Robinhood Got a Margin Call
The Internet, and the physical word for that matter, was abuzz on Thursday, as the popular trading app Robinhood among many others halted the execution of buy orders on certain meme stocks, such as $GME, $BB or $AMC. Although there has been much written about the rise of social media and it’s influence on the stock market (e.g. before and after), far less has been written about the core issue at play here.
This post tries to illuminate parts of the complex and obscure world that is financial regulation and how it apparently led to the events that unfolded last week. In particular, it will highlight the role of the National Securities Clearance Corporation, its risk assessment model and what the subprime mortgage crisis has to do with it. Buckle up, it’s gonna get technical.
How does trading actually work?
When you trade stock through an app like Robinhood, you enter a contractual obligation for exchanging a certain amount of certain equities for a certain amount of cash. Such transactions are most often handled by so called clearinghouses. Your broker-dealer Robinhood (in this case its subsidiary Robinhood Securities) is a member of a clearinghouse. This means when you buy stock of a company, it is handled through a clearinghouse, via your broker-dealer (this is known as multilateral clearing and settling)
The idea behind clearinghouses is a practical one: there are millions of transactions every day, with a multitude of parties involved. A clearinghouse acts as a central hub to all these transactions — it is easier, cheaper and more secure. You see, before such clearinghouses existed market participants had to manually send and receive physical certificates (i.e. stocks), cheques or cash, and all the other paperwork necessary to conduct a stock trade. This was turning more and more into an inefficient mess in the late 60s.
During this time, one such clearinghouse was established: the SEC regulated National Securities Clearance Corporation (NSCC), back in 1976. It is a subsidiary of the Depository Trust & Clearing Corporation (DTCC). In 2019, the DTCC collectively handled 654 million securities transactions with an astounding total volume of $2.15 quadrillion (a quadrillion is a number denoted by 10¹⁵, or a million billions). The NSCC is, among other things, tasked with the clearing, netting and settling of equities.
Clearing, Netting and Settlement
The NSCC usually clears and settles trades on a T+2 basis, which means that the stock trade is completed two days after its execution. The process of clearing can be thought of as bookkeeping between clearing members and the clearinghouse — it is determined if the parties agreed to the terms and have the necessary to-be-exchanged goods. After clearing, a trade is settled — this is the actual transaction of stocks for cash into the deposits of the parties.
To save time and money, something called netting was introduced, which happens right in between clearing and settling. As the name implies it is basically an aggregation of financial obligations to arrive at a lower net amount. For example: on day x, Robinhood clients buy 1.000 shares of company A, and sell 1.500 shares of the same company. This results in a net 500 shares that Robinhood must deliver through the clearinghouse (but they also receive the cash value of those 500 shares into their accounts). How does the NSCC handle this?
385 pages of horror
Enter the detailed Rules & Procedures (RP) of the NSCC. They act as a (legally required) guideline to its operations and thus for Robinhood, too. For the purpose of netting they have a system called Continuous Net Settlement (CNS), as outlined in Rule 11. It continuously clears, nets and settles obligations of its members by merging all transactions and carrying them forward, leaving behind only transactions that either failed on the settlement date or are not yet past their settlement date.
In order to secure financial stability the NSCC requires its members to maintain a deposit at the NSCC, e.g. in the form of cash — the so called Clearing Fund, as outlined in Rule 4. This fund is inter alia used to secure the obligations of a member to the NSCC, vital for the CNS process. To put it in a nutshell: it is the minimum necessary margin of a member to the NSCC. This basically means that Robinhood got a margin call on Thursday, one that they could not immediately satisfy. Now we are getting to the juicy bits: how to calculate the margin.
Law of Unintended Consequences
I mentioned earlier that the subprime mortgage crisis had a hand in this. Why? Because as a result of it the Dodd-Frank Act passed the House in a rare moment of bipartisan cooperation. The Dodd-Frank Act, named after two Senators, is a true mammoth of financial regulation. In it, you find Title VIII, commonly referred to as the Payment, Clearing, and Settlement Supervision Act of 2010 (Clearing Supervision Act). Sec.802(a)(2) talks about how clearinghouses (multilateral payment, clearing or settlement activities) may reduce risk for its members and the broader financial system, but may also create and concentrate new risks.
To prevent such risks, Congress finds in sec.802(a)(4) that certain enhancements in the rules and regulation of such systems must be implemented, in order to support the broader financial system, reduce systemic risks and promote robust risk management. And oh boy did the NSCC do that. They have devised a seemingly safe and sound procedure on how to calculate a member’s margin. Which in the case of Robinhood produced the exact opposite result (yes, the irony).
