Robinhood Puzzles Wall Street Collateral Explanation-Crunch

A week after Robinhood Markets tried to clear things up by explaining why he slapped the controversial limits on hot stock trading, Wall Street risk professionals are still puzzled: how the company was so ill-prepared for an obvious increase. warranty calls?

For the financial sector, anticipating requests for guarantees from centers such as the Depository Trust & Clearing Corp. is Brokerage 101. Large companies assign teams to study DTCC’s methodology, estimate its demands and ensure that sufficient cash is available. Everyone growls, sure, but they also know what happens when businesses fail: they scramble for a lifeline or stationary. Robinhood has gathered billions of funders to keep it going.

“They obviously fell very, very short,” said David Weisberger, a market structure consultant who built trading systems at Salomon Brothers and Morgan Stanley. He said he was perplexed about Robinhood, given what he called the “well-known” clearing house requirements. “It was a threatening event for the franchise.”

The Silicon Valley startup has left users furious by temporarily limiting some purchases during the height of the January mania. GameStop Corp. and other “meme stocks” that were booming. At the end of that week, as millions of customers downloaded his app to swap fallen darlings and new ones, risk managers were still stuck on how Robinhood got into the tough spot.

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Contacted for comment, a company spokesperson spoke on a Thursday blog post by Robinhood Securities President and COO Jim Swartwout.

“We grew up quickly. And we ran into challenges at times as we scaled up to respond to this moment, ”wrote Swartwout, describing how the growth of the business and an increase in transaction volume fueled demands for collateral. “To say that the overnight volume increases Robinhood experienced last week were extraordinarily high would be an understatement. The surge was magnitudes higher than the norm. “

Chief Executive Officer Vlad Tenev has linked the trading restrictions to a roughly $ 3 billion guarantee call that arrived in early January 28 from part of DTCC, which Robinhood said contributed to a 10-fold increase in weekly clearing house deposit requirements for stocks. While Tenev credited DTCC with being reasonable and ultimately accepting $ 700 million, he has at times described his formulas as opaque, noting that they include a “discretionary” element.

“We don’t have all the details” on how DTCC came up with its initial request, Tenev told Elon Musk last weekend in an interview broadcast on the Clubhouse social chat app. “Obviously it would be ideal if there was a little more transparency so that we could better plan around that.”

The industry executives say: It’s pretty much just math.

‘Shame on them’

In interviews, more than a half-dozen senior risk executives – some of Wall Street’s biggest companies – have reacted in amazement to any claim that the scale of DTCC’s demands cannot be anticipated. They spoke on the condition of not being identified, in some cases because of their interaction with Robinhood.

They acknowledged that there were always complaints about the difficulty of figuring out what clearing houses would look for and that things could go wrong. Some executives have even recounted times when they were pressed for millions of extra cash on short notice. But overall, the group said large, well-run companies were not surprised by the demands that threatened to empty their pockets.

A brokerage executive said Robinhood should have made sure it had enough capital or stopped processing volatile stock trades. TD Ameritrade of Charles Schwab Corp., for example, began limiting betting on certain stocks even the day before Robinhood. Robinhood’s subsequent restrictions were more severe, gradually diminishing over the next week.

“Once every ten years or so, improbabilities happen,” said Weisberger, who now heads cryptocurrency firm CoinRoutes. Self-compensation companies like Robinhood need to know what demands they might be facing. “If they studied it and found an answer and it was wrong, shame on those who studied it,” he said. “If they haven’t studied it, then shame on them.”

Avoid surprises

DTCC bases a large part of its filing requests on things such as a Clearing Member’s concentration in volatile stocks, the volume of transactions made, imbalances in buying and selling, and the financial condition of the company. The more a brokerage firm is exposed to erratic stocks, the more collateral it must present. The less capital a brokerage has, the more severe its surcharge can be.

The aim is to protect the financial system as a whole against trading failures. To make warranty calls predictable, the DTCC says it provides “reports and other tools to our Clearing Members to help them anticipate their margin requirements for a particular portfolio.”

The nightmare that clearing houses are designed to avoid is that a brokerage loses so much money before a trade is completed that the company cannot delay its completion. Without a clearinghouse, a company’s bankruptcy could affect the financial system. Canceling a single transaction means canceling all subsequent transactions if this action has already been resold.

A broker’s collateral burden increases if he lends money to clients, and especially if they bet heavily, for example, on stocks that have recently multiplied in value, like GameStop and others. did last month. If prices suddenly collapse – which has also happened – it increases the risk that clients will not be able to pay off their margin loans, leaving the brokerage to eat their losses. Some of the recent stock drops may be attributable to Robinhood’s liquidation of client positions to avoid loan defaults, Wall Street risk managers say.

Read more: Gamestop ends worst week in history, leaving $ 18 billion hole

“Someone has to pay,” said Eric Budish, professor of economics at the Booth School of Business at the University of Chicago. If you’re a brokerage, “you have the capital to deal with this existential risk. I was surprised Robinhood didn’t have more capital for this scenario.

Margin loans made up about 20% of Robinhood’s $ 6.7 billion balance sheet as of mid-2020. Robinhood tapped lines of credit and raised about $ 3.4 billion from investors at the end of January.

Robinhood, founded in 2013, hired Wall Streeters to help integrate the startup into the more traditional financial system. The company has appointed former Securities and Exchange Commission member Dan Gallagher, Norm Ashkenas of Fidelity Investments and Kelly Zigaitis of Wells Fargo & Co. to positions of legal and compliance responsibility.

Robinhood Ordinance

This week, Robinhood offered its own prescription to avoid future problems: the US exchange should abandon its two-day settlement system and move to a real-time process.