Why did brokers restrict trading in GameStop?
LAST week's unexpected price surge for stocks including GameStop, AMC and Koss prompted brokerages in the US to restrict trading for certain counters. Some brokerages in Singapore followed suit, sparking an outcry from a number of their users. The Business Times breaks down the story.
What happens when a trade is placed?
Brokers have to go through a middleman called a clearinghouse. Clearinghouses are financial institutions that act as intermediaries between buyers and sellers. They make sure that both parties are able to honour their contractual obligations when a trade is executed.
It takes two days for a trade to be fully settled, and there is a risk that upon settlement the broker won't be able to pay up for the shares that its client wanted to buy.
To manage this risk, the clearinghouse requires brokers to place security deposits for all trades. The more volatile the stock, the larger the deposit needed.
Robinhood, the popular US-based online brokerage, said last week that its clearinghouse-mandated deposit requirements related to equities rose tenfold.
The Depository Trust & Clearing Corporation, a major US clearinghouse, said industry-wide collateral requirements leapt to US$33.5 billion on Jan 28 from US$26 billion the day before.
Brokerages need to make sure they have enough capital to meet that obligation. In Robinhood's case, the startup drew down on credit lines and raised an additional US$3.4 billion from investors.
So is it just a liquidity issue for the brokers?
Not really. A sudden plunge in stock prices could lead to real losses for the brokerages.
Some clients engage in margin trading, which allows them to borrow money from the brokerage in order to buy more of the securities they already own.
In a hypothetical scenario, a client can buy 100 GameStop shares at US$300 per share by using US$15,000 of their own money and borrowing US$15,000 from the brokerage.
After GameStop's shares plunged from around US$300 at market-open on Feb 1 to US$90 at market-close on Feb 2, the above hypothetical client's portfolio is worth US$9,000 instead of US$30,000 - which means the client owes more than the value of the portfolio.
If the client is unable to top up the account, the brokerage could sell the 100 GameStop shares to recover US$9,000. But that still leaves it with US$6,000 in debt to collect - and that's just for one client. The risk could also be higher with options trading, which allows for greater leverage.
One way for brokerages to manage this risk is to raise the minimum deposit for clients. IG Group has said that existing positions in GameStop and AMC may be subject to margin changes at short notice.
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