DJ How Clearing Demands Helped Ground the WallStreetBets Stocks

By Telis Demos

When some online brokers including Robinhood Markets Inc. and Webull Financial LLC moved this week to restrict trading in GameStop Corp., AMC Entertainment Holdings Inc. and other stocks, fueled by Reddit's WallStreetBets forum, they did so in part because of obligations with clearinghouses that help ensure trading across the market isn't disrupted by defaults. Here's how it works.

What is a clearinghouse?

Consider the basics of trading: Buyers and sellers must agree on a price. The buyer then must pay the seller, and ownership must be formally transferred.

Enter clearinghouses. The clearinghouse collects and distributes payments and transfers ownership. So traders are free to focus just on price, and to take the best price in the market regardless of who is offering it. Neither side has to worry about the other's ability to pay.

For stocks in the U.S., the main clearinghouse is National Securities Clearing Corp., which is part of a larger clearing organization that operates in other markets, called Depository Trust & Clearing Corp.

How do they work?

Clearinghouses serve to mutualize risk. Members keep cash or collateral such as Treasury securities at the clearinghouse to cover their own activities and the obligations of other members should they fail. The clearinghouse might ask the members to post more of this money, often known as margin, if they are making riskier trades. The aim is to ensure that no individual member's failure causes the whole system to collapse.

How does the financial crisis figure in this?

In response to the 2008 collapse of broker-dealer Lehman Brothers Holdings Inc., lawmakers writing the Dodd-Frank Act sought to beef up supervision of clearinghouses and to push more trading into clearinghouses. The focus was primarily on so-called over-the-counter derivatives, like credit-default swaps, that didn't have a central marketplace. The reforms also affected some longstanding clearinghouses, including National Securities Clearing Corp., by designating them as systemically important financial market utilities, which subjected them to greater regulatory scrutiny.

Why would a clearinghouse have to increase requirements?

As noted earlier, margin requirements often rise with risk. A sharp rise in the price of any security raises the prospect that it will decline just as fast, potentially adding to the risk of those trading and holding as collateral these securities.

A challenge in the stock market is that settlement is not instant. The system allows two days after the day a trade happens until the shares and money must change hands, known as "T+2" settlement. Over those two days, the risk that a party might be unable to complete a trade can, in rare circumstances, change dramatically based on market conditions.

One such circumstance might be when the price of a security is extraordinarily volatile. In that case, the seller is exposed to increased risk that in the event of a failure of a buyer to pay up, the security they would be stuck still owning is worth dramatically less. The extraordinary volatility of a stock like GameStop would increase such a concern.

Another is the risk that a party suddenly owes an outsize amount of cash. In a normal market, any clearing member likely has a mostly balanced book of buys and sells, meaning they are both paying and receiving cash. And often many of their own customers' trades cancel each other, meaning they have no net obligation to the clearinghouse. But when a firm has a huge imbalance of buy orders, its obligation to pay cash skyrockets. This may have been the case this week, when there was much demand for just one or two stocks.

So who decides it's time to increase margin requirements?

How a clearinghouse judges these risks, and therefore when it makes demands for more upfront funds, is typically formulaic. Margins can be based on equations such as value-at-risk. Exactly how the formula works, and who is responsible for losses in what order, are important elements. In the case of National Securities Clearing Corp., losses would be covered by the defaulting member's funds before the clearinghouse's own funds or other members' funds would be used.

A broker like Robinhood would also have to make decisions about its own capital, and how much it was willing or able to tie up in settlement. A broker may face separate obligations for capital levels, like with the SEC. Other brokers also clear via another intermediary -- like Apex Clearing, through which WeBull clears -- that is a member. These intermediaries may have their own risk controls they apply to their clients.

Write to Telis Demos at telis.demos@wsj.com

(END) Dow Jones Newswires

January 29, 2021 19:33 ET (00:33 GMT)

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