Providing a reason for a wrong does not make it right.

Imagine purchasing a car online. You see pictures of the car. Online reviews of the same make, model, and year are stellar. You decide to go ahead and buy the car. Wiring your money to the seller, you receive instructions on how to pick up your car. You follow these instructions, begging a friend for a ride to the address where you can pickup your sweet new wheels. Upon arriving at the address, you find a vacant lot, where wind whips trash against a back corner of the chain-link fence—you discover there are no cars here. You’ve been swindled.

What if this did not happen with a car but instead happened with financial stocks. You click the buy button in your favorite trading app and a stock sale is made at a price agreed upon between you and the seller. The cash position in your portfolio decreases by the appropriate amount and you wait for the shares to show up in your portfolio. And wait. And wait…until finally, you lose all trust in the marketplace.

Fortunately, this should not happen to you. A clearinghouse exists to prevent this. They hold collateral of your broker’s for just such an event. If a buyer or seller fails to deliver their side of the deal, the clearinghouse will credit your account and spend their time collecting the owed asset so you don’t have to.

At this point, you may be wondering: why would one side of the buy/sell transaction fail to deliver? On the sell side, how can someone sell something they do not first own? On the buy side, how can a brokerage firm let someone buy what they do not have the funds to purchase? To answer these questions, we must discuss options and margin.

The Sell Side

A seller can sell what they do not have by performing a practice called short selling. In this case, a seller has high confidence that a stock price will decrease below a specific value in the future. To capitalize on this belief, they will sell a “put” contract. This contract gives the owner the right to buy the shares at the specific price—you know, the price the seller believes the stock will be below by the time the contract expires.

Let’s say this price is $100. Specifically, the seller thinks that the price of the stock will be below $100 dollars in, say, one month. They write the contract for the right to buy 100 shares from them in one month’s time for $100 and place it on marketplace where similar contracts are sold. Let’s say the list price of this contract is $150.

Along comes a buyer. They believe this stock is going up. Specifically, in one month’s time, they believe the stock will be well above $100. They see this contract on the marketplace and think the $150 premium to purchase the contract is a small price to pay. This is because they believe with near certainty that in one month’s time, this contract will give them the right to buy 100 shares for $100 dollars each when the shares have increased to well above $100 dollars.

For the buyer, the winning case is when the price increases above $100 within the month, say to $150. They now have the capability to purchase 100 shares X $100 and immediately sell them for $150 apiece. In this case, the realized profit is $4,850. In words, they purchase the stocks at $100 apiece, sold them for $150 apiece, and spent $150 for the contract to do so. Note that, in this case, the seller actually has to own the 100 shares, as this is where the money comes from for the buyer’s profits.

For the seller, the winning case is when the price decreases below $100 by the time the contract expires, say to $80. In this case, it does not make sense for the buyer to purchase the 100 shares at $100 apiece when they are trading for $80. If the buyer wants the 100 shares, they should just purchase them at $80 apiece. In this case, the contract expires worthless, and the buyer is out the premium of $150. The seller’s realized profit is this premium. This does not seem like a lot unless the seller writes thousands of such contracts and sells them for $150 apiece.

Now, what often happens is a large institution will write many, many of these contracts. Usually, they are so confident that the price is going to decrease, they don’t even bother to own the shares. Legally, they must affirmatively determine that they can easily acquire the 100 shares for each contract they sell. If they do not take reasonable measures to find a source for the easy acquisition of these shares, before they sell the contract, they are writing what is called a naked short. Since the 208-2009 financial crisis, naked shorts are explicitly illegal.

Well, nowadays in 2021, naked shorts are still written. One can get around this law because there may be significant grey-area on what are reasonable measures to ensure one can acquire borrowed shares. Even so, if we put aside naked shorts, and assume all contracts written today are clothed, the fact remains that these put contracts are being written for shares that are not owned at the time the contract is sold.

The Buy Side

There are a few ways someone can buy shares for which they do not have the money to purchase. One way is through margin. This is when the buyer borrows money from the broker in order to purchase shares. Now, you might be thinking that his sounds risky. You may barely feel comfortable buying stocks with your own money, let alone borrowed money. I am inclined to agree with you, though I’d argue that the majority of individual investors still use margin in one way or another.

In an age of convenience, we have things like Robinhood Instant accounts, which allow you to transfer money from your bank instantly. One click and you immediately have the cash in your account to trade with. In reality, it takes several days for your transfer to clear. Meanwhile, Robinhood never even checked to see if you actually have this money in your account. You could have bought a bunch of stock with this instant cash without even having the funds in your account. This is trading on margin, whether you realize it or not.

Who cares?

Now, you might be thinking: Surely there must be some guardrails in place so that either side cannot end up owing billions of dollars in assets that that they do not actually have, right?

