The elephant in the room is GameStop (GME) today. The House Financial Services Committee will be holding a hearing today at noon (EST) to discuss the events surrounding GME’s stunning rise and fall in late January. Like many in our industry, I expect to be riveted by the hearing. Also like many, I hope that the questions will be focused more upon crafting intelligent regulation rather than assigning blame and airing grievances. There should be no shortage of interesting facts and opinions offered, but by failing to invite anyone from DTCC, I fear that they will miss hearing from perhaps the most important, but unsung actor in the drama. The financial sector as a whole may have been threatened when the clearing houses came under stress. I would certainly like more clarity on that topic.
Here are some quick thoughts of mine on topics that are likely to be raised:
Shorting – It is a legal, ethical and a necessary feature of markets. That said, the stock lending process behind it is one of the few remaining truly opaque areas of modern markets. Stock lending is still largely a negotiated process between two brokers. Borrow and lending rates are privately negotiated and can differ widely between counterparties. This is analogous to over-the-counter stock trading in the pre-NASDAQ days, except that NASDAQ became a largely transparent marketplace decades ago.
Short interest is reported by the exchanges only twice a month, and even then it is on a lag. Exchanges and/or clearinghouses have to have that information in either real time or at least after shares settle two business days later (T+2). Also, clearing brokers don’t know if the shares they receive have been sold long or short. That means that shares can be re-lent multiple times, allowing short interest to potentially exceed the available float (this occurred in GME). I am told that it would be staggeringly difficult to flag shares as long or borrowed, but releasing short data on a daily basis would be an easy fix. See here for more.
Speculation – A recent Yahoo Finance-Harris poll showed 28% of investors bought GME or another viral stock during January. That is a stunning statistic. We have seen great strides in the democratization of the markets, which is a very good thing overall. I think it benefits both markets and individuals when they have the tools and the knowledge to take ownership of their finances. But that benefit is much more sustainable when it is in the context of investing, not pure speculation. This is a worrisome sign of excess speculation
Clearing and Systemic Risk – I hope that we will have an opportunity to learn more about how the clearing process was affected by and a key player in the events surrounding GME; but as I noted earlier, I am dismayed that no one from a clearinghouse will be present. This is a missed opportunity, since it would be important for the public to understand that the freezes that came in GME and related stocks were about clearing, not helping hedge funds.
The Dodd-Frank Act and the Financial Stability Oversight Council has designated the major US clearinghouses as Systemically Important Financial Market Utilities (SIFMU’s). That means that any risk to clearinghouses are by definition systemic risks. For both their own sake and that of the whole financial system, the clearinghouses have to protect their risk profile. To facilitate their own risk management, they can and do raise margins and haircuts on a stock by stock or firm by firm basis. The concentration of buying in GME and related stocks and derivatives that were having 100% intraday moves was threatening their health, and it meant that they needed to pull the plug on new GME exposure.
Risk flows up the financial stream. If a customer can’t meet his obligations, the broker must meet them on his behalf. If a broker can’t meet its obligations because too many customers can’t meet theirs, then the clearinghouse must meet them on the broker’s behalf. This is where it becomes a systemic risk. If a clearinghouse needs more capital, it calls on its member firms to supply it. A broker may be doing a solid job of managing its own risks, but may not be prepared to meet the incremental risk of facilitating a clearinghouse’s shortfall that arose from a less responsible member’s failure. That could lead to cascading failures and threaten a major SIFMU.
We may have been quite close to a systemic failure. The most crucial questions that can be raised at today’s hearing are “how close were we” and “what can we do to avoid a similar potential calamity”? I fear that those questions will need to be asked again at a later date in a different setting.
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