Going to attempt to explain this with just the mechanics & facts, and going to do it in TLDR format. It’s long… because I have to give you the whole structure of the market financial system to understand what happened:
BACKGROUND You’ll need to know:
- The “markets” (like our banking system) are largely a self regulated system. The Government “oversees” it, but only steps in to say, “hey, what’s going on?!” Attorneys, accountants, and many other “professions” operate this way. Other “adults” are left in charge and the “industry” elects those chair people to be the “adults” so the regulators don’t have to oversee every transaction.
- Depository Trust & Clearing Corp (DTCC): ~90% of trades must be cleared by this entity (1.7 quadrillion a year). They are the largest adult in the room. They are essentially the insurance company that makes sure that none of the quasi-banking entities involved in the “market” blow up the whole system. They require collateral and set those requirements. They allow the brokerages and other market players to execute/process transactions… but manage the amount of money they process. It would be highly ineffective to check every transaction these entities do. So collateral is put up relative to the volume they process. For example, you don’t want a bank with $20 to process transactions of $50 million a day! What if they make a mistake! The DTCC exists to make sure no one is left “holding the bag”… or that the “bag” doesn’t get big enough to tank the whole system. FYI: Reg T managing collateral dates back to 1974.
- The “Broker Dealers” (i.e. Robinhood, Schwab, TD, Merrill, etc. are who you interact with) take your buy & sell orders… they’re your “person” for interacting with the markets. You can’t really access the markets otherwise… just like you couldn’t access the internet without Verizon, Comcast, AT&T, etc…
- The DTCC’s CLIENTS are the Broker Dealers. Remember the word “Clients”… because that relationship gets tricky and morphs.
- When you click “sell” on the computer to sell a stock (i.e. “security”… a bitcoin, bond, Topshots, etc.), the broker dealer gives you the price on the screen, ON FAITH, that they can find a buyer for that stock without a large fluctuation in price. If they cannot, they’re left “HOLDING THE BAG”. I want you to remember the concept of “holding the bag” as that a folk term for risk, counterparty risk, risk of all sorts.
- Some broker dealers like Merrill, TD, Schwab, JP Morgan, the “big guys” handle the risk of finding a counterparty to your sell/buy order. Some broker dealers are also large banks and can certainly handle this risk (i.e. balance sheet… the money in their “savings account”). Other broker dealers like Robinhood and WeBull… are new and smaller and cannot handle this risk as they’re younger and don’t have as strong a balance sheet.
- The DTCC requires a certain amount of collateral based on the volume of trading vs balance sheet. Smaller newer upstarts like Robinhood reduce the amount of collateral they need by working with MARKET MAKERS. I know… it’s like F*ing game of thrones.
- Market Makers take the risk of finding the buyer of your stock… FOR the Broker Dealer. The Broker Dealer is their customer. The Broker Dealer gives you a bid-ask spread that is wider then the Market Maker, and those little spreads are a source of revenue. If this bid-ask spread is Greek to you… they buy & sell things with a little bit of a markup (usually a few cents).
- Because the Broker Dealers utilizes the market maker, they require less collateral as they have a “Daddy/Mommy” to co-sign for them. So the DTCC requires less collateral because there’s less risk.
- The cost of the Market Maker is passed to you… the consumer, through the bid ask spread. COLOR NOTE: “Fill prices / price improvement” is a big thing with traders. Charles Schwab is a “big guy” (i.e. bank, market maker, broker dealer all in one, just like JP Morgan etc.) and I think they do a great job… no real mark ups, etc. I’m a customer. “Big Guys” don’t always have to be “money center” brick & mortars like Wells Fargo.
- When the Broker Dealer & Market Maker are NOT the same company… (like Robin Hood) Market Makers help Broker Dealers manage the risk of finding a buyer or seller for a transaction. They take the risk of HOLDING THE BAG off the Broker Dealer so the Broker Dealer can provide you a great customer experience; because you probable don’t give a crap about pay $20 per share vs $19.99 per share. Sometimes, the Broker Dealer gets a “profit share” (or kickback, call it what you want) from the Market Maker for the fractions of pennies between the bid/ask spread. This is how Robin Hood makes money.
- Market Makers include a lot of firms, who are owned by really really wealthy people (some are public, i.e. Virtu Financial, but most are NOT, they are privately owned businesses). For example, Bloomberg is a market maker (amongst many many other things)… and some market makers are also hedge funds / high frequency traders (high frequency trading is a way of mining these fractions of cents in market transactions). These include Citadel & Two Sigma.
- NOTE: Ken Griffen owns Citadel, and Citadel is the market maker for Robinhood. Robinhood makes money from “profit sharing” Citadel’s market making activities. Ken Griffen also owns a large stake of Melvin Capital, the hedge fund targeted in the GameStop short squeeze that’s in the news. Just for color on my tin foil hat: Ben Bernacke (former Fed Chair.. Fed chair = “the person who is allowed to create US dollars out of thin air, and give it to banks”) is currently employed by Citadel.
PHEW… Now on to how this matters to what happened this week with GameStop, Robin Hood, and Preventing people from buying shares of GameStop.
- A group of traders on an online forum (Reddit) discovered a trick they could play on Melvin Capital, and (to try to keep this short)… had Melvin by the nuts in a GameStop trade / bet. They were executing a “short squeeze”. Please Google Reddit short squeeze and you’ll get that story and all it’s various colorings.
- The price of Game Stop stock shares skyrocketed… to the f*ing moon! Crazy price action, never before seen (18,693% increase…new record and possibly still going up.. to Mars).
- Remember… Broker Dealers need COLLATERAL as determined by the DTCC.. based on the dollar volume of trades vs the CURRENT collateral they gave to the DTCC.
- A LOT of the trading volume & short squeeze participants in Game Stop used Robin Hood as their Broker Dealer… and by extension, Citadel as the Market Maker.
- The share price of Game Stop rose so fast.. that the dollar volume of transactions being handled by Robin Hood increase as fast as the price of Game Stop.
- On Thursday morning, January 28… the DTCC raised collateral requirements for all Broker Dealers on trades for Game Stop (and the other stocks that were popular amongst the Reddit crowd.. who were squeezing Hedge Fund short positions).
- This move by the DTCC caused nearly all Broker Dealers to limit trading of Game Stop in various ways. This part is bananas… some Broker Dealers (like WeBull) said they halted all trading in GameStop because they couldn’t fulfill sell orders… and some Broker Dealers (like Robin Hood and Interactive Brokers) said they could not fulfill buy orders. This was because the Clearing Houses… the DTCC (and it’s downstream partners.. that’s a whole other world we’ll just call the DTCC) would not allow it.
- COLOR NOTE: Interactive Brokers, the only other broker besides Robin Hood to only allow selling… is the preferred broker of algorithmic traders… these folks piggy back on buying (or selling) momentum. My guess is that a LOT of Game Stop buying orders were coming from Interactive Brokers along with Robin Hood.
- This tanked the stock prices of Game Stop because it could only be sold on some platforms, could not be traded on others, and was just a mess to try to trade on the rest. It halted the market in Game Stop and the Reddit preferred stocks.
PHEW. I tried my best.