As a hobbyist investor, I thought so too. This past week changed all that.

This January, several institutional investors wrote large amounts of short sell contracts with borrowed shares. At one point, there were so many contracts written, that the short interest was above %100. This means that there were more shares spoken for in short contracts than there were shares in existence for these specific stocks. The contract writers were borrowing shares that were already borrowed. Now I’m not one to haphazardly pass judgement, but this certainly does not seem like appropriate measures were taken to make certain these borrowed shares were readily attainable. I’d say these shorts were scantily clad at the very best.

As I said before though, writing contracts with borrowed shares happens all the time. It’s usually no big deal. However, on this particular January, a critical mass of individual investors was collecting on the internet. They went at these shorted stocks with a singular focus I have not seen in my lifetime. The increase in demand caused the stock prices to dramatically increase. In the case of GME, the share price was hundreds of dollars higher than the short contract prices. This huge increase above contract prices meant that these individual investors would be coming to collect billions of dollars from the institutions in the near future.

What does this have to do with a clearinghouse?

Remember the role of the clearinghouse? They sit in the market to ensure that all this stuff goes smoothly. Under normal circumstances, the short sellers can usually purchase the borrowed shares at the higher price and call the loss a learning experience. In the event that they cannot buy the shares, the broker’s collateral held by the clearinghouse comes into play in order to cover the side that is unable to deliver.

These collateral obligations were reinforced with the 2008-2009 financial crisis and enacting of the Dodd-Frank act. There is no set number of how much collateral each broker must post, and with the amount depending on the overall risk of the brokerage’s clients’ overall holdings.

The drastic increase in Game Stop share prices was a technical increase rather than a fundamental one. The underlying company was not suddenly better or more efficient. Instead, the demand for buying shares outpaced the supply. As more and more retail investors piled into the stock by purchasing shares and options, market makers also had to purchase more shares to delta hedge the already sold call options contracts. This put an enormous upward pressure on the price of the stock. As the price increased, short sellers also had to acquire physical shares to cover their short contract, applying still more upward pressure in demand. The result was a meteoric rise in share price over just a few days.

This is a bubble. Eventually, the retail investors will start to want to turn paper gains into realized gains by selling their shares. As more and more share owners want to capitalize on the price increase, the supply of shares may outpace demand. This shift from high-demand and low-supply can to low-demand and high-supply can happen in a matter of hours with the price of the stock settling at normal, fundamental levels. In other words, the pace at which this bubble could pop is much faster than the speed at which transactions are settled at the clearinghouse. Without collateral, the clearinghouse could be left holding the bag when all those shares purchased on margin at $300 apiece or more are suddenly worth $10 each. To mitigate this risk, the clearinghouses reasonably asked their brokers to post more collateral.

Now here’s where the really shady business started…

There is nothing wrong with the clearinghouses asking for more collateral. In some cases, these new collateral obligations were reported to be an order of magnitude higher than what the brokers had planned on posting. What is suspect, however, is how the brokerages handled the new collateral requirements.

In February 2’s print issue of the Wall Street Journal, there was an article written by Peter Rudegeair titled “Robinhood Raises $3.4 Billion in Days”. The article portrays Robinhood as gracefully and tactically reacting to a difficult position imposed by its clearinghouse. The article states “Robinhood restricted buying in more than a dozen stocks and related options on Thursday, which helped lower the amount of collateral it needed to post…”

Wait! Pump the brakes!

The brokers were only limiting buy orders, not sell orders.

To limit only buy transactions is to apply a ratchet mechanism to the price of a stock, it can only go one way—down. If you were to look at the order book of such a limited stock, you would see the number of shares for sale greatly outnumbering the shares desired. This is a calculated shift of the supply and demand curve.

The calculation worked, and it did reduce the size of the bubble, which in turn reduced the risk to the clearinghouses, which in turn reduced Robinhood’s required collateral. However, I would like to point out that this is also calculated market manipulation. The ultimate goal was to reduce collateral, and in order to do this, the price of specific stocks had to decrease. That’s exactly what happened when several brokers only limited buy orders. Just because they gave a reason for their manipulation does not make it anything else but manipulation.

Why not limit both buy and sell transactions, essentially freezing the market for these specific stocks until they could raise the appropriate capital for their collateral obligations? Why not drastically increase their maintenance margin for the stocks in question, essentially putting the collateral burden on its users? To be sure, margin calls were happening, which is when the broker requires larger amounts of collateral in a user’s account to cover shares purchased on margin. If the user cannot provide the required collateral, Robinhood sells the shares at whatever market price is available at the time.

