We’ve reached the point of the WallStreetBets/GameStop/RobinHood madness where we could use one of those whiteboard videos that explains how a stock is bought- from order entry to clearing to settlement, but because I can’t draw, you get this rant about plumbing instead!

Am also out stuff to throw at the TV so while this might be cathartic to me, it hopefully is useful and insightful to you- so grab your coffee and buckle up!

Irregardless (yes it’s a word!!) of what the media pundits, celebrities, Politicians and CrytoBros say, there is no giant conspiracy to screw “the little guy”- we live in the age of misinformation where lies, Big & small spread like wildfire, fueled by folks’ feeling that the system is rigged against them- like in politics, this is dangerous and those of us in a position to explain what happened have a duty to the Truth.

Veritas Vos Liberabit

As in many cases, Occam’s Razor applies- with regards to the RobinHood & GameStop drama, this really comes down to a boring, albeit esoteric plumbing issue within finance- even for those of us who’ve been in the business for a while, this is largely behind the scenes brokerage operational boring stuff that we don’t even think about.

So yes, the toilet got clogged!

As clients begin to ask, “What happened last week?”, we should all be reminded that what happened with RobinHood is a much broader issue- they were not the only ones restricting orders, but for our purpose we’ll reference them as a proxy. One should note that this didn’t only impact “retail”- it applied to Institutional players like Prime Brokers and their Hedge Fund clients (not a dirty word by the way!).

A bit of context: RobinHood like many other brokerage platforms nowadays allow folks to trade commission free- but as we know there is no free lunch, never has been, so like with other brokerage firms, RobinHood makes money by selling their customers’ order flow to market makers- in this saga, you’ll hear a lot about Ken Griffin’s Citadel (Securities) which is related to Citadel Capital (hedge fund)- these are two distinct business albeit with a shared corporate owner. Market Makers like Citadel pay RobinHood good money to “preview” their clients’ orders- this allows them to make a tiny spread on trades while helping to increase order execution volume. RobinHood is not a member of the NYSE or other exchange, so they route their orders via Market Makers. Citadel has been ranked as the #1 Market Maker for the past few years by the way.

We should also note that by default RobinHood accounts are “margin” (type 2) and not “cash accounts” (type 1). Now whether that should be the case is an entire discussion for another day, yet this is how this whole drama became a story of lending & capital.

In practical terms, when an investor uses a margin account, they don’t actually own any securities, rather they own an “IOU” from their broker. Thus, when a RobinHood trader buys shares of your mid-2000s favorite videogame retailer, GameStop (GME), an intricate dance of capital and risk management processes takes place deep in the plumbing of Wall Street. This is an oversimplification, but because buyers don’t know who they’re buying shares from, it’s not like we meet over lunch to exchange stock certificates, their respective brokers use a third-party company to actually match & “clear” their buy & sell trades against each other- this little known third party is The Depository Trust & Clearing Corporation or DTCC, which moves title from selling broker to buying brokers while ensuring that transaction proceeds are moved on time (T+2). One should note that for options contracts, this function is handled by the Options Clearing Corporation or OCC.

As we know settling of a stock trade takes “T+2”; however, buyer and sellers brokerage accounts reflect transactions immediately – what folks often don’t know is that this is the byproduct of lending, which means counterparty credit risk. The DTCC essentially provides its own balance sheet to guarantee settlements between buyer & sellers’ brokers, but because the DTCC’s balance sheet isn’t as large as the volume of US equity trades, it must manage a tightly coordinated counterparty risk dance in order to guarantee accurate settlement. As such, the DTCC acts as a central repository of tittles and guarantor thereof. This is typically a very low risk structure, but low risk doesn’t mean risk-less.

In order for things to function in a super-duper-speedy manner [technical term], DTCC generally holds on to the “physical” title of stocks, so when you sell, they just re-assign that tittle from one DTCC client to another and thus the transaction is “cleared”.

