Why Understanding Financial Services “Plumbing” Isn’t an Afterthought-Yes, GameStop and Robinhood will change things
For those of you who are not involved closely with finance I have a spoiler alert, finance isn’t nearly as complicated as you have been made to think. In fact, almost all financial transactions can be broken down into one simple concept — risk. Financial transactions are by and large about the quantification and transference of risk. That’s it. When you take out a loan for a house what exactly are you doing? You are transferring to a lender the risk that you may fail to pay. The lender will quantify the risk and charge you an interest rate that reflects the risk. That’s it. End of story.
Much of the hand ringing over Robinhood’s activities around Gamestop can be seen in terms of the same thing — a quantification and transference of risk. But this transference of risk is a little less understood, maybe because the process is one that is relegated to the “back office.”
If a brokerage firm back-office seems like the most unsexy place possible, then by comparison clearing houses make them look like Rockstar's. That is, until the latest installment of the Robinhood saga, in which everyone was startled to find out that there is a lot more to brokerage firms than what is portrayed in the media. The “plumbing” of the financial services industry (the means by which the risk is transferred) has always been considered boring and not worth understanding, except for those that realize why understanding how all of the parts fit together presents some spectacular opportunities to avoid pitfalls like the Robinhood situation.
That Robinhood app on your phone is just the start of a complex and age-old system devised when paper stock certificates were exchanged. The clearing house for almost all securities in the US, the Depository Trust Clearing Corporation (DTCC), is charged with facilitating the “settlement” of all of these transactions. Settlement is the process of securities moving from the buyer to the seller. However, as anyone who has sold a stock and tried to take the funds out immediately has found, this is a two day process, known as T+2 (trade date plus 2 days).
During these two days the DTCC has exposure (risk) to the price movement in the market, as a stock price could swing up or down, sometimes quite dramatically (GameStop anyone?). If the stock or the funds used to pay for the stock are not delivered by settlement date, there could be significant risk to the clearing house, because they would need to go into the market to complete the trade. This potential market exposure could require the clearing house to cover the cost of price changes during this period in cases where they have to go into the marketplace to facilitate the settlement.
To mitigate this market risk during the settlement period, the DTCC charges brokers a “deposit” that accounts for the probable price swing of a security. This can be thought of as the risk that the clearing house assumes. The clearing house wants to transfer this risk, of course, but step one in the two step process is to quantify the risk. This process of risk quantification is often completed through a formula known as the value at risk (VaR) which is used to measure portfolio market risk. When a security is significantly more volatile, say like having 1,000% swings, the VaR, as calculated by the clearing house, may incur a “multiplier” that would require the brokerage firm to post an even larger deposit. Because this deposit is calculated on a “portfolio” basis of all securities traded on a specific day, the buys and sells can act as a “balance” to help to reduce the required deposit. However, when there are a significant number of trades, all in a one direction, the imbalance can cause significant deposit requirements. And keep in mind that the deposit has to cover the price shifts for two days while clearing and settling the trade.
Lets take a look at how this might play out. Say a firm has roughly a 50/50 split between buy and sell trades, and the trades are in similar types of low or medium volatility securities. In this case the required deposit will be rather minimal, maybe a few million dollars (yes, that’s VERY minimal in clearing deposit terms). However, if a firm has a large number of customers that are “momentum” traders — that is, they trade securities in which a lot of other trades are going on, usually with increased price volatility — then the buy/sell split may be heavily weighted, say 80/20.
With such a low portion of the “trade portfolio” buy/sell balanced, the deposit requirement is significantly increased to cover the potential excess market risk brought on by the imbalance. Thus, by encouraging, or allowing, only trades on the “other” side of the market (e.g. only sell orders when there is a large buy imbalance) the brokerage firm is reducing the firm’s Value at Risk and, in turn, the required deposit.
Oh, and about those deposits. They must be met in cash within a very short timeframe. And for firms with these large imbalances, the required deposits can easily run into the billions of dollars. Yes, that’s billions with a “B”. This is another reason why firms need to understand what type of behaviors they are incentivizing and the impact of those behaviors when they are successful — in some cases, very successful.
The VaR calculation itself is rather complicated, especially when you consider that it covers a portfolio of securities that have varying degrees of positive and negative correlation. The calculation takes into account historical observations of a security’s price movement and the probability and confidence of expected movements over the course of the settlement period. For securities or industries that exhibit anomalous behaviors, there may be “multipliers” applied to the VaR that significantly impact the required deposit.
Having had the opportunity to see this play out at a number of firms and having been hired to reverse-engineer the depository calculation, I can assure you that most firms understand the need to anticipate and plan for the deposit requirements.