Clearing Firms Caused Brokerages to Restrict Trading: Q&A With Larry Tabb

(Bloomberg) -- The rarely discussed role that clearing firms play in settling stock trades is at the heart of what caused Robinhood and other brokerages to restrict trading of some companies this week.

Larry Tabb, head of market-structure research at Bloomberg Intelligence, explains how the process works in a Q&A below.

Question: So what is the most important thing to understand here?

Tabb: The settlement process -- cash and securities officially change hands two days after a trade. During those two days, a lot of things can happen. The problem is, what happens when a trading counterparty and/or a firm cannot afford to pay for the securities they bought? If that occurred, and if the clearinghouse didn’t guarantee the other side of the trade, then the client would either not receive securities or not get paid, and the trade would have to be broken.

That is very bad. Not necessarily for a retail client buying 100 shares or so, but what if it was a big fund or a major player, like Robinhood or let’s say Lehman Brothers?

So if Lehman were to default (which it did) on all of its trades, then all of the folks on the other side of Lehman’s trades would send in their securities to Lehman, but wouldn’t get paid. Then the brokers who didn’t get paid wouldn’t be able to afford to pay for the securities that they bought. So you would have cascading failures.

So to ensure this doesn’t happen, they have clearinghouses. The clearinghouse takes the other side of the trade and guarantees settlement even if someone like Lehman goes bust. To do that, they have a waterfall of capital. First there is the securities in the client’s account (which support the broker and not the clearinghouse), then the margin provided by the broker , then there is capital provided by the clearing member, then there are IOUs by the big brokers to fund the clearinghouse, then there are central banks.

Question: Can you explain how high-flying stocks like GameStop and AMC make clearing firms require more margin collateral?

Tabb: So the amount of margin needed is determined by the riskiness of the securities that are bought. Most securities’ value stays pretty stable. However, given the volatility of these names and their overvalue, the problem is: Who knows what they are worth? And given that two-day lag, the clearinghouse can’t guarantee that the buyers will pay for their securities nor the sellers will come up with the securities to deliver.

Question: So if I’m a Robinhood customer, and I buy shares of GameStop or AMC or any of these wild Reddit stocks, what would prevent my counterparty from being able to deliver? I’m guessing if it’s a super-high short interest, the brokerage on the other side may struggle to find the stock to deliver?

Tabb: Yup. And the problem is, if I am a hedge fund and I am short GME at $30, I have to buy it back at $500 or pay some astronomical fee to borrow it.

Question: So firms like Citadel, which execute trades for brokerages like Robinhood, have nothing to do with this?

Tabb: No.

Question: So a clearing firm somewhere got concerned, and called Robinhood and said this has all gotten out of hand, we need more money in your account?

Tabb: So Depository Trust & Clearing Corp. -- actually National Securities Clearing Corp., which is owned by DTCC -- upped the capital that is needed to guarantee those trades. Now the broker can’t guarantee those trades with the clients’ cash -- a la MF Global -- the broker needs to pledge their own capital. And given the massive trading in GameStop, AMC, the amount of capital was really substantial. And Robinhood and a few others just didn’t have the capital. So Robinhood needed to borrow $1 billion to cover their clients’ settlement.

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