Who are DTCC’s clients? Well, those are brokers- ever hear the expression “held in street name”? This comes from the fact that your stocks are held in the name of the Broker- not your name!

Ok, so here is where it gets squirrely; say you bought 100 shares of GME in your RobinHood account, because we’ll, you’re gonna stick it to the man! Burn the shorts!

We’ll, what really happens is more like this:

1. You enter an order to buy GME while sipping on your latte & eating avocado toast
2. At the end of the day your Broker nets all the money it needs to send to DTCC
3. Say RobinHood is a net sender, it will borrow the money it needs to send via a web of interbank lending and thus pay DTCC.
4. If a broker is a net gainer, then DTCC sends the net proceeds to the respective broker
5. The formal settlement happens within two days- remember T+2?
   So, if you think about it, the whole system operates on a very complex series of lending & counter party risk. As such, there is counterparty risk between everyone!
   RobinHood & DTCC; DTCC vs DTCC, Brokers vs Clients; DTCC vs Selling Broker; DTCC vs Buyer Broker; Client vs Client; RobinHood vs Creditors etc etc etc
   Make sense yet? Ok, stay with me now!

What folks seemed to only now have learnt, is that when you trade for free, you’re not the customer- you are the product! Even Institutional clients like us are now the product to our Brokers. A brokerage firm’s real customer are the buyers of order flow, the largest which we’ve come to learn is Citadel. But just because you’re not the customer, it doesn’t mean that a brokerage firm doesn’t care about you- after all, they need you happy enough to sit there and trade more and more. They need you addicted, and gamification of trading certainly helps- specially amidst a pandemic where folks don’t have many other traditional outlets like sports.

Another thing that folks are just learning is that Customer Agreements and Terms of Service matter- yeah, we all click “Agree” because like with this email, who really reads them! Well beyond arbitration clauses, another clause found in these agreements are hypothecation clauses- which allow your broker to lend your shares (or rights to) to the market’s participants such as short sellers. A broker like RobinHood will make money from this securities lending- depending on how hard it is to borrow a stock. As such, the harder to borrow the higher the variable rate earned- which by the way nobody really knows how this rate is set, but for example, borrowing shares of Apple is way cheaper than some small cap like GameStop.

So, this is where short selling makes things spicey, albeit in technical terms. Let’s say that you are Gabe Plotkin at Melvin Capital, and you’ve determined through your process that GameStop is likely to go extinct much like Blockbuster Video did when Netflix ate its lunch. Naturally, you choose to short the stock seeking to benefit from its inevitable collapse. The first thing you’d do is call up your Prime Broker [PB] (Goldman, Morgan etc), and ask them to find you some shares to borrow. However, in order to meet legal requirements, the prime broker has to find shares that have not been lent or that are not excluded from securities lending by their beneficial owner- you can request this by the way. When they find you some shares, they’ll tag those shares at DTCC and tell their HF client the cost to borrow them along with their locator ID, which guarantees those shares are available to the short seller. You can’t lend a share twice.

So, with this newly gathered information in hand, the HF manager decides whether to go forward, and we’d expect the transaction to look something like this:

1. The PB lent the HF specific GME shares, which the HF immediately sold, receiving cash.
2. The HF balance sheet is: owes shares and has cash…along with other assets it’s long
3. The HF receives money market interest on the cash in its account (called “short rebate” – this is nominal in today’s zero rate world, but can be meaningful in a high interest rate environment)
4. The HF pays borrow cost on the owed shares

As we know, because the HF owes shares to the PB, and not money, its performance moves precisely inverse to the share price movement (profit on decline, lose on increase), but behind the scenes, the prime broker deals with the plumbing. The prime broker needed to find someone who owned the GME shares with clean title. Ideally, the PB found those “in house” (from another client of the same brokerage), but often they locate them from a 3rd party (like RobinHood or another PB) … The PB pays RobinHood daily for the borrow and charges its HF client daily to owe them shares.