Such events are known as unintended consequences in the realm of social sciences, more specifically an unexpected drawback. The goal of the Clearing Supervision Act was to increase financial stability of the market, which it surely did. But as a result, smaller players such as Robinhood can encounter liquidity issues when faced with high volatility that in turn ultimately led to massive downward pressure on certain stocks, which then incurred significant losses to many investors. But why did the increased volatility lead to a margin call for Robinhood?
Value at Risk
The NSCC utilises a comprehensive formula to calculate a member’s required margin. It is detailed in Procedure XV of the RP. In total it almost spans seven full pages, because it‘s, needless to say, described in words instead of mathematical expressions. Since this is only a blog post, I will not go into full berserk mode, but rather emphasize various central components. One of them is the value at risk model (VaR-model), which is the main volatility factor of the Clearing Fund formula.
A VaR-model is an estimation of how much an investment might lose, given a certain probability in a given time frame. The NSCC calculates the volatility through a multistep process, where the base for its calculations are the Net Unsettled Positions (positions that have not yet passed their settlement date + positions that failed on settlement date). This makes sense, because the rest has already been successfully netted. We can start to see where it gets sticky here. Imagine: you have a T+2 system, and all of a sudden certain stocks experience enormous volatility within that time frame. This in turn increases the required margin of a member. Why?
The NSCC uses a volatility estimation (backtested at least daily) where no less than two standard deviations shall be calculated, which means that it intends to capture at least 95.45% of a normally distributed set of values, in our case the market price risk. They have two ways to reach that, where the higher estimation of the two shall be the Core Parametric Estimation: either through an exponentially-weighted moving average (EWMA) model, or an evenly-weighted volatility model. Both estimate volatility based on historical data. The main difference between the two is that the EWMA-model gives more weight to recent volatility changes, whereas the evenly-weighted model takes longer periods of time into account. A rapid change in volatility has more impact on the evenly-weigthed model, because historically volatility in equity markets rapidly revert to pre-volatile levels (see p. 9).
Intransparency as a Risk Management Issue
From what we can gather in their blogpost, Robinhood had to increase their margin ten-fold. To mitigate liquidity issues they decided to halt the buying of all the meme stocks. Why? It’s simple, really. We learned that the CNS systems nets all positions by aggregating and merging. When they have more buy orders than sell orders, it increases their obligations to the NSCC and thus the required margin. Vice versa, if they have more sell orders than buy orders, it decreases their required margin. Robinhood decided to defer risk to its customers before potentially becoming insolvent.
Although it may look pretty straightforward, it is in fact quite intransparent. For example, the NSCC does not tell us how many days the look-back period in the evenly-weighted model is (at least 253 days). It also does not tell us the necessary decay factor in the EMWA-model (less than 1). There is also something called the concentration threshold (if e.g. more than 30% of Robinhoods portfolio consists of $GME) that can kick in, which also has severe impacts on the required margin. But the NSCC does not tell us the exact number of the necessary multiplier to reach its final value (not less than 10%).
They also don’t tell us how many times the margin is calculated (just at least daily, but they have discretion to backtest intra-day). The co-CEO of Robinhood, Vladimir Tenev, recently said in an interview with Elon Musk on Clubhouse that they can only try to reverse engineer their required margin. This presents a serious risk management issue for companies like Robinhood, because they do not have massive amounts of cash or credit lines that behemoths of a Goldman Sachs or Charles Schwab calibre have.
What does it all mean?
As of today, Robinhood has raised another $3.4b in cash from investors. It could also delay its IPO, which was planned for May this year. Vladimir Tenev is expected to testify before the House Financial Services Commitee in its investigation into the $GME turmoil, in mid-february. Although the now infamous subreddit r/wallstreetbets is furious with Robinhood, downloads for the app are at an all time high.
As always, prediciting the future is an inherently uncertain business. Will the House conclude that Wall Street needs more regulation, or less? Will they find that smaller players like Robinhood should have more room for entering a competetive market, or not? Will the SEC fine Robinhood for possible violations for burdening its customers with more market risk, or will Robinhood be successfully sued? Time will tell.
What I do believe is that Robinhood was stuck between a rock and a hard place. We people are always quick to vilify certain actions without a real understanding of the mechanics and motivations behind it. More often than not we are wrong. It is now up to all three branches of the US government (executive, judicial and legislative) to decide the fate of Robinhood and us retail investors.
About the author: Timo Leiter holds a degree in business administration from the University of Liechtenstein, is about to finish law school at the University of Vienna and also pursues a degree in philosophy at the same university. You can contact him via twitter.
