On February 4th, 2021, the Securities and Exchange Commission called for a “robust public discussion” about whether online brokers’ late January suspensions of retail trading should lead to changes in the market infrastructure. In the view of attorneys for the aggrieved retail traders, there will be a lot for the SEC to consider. More than 50 lawsuits have been filed as of today, creating another form of discussion. Our blog series on the potential infrastructure changes continues with a few of the likely discussion topics.
A large class-action lawsuit has cited, as evidence of an anti-trust conspiracy, the alleged wave of selling by hedge funds and institutions in the overnight markets of January 27th, 2021. Plaintiffs allege that the hedge funds, their brokers and the institutional investors conspired to prevent further increases in the prices for the contested issues, which would have deepened their already-substantial losses.
"As the markets opened on January 28, 2021, Retail Investors woke up to find that the Brokerage Defendants and other unnamed brokerages had suddenly and without notice restricted their ability to buy long positions in the Relevant Securities. Pursuant to the anticompetitive scheme, the Brokerage Defendants implemented these changes on or about the same time. It would not have been in their economic interest to do so, but for the illegal conspiracy."
Antitrust lawyers will debate the “but for” scenario, presented by plaintiffs as an alternative to the allegedly anticompetitive world rigged by the alleged co-conspirators. It will be no surprise if the central questions from the defense in these lawsuits become such as: Why would it NOT have been in the “economic interest” of Wall Street to shut down trading in the disputed issues? The risk of a brokers' failing to meet minimum capital charges, i.e., insolvency, is as much to the customers' interest, as it is to the broker. Minimally, there is the burden of contentious legal matters after the failure of a regulated financial institution. Certainly, it will be argued that risk management is more important to everyone than order flow. The clearing system can be shown to run extremely well... and usually has. Still, and more to the point, what would have happened to the market if the online brokers had un-economically allowed retail trading to continue toward an implosion? In the 'but for' world, would that degree of “price discovery” have been rational economics for the customers or their brokers, from a risk capital standpoint?
Perhaps the SEC’s report on the 1987 Crash can help shed light on the answer to the issue of relative economic interests in volatile markets:
“[D]uring periods of increased economic uncertainty it is not surprising that increased volatility occurs. Nevertheless, when price swings reach extreme levels, they can have a number of adverse consequences. First, such volatility increases market making risks and requires market intermediaries to charge more for their liquidity services, thereby reducing the liquidity of the market as a whole. Second, if such volatility persists, securities firms are less able to use their available capital efficiently because of the need to reserve a larger percentage of cash-equivalent investments in order to reassure lenders and regulators. Third, greater volatility can reduce investor confidence in investing in stocks." (SEC, The October 1987 Market Break, February 1988, p.xii)
Today's infrastructure debate began when Alan Greenspan's Fed stepped in as Lender of Last Resort for the first time during the 1987 crisis. As the backstop to the financing markets, the Federal Reserve used its power to reform the infrastructure. For example, new regulations required circuit breakers to suspend trading when volume and volatility were so high as to impair confidence in the market itself. At the time, Professor Ben Bernanke at Princeton was studying the crisis and publishing his insights into infrastructure liquidities at central banks, concepts that he would later use to great effect in his own Fed chairmanship.
Having studied their own lessons of 1987, brokerage risk managers and other market professionals in 2021 were on high alert for potential capital market lockdowns in the face of such volatility. Robinhood Securities' chief operating officer wrote on February 4th describing the situation that his firm faced on January 27th and the actions that his firm took to deal with the crisis:
"To say the overnight increases in volume Robinhood experienced last week were extraordinarily high would be a vast understatement. The surge was magnitudes higher than the norm. By applying the lessons of last year and making system-wide improvements over the course of 2020, Robinhood remained operational through unprecedented volumes. However, the scaling challenge Robinhood encountered last week, as we have described extensively, came in another area. When clearinghouses raised their deposit requirements based on the volume and volatility of trading, Robinhood Securities had to put temporary restrictions in place on certain securities. That’s why we are now starting a conversation about real-time settlement to steward our industry into the future, and most of all to meet customer demand."
Within days, the Depository Trust and Clearing Corporation posted a statement that responded to the SEC’s call for a robust public debate. Among other barriers to Robinhood’s call for real-time gross settlement, wrote DTCC, is the fact that, "T+0 does not allow for predictive financing, so clients would likely not know their financing needs for a given day until trading has stopped. Securing end-of-day funds, or determining intraday investment amounts, could be difficult and costly.” The stock market cannot function without the equity financing markets, which have practical limits to compression.
The Securities Industry is continuing a thoughtful period of debate about the resilience of the current equity financing system in relation to future challenges and possibilities. Repo funding and securities lending markets may have to undergo “difficult and costly" changes in procedures and technologies to conform to accelerated settlement dates. At some early point, this emerging infrastructure debate will merge into the parallel debates over the demands of cyber securities/currencies and the potential for distributed ledger technologies. The last paragraph in the statement announcing DTCC's push toward T+1 says it all:
"Equity clearing and settlement is part of a much larger ecosystem of linked financial markets. Accelerating the settlement cycle would have upstream and downstream impacts on other parts of the market structure, including derivatives, securities lending, cash borrowing, foreign exchange and collateral processing, and developing a new accelerated settlement system could fundamentally change current market structure. In order to move to T+1, industry participants must align and implement the necessary operational and business changes, and regulators must be engaged."