Now let’s zoom out and see what happens at the higher level.

RobinHood’s margin client (a retail investor) thinks he owns GME shares, but he never did, because his is a margin account. RobinHood itself actually owned the shares (in Street name) and they lent those shares to a Hedge Fund’s Prime Broker (aka “hypothecation”), in exchange for daily borrow fees. Follow the money!

That loan creates a debit/credit relationship between the broker and PB. The PB took those borrowed shares and re-lent them to its client, who sold them to a 4th party. The RobinHood client and the 4th party simultaneously “own” the same shares.

Summary from various perspectives:

• The RH Client has a stock credited to its margin acct. This is actually a promise from RH
• The HF owes GME stock + borrow interest. It owns “cash” from the short sale, which is credited to its margin account. It receives interest on that cash (even that cash is actually just a promise from its PB)
• RH has a security loan to PB, and collects variable borrow interest in the meantime
• PB owes RH stock and daily borrow interest. PB holds HF client margin account assets as collateral. HF pays PB a daily borrow rate. PB scrapes a vig off the borrow rate and pays the balance to RH
• A 4th party owns the actual shares that the RH client thinks they own

And..of course:

• DTCC is recording the ownership chain and ensuring cash from purchase and to sale flows through.
  DTCC’s main worry is that someone mid-chain hits a problem. If that happens, the problems flow all the way up the chain to RH’s client and down the chain to DTCC.

In this way, RH is at risk to downstream problems, which is why the plumbing metaphor is apt: when you flush, a downstream clog causes a mess that backs up into your toilet. Don’t handle that clog well & you end up with a mess on your floor. Handle it really-really poorly & you burst a pipe – wastewater seeps into your walls and you end up with feces in your living room!

To avoid this, DTCC has risk-weightings based on the counterparty and the securities. When GME became the most volatile asset in the world (step aside Bitcoin!), it created massive risks to the system. Likewise, DTCC views transactions from margin accounts as riskier than from cash accounts. From the broker’s perspective, its risk with RobinHood traders’ margin accounts is mitigated by the broker’s ability to close clients out of positions, liquidating them when risk thresholds are breached.

Stocks that are extremely volatile increase the odds of breaches, so to mitigate the risk of a failure to get paid, DTCC requires brokers (like RH and a PB) to keep collateral on deposit at DTCC (cash and Treasuries) in proportion to the risk that broker poses. As more and more of a broker’s DTCC assets increase in risk, for example, GME becomes disproportionately part of RH’s assets), DTCC says to RH “hey, you need to send us more collateral.”

Collateral means liquidity and liquidity is the oxygen of financial markets, so accessing liquidity is easy when you don’t need it and hard when you need it. Thus, maintaining big buffers is important, which is why this whole saga has been about managing risk- not some David vs Goliath, stick it to the man narrative you’ve heard on TV. It’s much more boring- at least for now.

That’s not to say that the heard and almost cult-like stuff happening in Reddit has no role, I do think we’ve approached a point where some folks are actively trying to burn down the system- sound familiar? We have way too many pissed off folks running around angry at the system. Melvin Capital’s story on the news has helped validate some of these folks’ point of view that by bidding up crappy companies that Hedge Funds are short, that somehow, they’ll get revenge for Wall Street’s history of screwing the little guy… but what they fail to realize is that in order to burn the shorts, they have to force them to de-gross, or to sell liquid securities in order to acquire the cash to buy back the short stock. This is cutting off your nose to spite your face. Also, folks fail to realize that for the most part a Hedge Funds’ capital is that of teachers, pensions, unions, retirees like ours within DAFI- yeah, there’s some rich guy investing to buy his 5th yacht, but for the most part HF’s capital is institutional money- so when these pissed off traders go burn the Hedge Funds, they’re burning Grandma’s pension plan! …Steve Cohen is going be alright, Ken Griffin is going to be alright- some like Gabe got hurt, but the so-called Masters of the Universe will be alright. Who gets really hurt in all of this are everyday investors who lose trust in the system or sell out of fear- this is why We must tell the truth about what happened.

