It's never a good idea to get caught exposing yourself in public

A brief lesson in counterparty risk

What happens when the line goes up? Or down. Doesn’t matter. But quite lot, in any case, happens under the hood and whether that’s good or bad depends upon which balance sheet you’re looking at. Here’s a quick explainer in counterparty exposure and risk management. This is boring shit, but it matters quite a lot in understanding all of this mall stocks madness. This is very general, and will probably annoy some quant guy as I make some errors on the specifics, but the broad strokes hold and that’s all we need here. My intended audience are regular people who read my shitposts on Twitter, and say to themselves:

“Sir, you had my attention. But, now you have my interest.”

These are mostly good people who want, nay yearn, to understand why a retail trading platform might be forced to suspend trades, even if there’s no shady business going on.

When you enter into a trade with a brokerage to purchase a stock you establish a financial relationship between yourself and the brokerage. You’ve also established an indirect relationship between yourself and the bank that settles the broker’s accounts. The direct relationship looks like this:

When you buy a stock it takes a few days for that transaction to settle. Until it settles that transaction is the same as an open credit - debt relationship that is subject to counterparty default risk. It takes time for money to move through clearing and payments systems, but the value of that transaction is changing along the way. The money you agree to part with in exchange for the security and its value are the same, but there is settlement risk so long as this transaction remains open. The uncertainty around what the risk means in terms of costs to the brokerage firm or its settlement bank may be considerable and difficult to quantify, so there are institutional methods for managing risk, which are legally structured through contracts and regulatory practices.

In terms of our relationship above, the first risk management tool is to require maintenance of settled funds to cover the value of your trades. To buy that stonk you you must do so with settled funds or on margin - if you have a margin account with marginable securities. Think of a margin account as a very short term line of credit. In the simplest case where a person buys a single stock with funds already settled and then walks away, this is a pretty low counterparty risk affair.

Now, recall it takes a few days to settle funds. Imagine this person is buying many stocks, each in different quantities at different prices, and maybe selling some stocks to raise cash to buy others, and so on. Every single transaction has it’s own notional value, (the # of stocks times the price of the stock), which must be covered by settled funds or margin to ensure that it offsets some of this counterparty risk. This is all quite common and this is still a pretty low risk affair, due to those counterparty risk controls.

Now, imagine you’re running a firm and you don’t really require individual investors to maintain a balance of settled funds (or margin) to execute intraday trades. And you allow for instant fund transfers into your app that acts as if your funds are settled (they are not). And then volumes in single stock trades with notional values in the billions emerge during this period of time in which there many transactions not covered by settlement funds. What then? This is very bad from a institutional counterparty risk management perspective.

The brokerage and its bank (or near equivalent) must also manage counterparty risk. Such an arrangement will be governed by legally enforceable documents that specify the nature of their risk management controls. If I am the creditor to the brokerage and notice that a huge part of its balance sheet is exposed to a narrow set of securities not covered by sufficient marginable accounts or settled funds, then I’m going to simply flip the fuck out and I’m going to call an emergency meeting with the front office and the Chief Risk Officer and initiate some protocols. At the minimum, I am highly unlikely to extend them further credit to float the risk that it chose to shoulder rather then make its customers bear. This is going to be a shitty meeting to have because everyone in the room knows this potential existed, but they assigned a low probability weight to its occurrence and allowed it anyway.

As the brokerage, having now exhausted my line of credit with the bank, I have no choice but to stop engaging in the very trades that blew out my settlement exposure to the bank. And in some cases I might have to liquidate the positions of my customers. The extent to which I act to remain solvent minute by minute depends upon what’s going on in the market. Extraordinary market events will make me do extraordinary risk management things.

This is basically what happened with the zero fee trading apps this week. It’s a tough spot to be in, because the platform depends upon having a lot of users that don’t want to wait to trade or can’t carry a settlement balance, or any of those combinations, so that it can sell order flow data to institutional investors so they can more efficiently find the greater fool.

So what now? Well, I think we’re gonna see some investigations and maybe some regulatory reform over retail trading risk controls, and that’s going to anger a lot people who think this was the key to democratizing the market. I don’t have a broader take than that. But, stay tuned for more on what I think about democracy and markets.