The rise of the Reddit traders have made a lot of news recently. There seemed to be a titanic battle between wall street funds and retail investors over the fate of stocks such as GameStop. Wall street funds were betting that the stock price would go down, and Reddit traders were running up the stock price in retaliation.
At a critical point during this battle, brokerages seemingly cut off retail investors from buying certain stocks which essentially handed the big wall street funds the victory.
What Might Have Happened
To start off, the funds that were shorting stocks like Gamestop (GME) had already lost a bunch of money due to the increase in stock price. There’s been speculation that a market maker with a conflict of interest influenced various trading brokerages like Robinhood, and forced them to ban retail investors from buying more stocks such as GME in order to force the prices to drop.
It is possible that a large financial company who owns a brokerage may have invested in a wall street fund that suffered severe losses on GME short positions, and then use their influence to force brokerages to turn off trading on certain stocks to reduce losses.
We may never know what happened unless a full government investigation is performed, but the whole situation does seem a bit convenient and beneficial for the wall street funds.
However, there are also legitimate reasons why certain brokerages may have had to cut off trading on these meme stocks.
Clearinghouses, Brokerages, and Trading
In order to understand the legitimate reasons why certain brokerages turned off the taps on trading, we will need a better understanding of how the whole system is set up.
- Clearinghouses. A clearinghouse ensures that the person selling a stock gets the money and the person buying the stock gets the stock. They are essentially a trusted third party who ensures that the trade is executed as agreed to.
- Brokerages. A brokerage acts as a middleman who connects buyers and sellers to facilitate a transaction. Clearinghouses mandate that brokerages must have enough money on hand to ensure the integrity of the transaction. They need to have enough money to pay a seller or enough stock on hand to pay a buyer.
- Settling Trades. Trades are usually settled two business days after it is made. However, it’s much more efficient to allow the trade to execute instantly, and settle up the numbers later. This is what most brokerages do in order to offer convenience to the investors. However, this system comes with some risks. What happens if the buyer doesn’t end up paying the seller? What happens if the seller doesn’t deliver the stock to the buyer? In order to mitigate these risks, the clearinghouses require a certain amount of cash to be held in reserve by the brokerages in order to cover these non-payment events.
The amount of cash that a brokerage needs to have doesn’t stay constant. It can go up and down depending on how much risk they’re taking on, and clearinghouses can demand that a brokerage increase their cash reserves.
This is exactly what happened with brokerages such as Robinhood who limited trading of certain stocks. Due to the crazy price swings of certain stocks, there was a massive increase in risk and volatility that were centered around a few select stocks.
The clearinghouses responded to this volatility by demanding an increase in cash reserves for brokerages. The smaller and newer brokerages such as Robinhood did not have enough cash on hand, and had to limit trading around the volatile stocks as a result.
Some of these brokerages even took out loans and sold equity in their companies in order to meet the cash reserve requirements. This was the formal reason given by brokerages for limiting trading on stocks such as GameStop (GME).
It could be that brokerages really didn’t have enough cash reserves, or it could be that it was just an excuse to ban retail investors from running up the price of certain stocks so that wall street funds didn’t lose their bets. We will never know what truly happened.
We do want to say that brokerages make money with every trade so it is generally in their interest to allow trades to happen. Let’s just hope that this scenario where small retail investors are cut off from trading never happens again.