Over the past few days, we’ve seen the likes of Mark Cuban, Chamath Palihapitiya, the insufferable crypto Winklevoss twins and Politicians of both stripes come out and cheer on the little guy fighting back against Wall Street- Ted Cruz & AOC even agreed on this! Talk about hell freezing over- where’s my skates!? Dave Portnoy, who garnered fame for day trading his Barstool sale proceeds online, spent 10 minutes on Fox crying foul when RobinHood had to restrict orders in GameStop and other high-risk stocks. All these pundits have trafficked in lies, conspiracy theories and inuendoes that somehow HF managers called up Brokers and told them to stop GME trades to their own benefit. This is completely irresponsible of them and only furthers the narrative that somehow the game is stacked against the little guy by Wall Street. Markets are not a casino- statistically markets are up 85% of the time- I’d love those odds in Vegas any day of the week and twice on Sunday!

The downward momentum created by these lies has the capacity to create a contagion risk within the system as folks try to sell before others sell- a downward spiral of fear amplified by algorithms designed to pick up on increases in volatility measures. This is why lies like these are so dangerous- they can amplify half-baked truths and turn them into something much more catastrophic- and guess what, it is at these points that the little guy does in fact get holding the bag! It is them who lose capital beyond recovery.

During this episode, the financial news media has also failed investors, rather than investigate and educate on the inner workings of Wall Street’s plumbing, they platformed the loudest mouths referenced above- all pushing their agenda, whether it’s a utopian version where Bitcoin would cure cancer and solve world hunger eye rolls or give guys like Chamath yet another reason to pitch his SPACs, to Cuban’s loudmouth which has to have an opinion. And now the politicians come jumping in- these are folks who make regulation and laws – you’d think they’d be informed, but they’re just as ignorant. This is asinine as none of these folks know what the heck they’re talking about!! Even well-known financial bloggers jumped into this zest pool of lies… their hypocrisy shows when they fail to realize that they, like us, ARE Wall Street!

In the end this is a story about risk, about managing it and last week the system held, but the House’s risk is building & building, folks are now actively trying to pump up silver to crush the banks…it’s like we’ve reached the QAnon-level of markets!! At a systemic level, this all basically nets out, but, at any given counterparty, it may not. That counterparty might be the client (a HF or individual) or the broker (RH or PB) depending on where you are in the chain, you have different worries. And while this is what Risk Management processes and systems are designed to mitigate, but if your system did not consider this type of event, and you did not override with commonsense early on, you can be caught offsides. Badly. Lethally.

Yes, there have been huge winners already, Reddit user DeepFuckingValue has gained cult status for betting $50k [not the little guy btw] and turning that into $40MM…but if you are only a winner on paper, your story is not yet finished. The game is not over until the whistle blows. You need to ultimately be a winner in realized gains held in a safe brokerage and many of these YOLO traders are now unwilling to sell by hoping to further drive the gains in these ShitCos upward & keep the HFs on fire. Well, guess what sophisticated players know this, they care about the quality of their counterparties and risk-manage their own portfolios.…and that all brings us back to RobinHood. They just raised $1B last week to improve their liquidity position – that says something about where they were prior to this, but should they fail then they could trigger a loss of confidence that can ripple across the markets- and we didn’t even cover the asymmetric rise in risk because of what’s happening in the options markets! Talk about adding napalm to a bush fire…I may rant about that later…if you’ve made it this far congrats.

Anyways, when the dust settles, we’ll learn an inevitable truth: Pigs get fat, hogs get slaughtered!

Stay safe- the Rona sucks

Jorge A. Romero, CFP®
Senior Wealth Advisor