (similar to how banks are required to keep reserves of cash). These reserves are determined proportionately to the amount of risk each broker incurs. When something unusual happens, and DTCC finds its customers (the brokers) increasing risk, they require more collateral (cash). Cash in these cases is like batteries, you can never find them when you need them. According to the Wall Street Journal on Friday, January 29th, “industrywide, collateral requirements rose to $33.5 billion from $26 billion on Thursday, an increase of nearly 30%.” 

This problem is significantly magnified when you throw in advanced trading instruments like options and traders who trade on borrowed money. It would take a series of posts to adequately explain the role of options, but Mr. Peterffy touched on the role they played in the recent debacle by saying:

“When some options holders, sellers, or buyers on their own side lose money we have to collect money from them and give it to the clearing house. If our customers are unable to pay for their losses we have to put up our own money.”

In short, brokers are on the hook for their client's losses, even if the clients haven’t covered them. If they don’t have adequate reserves, there is a problem. Now consider this, what if a broker had a client base that was hyper-focused on a small group of highly correlated securities, and mostly taking the same side of the trade…that broker’s risk is further elevated because they aren’t receiving money from the other side of the deal. When everyone scrambles to get in (or out) the pipes can become clogged, and if that clog occurs in the middle of the pipe, it’s going to affect those on both ends of that pipe. 

What Now?

No one seems to care about the plumbing until there is a clog. It’s yet to be seen how this plays out, and as I mentioned, this is just a primer, and plumbing is far more complex than I briefly explained here. I’m guessing, the brokerages that have high exposure to the volatile positions will be looking to inject cash as soon as possible. Robinhood for example already raised an additional $1B. There have already been several congress members, and government officials issue statements calling for deeper investigations. This presents an excellent opportunity to scan for threats to our financial system, spot weaknesses and areas of possible exploitation, and find ways to ensure we have a fair, balanced, and safe system that allows everyone to invest for the future on a level playing field. 

*This article is provided for general information and illustration purposes only. Nothing contained in the material constitutes tax advice, a recommendation for purchase or sale of any security, or investment advisory services. I encourage you to consult a financial planner, accountant, and/or legal counsel for advice specific to your situation. Reproduction of this material is prohibited without written permission from James Vermillion, and all rights are reserved.