Thursday, March 11, 2021
The trading suspensions set by online brokers in late January 2021 reminded many industry veterans of the systemic circuit breakers that were first deployed during the Black Monday crash of October 1987. In both instances, a loose band of derivatives traders was prevented by the capital rules of the equity clearing and settlement system from continuing to crush exposed short sellers and risk a systemwide collapse. Then and now, changes to the infrastructure were front of mind for regulators when the chaos subsided. This blog series will discuss the issues and present ideas from experts as to possible solutions for improvements to risk management in the current market system.
Dealer Linkages and Risk-weighted Capital Requirements
On Black Monday, 1987, options traders in S&P 500 stock index futures helped to precipitate a 22% one-day plunge in the corresponding stock market indices. Even the rudimentary capital rules at the time were enough to trigger intraday trading suspensions.
Three decades of capital rule changes to consider market risks were invoked when, in January 2021, retail options traders purchased out-of-the-money call options for individual stocks in GameStop (GME) and other volatile issues. Rising prices forced the dealers to acquire the underlying equities as a hedge. Just as in 1987, the options traders’ goal was to manipulate prices for the stocks by leveraging their relative liquidity and leverage advantages. And it worked again.
As prices for the contested stocks rose, along with their volatility metrics, the increasing risk-capital requirements on dealers threatened their balance sheets. At the same time, managers of large institutional portfolios started to rebalance by selling their bloated GME positions. However, any downward pressure on price, as would normally result from managers’ sales, seems to have been more than offset by increasing demand from the short sellers’ prime brokers.
On the morning after the worst of the market turbulence, lending agents sent recall notices to the prime brokers, asking for borrowed GME positions to be returned, so that asset managers could prepare to deliver their shares for payment at the clearing house. The risk capital dynamics resulted in a scramble to borrow elsewhere so as to avoid closeouts and buy-ins, but those efforts went mostly for naught.
The shares in play became very costly to borrow, so the carrying costs for the traders as well as the dealers rose along with their risk-capital charges. The brokers’ purchases had the knock-on effect of further squeezing the GME short sellers and forcing buy-ins to close out their positions. Stock prices skyrocketed. Meanwhile, the online brokers seem to have been almost entirely on the buy-side of the trade, which resulted in vastly higher deposit requirements in advance of settlement at the clearing houses.
At that point, margin calls went out from the online brokers and the clearing houses. Suspensions on new purchases were imposed until the trades could be cleared. Ironically, even though their strategy worked, the options traders were being trumped by the capital rules of their own equity finance managers, who manage the limits on agreed risks for brokers as clearing members. It is never a fair contest when the auditors get involved. Game over.
Calls for Reform of the Clearing System
As a result of the trading suspensions by online brokers, regulators and operations managers alike are calling for a review of the market infrastructure. Whereas in 1987 the derivatives traders worked in Wall Street banks, the new retail Reddit crowds are working from home. Markets are volatile but the system is functioning well, practitioners believe. Still, the clearing system infrastructure, widely praised for steering away from disasters, is now being attacked by some as if it were an anti-competitive platform.
Many lawsuits have been filed against the brokers. In time, defendants will no doubt respond that these are disputatious cases being supported weakly by naive academic theories. However, the regulators are paying attention. The defense attorneys will have to educate the courts on the nuances and importance of risk capital efficiency in markets and firms, as well as traders.
On February 4, 2021, a statement appeared on the SEC website which read, in part:
"The Commission is closely monitoring and evaluating the extreme price volatility of certain stocks’ trading prices over the past several days. Our core market infrastructure has proven resilient under the weight of this week’s extraordinary trading volumes. Nevertheless, extreme stock price volatility has the potential to expose investors to rapid and severe losses and undermine market confidence. … The Commission will closely review actions taken by regulated entities that may disadvantage investors or otherwise unduly inhibit their ability to trade certain securities. In addition, we will act to protect retail investors when the facts demonstrate abusive or manipulative trading activity that is prohibited by the federal securities laws."