These margins calls were and should have been happening. However, when they happen in a sell only market, they only serve to increase the ratchet mechanism and reduce the asset price even further. More shares for sale to increases the supply with an artificially limited demand. This behavior is contrasted with the appropriate reaction of the Chicago Mercantile Exchange on February 2. Instead of manipulating the market by limiting one side of transactions, they increased their margin requirements on silver futures, which were also rallying due to online enthusiasm.

Am I missing something?

When I look in the news, I don’t see journalists asking the above questions. Please, correct the retail investors. If the brokerages’ decisions to only limit buy orders was not market manipulation, explain how it wasn’t. We’ve heard the reason the brokers decided to manipulate the market, though we have not heard why this form of manipulation is acceptable. I would like to see along side such an explanation a report on the total revenue such news outlets like the Wall Street Journal receive from these brokers in the form of paid advertisement.

I hope when the dust settles and the CEOs of these brokerage firms are in the planned congressional hearing, our law makers ask these tough questions. We’ve seen too many times when irresponsible lending practices have tanked our economy and destroyed real lives. Why then do we think it’s acceptable for institutional investors to leverage themselves past the carrying capacity of a stock and retail investors to purchase stocks with money they don’t have?

EDIT in response to comments

I believe you are referring to the practice of market making. This is the act of introducing liquidity and depth to a market, and it usually involves facilitating both sides of a transaction. To do this, they own large quantities of shares as well as write options contracts on both sides of a transaction. However, I disagree with you on who is doing the bulk of the market making.

To be sure, brokerages do their fair share of market making. As you point out, this is evident by the TD Ameritrade link you provided, and is a way to allow for 24 hour trading of popular stocks. In this case, TD Ameritrade (or someone they work with) is purchasing large amounts of shares in these popular stocks and creating their own marketplace. All the overnight transactions then get settled on the main exchange at a future time.

However, the vast majority of market making happens inside clearinghouses like Citadel. These firms then pay brokers for their orders. Not only can these firms profit on the spread between the bid and ask price they create, but they also coalesce orders from all over the market. But, why would these firms pay your broker for the privilege to execute your trade?

The reason is high-frequency trading, and Citadel is one of the largest high-frequency traders by market share. These market makers have direct connections to the actual exchanges (e.g. the NYSE and NASDAQ) and these connections are at speeds that represent fundamental limitations in today’s processing technology and the speed of light in a material. They also pay brokers for as many orders as they can get their hands on. We’re taking about grouping together millions of buy and/or sell orders for the same stock at any given time. In short, these market makers have direct access to real-time market trends, as well as the speed to get in front of these trends and perform arbitrage in various ways. This seems like an upper hand, though most people (including the SEC) look the other way, because, as mentioned, these market makers also provide liquidity, convenience, and depth to the market, which all players benefit from.

The market makers were getting squeezed from both sides during this market event. The obvious way was having to purchase shares to cover their short contracts. The other, which I eluded to in my article, was through having to delta hedge their written call options. The writer of the call option does not want the price to rise. They want to collect the premium for selling the option and then let it expire worthless if the share price stays below the strike price. To hedge this risk, the writer can purchase shares of the underlying stock. This is because, if the stock increases above the strike price by expiration, they have to cover the call. This loss is hedged because they also purchased shares that now went up in value, which covers some of their losses and maintains their neutral position in the market.

All this is to say that I agree with you. When stocks undergo drastic technical changes up or down to the rhythm of technicals the market makers are not privy to, risk exposure is increased substantially. This is what we saw.

I also agree that a company has an obligation and right to mitigate risk. This is the reason cited by the brokers for their actions last week. I agree that people often confuse a customer service with some innate right to said service. This was evident by hordes of angry redditors showing screenshots of their portfolios being margined called last week claiming their rights were being violated. In fact, they were playing with their broker’s money, and when the risk landscape changed, the broker took their money back, as per their terms and conditions.

I wouldn’t even take issue if the brokers no longer facilitated transactions on their platforms for these specific stocks due to the changing risk. They are free to choose what services they provide. Market participants should have no pretense that what is on their brokers marketplace today will still be their tomorrow.

What I take issue with is what appeared to me to be illegal market manipulation. The SEC defines market manipulation when “…someone artificially affects the supply or demand for a security”. As mentioned in my article, this is exactly what the brokerage firms were doing. To only limit buy orders is to fundamentally skew supply and demand. Regardless of the reason or the risk these firms were trying to mitigate, it seems that they were performing illegal market manipulation. Just because someone has good reason to break the law, does not mean they didn’t commit an illegal act. They could have changed their margin requirements to 100% and margin called every single user that did not enter their position with cash on hand. They could have stopped all transactions in these stocks all together. Instead, they chose to manipulate supply and demand to suite their interests. This is what I have an issue with, and it seems glossed over in the mass media patronizing their readerships with such reasons for the brokers’ behaviors.