As many are still trying to wrap their heads around what is going on in Wall Street right now, the Twitter user @Compound248 has detailed in a thread that there’s a major plumbing issue on the financial system, and the Robinhood episode is just one of the many problems disrupting and clogging market operations. He elucidates that Robinhood was just the first but not the only brokerage firm to limit the purchase of GameStop stocks. Institutional prime brokers have also imposed restrictions on their hedge fund clients. In essence, the restrictions have affected retail just as well as institutional players.
That has happened because most brokerage clients and all hedge funds use margin accounts, instead of cash accounts. It’s a standard procedure in brokerage firms’ sign-up process to put new customers into margin accounts, which are Wall Street’s way of denoting lending accounts. In short, in margin accounts, the client does not own any securities, they essentially own a “promise” from their broker. So when a brokerage firm buys stocks, a lot happens behinds the scenes – inside the ugly plumbing of Wall Street. To simply put, since the buyer doesn’t know who the seller is, brokers for buyer and seller use a third company that might be OCC (Options Clearing Corporation) or DTCC (Depository Trust and Clearing Corporation) to match and “clear” stock transactions, moving title from selling broker to buying broker while making sure proceeds are moved on time.
Since hedge funds primarily own shares and not money, their performance is inverse to the share price movement, which means that they profit when the stock price declines and lose money when the stocks go up. On backstage, the prime brokers are the ones dealing with plumbing, so they need to find someone who actually owns the stocks with a clean title. The prime broker pays the brokerage firm a daily rate for the borrow and it charges its hedge fund client on a daily basis too.
Putting that into perspective, we have a brokerage firm margin client, namely a retail investor, that believes he owns the shares he bought, but he never actually did. The firm owns the shares, then lends them to a hedge fund prime broker in exchange for daily borrow fees, in that way, creating a debit/credit bond between the firm and the broker. So the prime broker takes those borrowed shares and re-lent them to its client, who sells them to a 4th party. Ultimately, both the firm’s client and the 4th party simultaneously “own” the same shares. But, in reality, the 4th party owns the actual shares that the firm client thinks he owns, while DTCC is observing and registering the ownership chain and ensuring cash from purchase and to sale flows through.
The main concern for DTCC is that someone in the middle of this chain hits a problem because if that occurs the problem will spread all the way up to the brokerage firm and down the chain to DTCC itself. And that’s where the plumbing metaphor fits. According to the user, “when you flush, a downstream clog causes a mess that backs up into your toilet. Don’t handle that clog well and you end up with a mess on your floor. Handle it poorly and you burst a pipe – wastewater seeps into your walls”. In simple words, everyone loses and the system enters in a chain reaction and starts to implode.
The online analyst points out that the GameStop situation is not about online investors vs. hedge funds any more. It is Hedge Fund vs. Hedge Fund. At this point, literally everyone – on the short side and on the long side – is already aware that knows that GameStop, AMC stocks, and all the others inside the lastest market narrative are all shorts, in the long-run.
What this highlights that the losses experienced could potentially trigger the bankruptcy of pretty much everyone inside the chain. “This is quantitative risk management death. You die and go to balance sheet hell,” the Twitter user notes. In sum, as risks are building for all parties involved, the current market rally may end not only in a crash but in the worst financial crisis in the entire U.S. history. And considering that there’s no end in sight for this battle, the consequences of it will be revealed in the fullness of time.