Now and then, an extreme event occurs that provides a glimpse of the plumbing of the financial system. But, alas, after the media attention passes, everyone goes back to "business as usual" and forgets the plumbing. However, these small technical details, which tend to be ignored when talking about capital markets, affect us in elusive ways that are difficult to identify. 

In this post, we'll dive into and try to understand the controversy surrounding securities clearing on the US stock market.

I promise - it's not as boring as it might sound.

This controversy surfaced very recently, in early February 2021, after private investors assembled on Reddit decided to buy (read: pump) specific stocks (the most famous of which is GameStop) to fight the elite, short-sellers, the "establishment", and common sense.

At the height of the drama, when hundreds of thousands of investors used their trading apps to send buy orders for a small group of stocks, several retail brokers, led by Robinhood, began blocking people from buying these stocks on their apps.

The public was furious at this move and accused Robinhood of joining the dark side and changing the rules to serve the elite at the expense of retail traders.

That, of course, was not the real story, and Robinhood's inability to respond in real-time and explain the problem to customers was a first-rate PR crisis.

The problem was, quite simply, a blockage in the pipes.

Trading in shares on the US stock exchange uses what's called a "T+2 Clearing".

The meaning of this is that when a transaction is "closed" (at time T), its clearing (i.e., the transfer of shares for money) will only take place in two days (T+2).

This structure created severe liquidity problems for retail brokers, leading them to restrict their clients' trading, and in the case of Robinhood, to urgently raise capital from its investors.

Let's review the current clearing structure, the problem it has created for Robinhood (and may later for other brokers) and try to understand the barriers to faster clearing. As you'll soon realize, "real-time" clearing can do more damage to the capital markets...

We will illustrate the current set of rules (clearing T+2) using the following example:

1. Broker A sells Broker B a share of XYZ company for $100
2. The deal was made on a Sunday.

So far, nothing has happened.

Each of the brokers has until Tuesday at 10 a.m. to take care of completing their part of the deal. Broker B needs to raise $100, and Broker A needs to find an XYZ share that it is not obligated to sell. Come Tuesday, the actual clearing will occur, meaning one share and $100 will change hands.

If this method sounds to you like a historical remnant of systems developed somewhere in the 1960s, consider that it was only 4 years ago that the DTCC (the largest post-trade financial services company in the US, providing clearing and settlement services) proudly announced a technological advancement that led to stock clearance being completed in two days instead of three days (T+3) as was customary until then.

As it turns out, T+2 clearing is a pretty innovative concept for stocks.

Remember that stock exchange clearing houses' utmost vital interest is to ensure that transactions are carried out with absolute certainty. If you sell a stock and two days later receive a message that the money has not been transferred and the transaction has not been executed, the capital market will not enjoy a high level of reliability.

In a world where a deal clears after signing it, there is always a risk that one party will try to bail out the deal if the market didn't move in the direction they expected it to.

For example, people who bought stocks whose prices have subsequently plummeted may "run away with the money" to avoid completing the transaction.

The clearing house ensures the execution of transactions by requiring collateral for all positions from its members (banks, investment houses, and brokers - including Robinhood). If they reach insolvency before the transaction clears - the collateral is used to make sure the deal goes through.

As long as stock trading volume is relatively high, the amount of money that changes hands between the various brokers is only a tiny fraction of this activity.

On a typical day in 2020, $1.77 trillion worth of transactions occurred on US stock exchanges. In reality, only about 2% of this amount ($37.7 billion) actually changed hands between the various players (brokers, banks, etc.).

This is the great advantage of delayed clearing.

The clearing mechanism constantly examines the amounts of money that need to change hands and offsets it by charging brokers the required collateral.

Thus, if a broker's client sends $5 million worth of BUY orders and $4 million worth of SELL orders during a trading day, her total trading turnover is $9 million. However, the broker's collateral needs to transfer the clearing house for that client is only $1 million.

The practical result in today's trading is that the net amount that brokers transfer is orders of magnitude smaller than what it theoretically should be. As a result, the required collateral that they have to deposit is very small relative to the level of trading turnover.

Unfortunately, the GameStop craze has led many retail traders, using very specific brokers (read: Robinhood), to send many BUY orders for a handful of small stocks. Most Robinhood customers wanted to buy. Only a few wanted to sell.

As a result, the clearing house's collateral requirement from brokers like Robinhood skyrocketed. As the trading volume of these stocks increased, so did the total collateral that Robinhood had to deposit in the clearing house to ensure execution.

Robinhood found out that they are now required to deposit a lot of money in the clearing house as collateral in order to be able to allow its customers to trade these stocks.

When a Robinhood customer buys stocks during a trading day, they immediately appear in her account. When she sells stocks, the money appears immediately and is available for further stock purchases. This is what's known as a margin account.

But as we just learned, from the moment the deal is made, it will take two more days for the money or shares to land in Robinhood's account. The implication is that, technically, Robinhood is actually lending its users either money or stocks.

What's worse is that the clearing houses' demand for more collateral came when Robinhood's money was actually with their customers - posing Robinhood with liquidity risk.

The chaos of late February led to a hearing in the United States Legislature. Robinhood's CEO accused the clearing method, T+2, of being responsible for the mess. The theme was that it creates liquidity risk that can be resolved by moving to a faster, and preferably immediate, clearing of transactions.

He suggested that when a client enters a transaction, the money or shares should be transferred immediately - eliminating the need for collateral by the clearing house or fear of a liquidity crisis among the brokers.

Not so fast...

A White Paper recently published by the DTCC claims that with a lot of effort, US stock clearing can improve to T+1 by the end of 2023.

What about immediate clearing? Well, the clearing house warns that shortening the clearing time solves one problem (eliminating the collateral requirement) while, at the same time, causing other, even worse problems.

The first problem with immediate clearing is that we lose the big advantage mentioned earlier - the ability to offset the transaction amounts and reach a clearing amount two orders of magnitude smaller.

Reducing clearing to T+1 or T+0 (clearing at the end of the day) will not hinder that advantage, but real-time clearing will. It will not offset trading turnover using collateral, which will require brokers to clear a massive turnover of funds.

If on a "busy" clearing day, 80 billion dollars changes hands (after offsetting), then immediate clearing will require them to transfer trillions of dollars. The potential for failure due to the lack of money in the broker's account becomes greater.

Furthermore, Robinhood would have had to ensure that they have a lot more available cash with immediate clearing. Every time their customer bought a GameStop stock, that cash would have been subtracted from their account.

Shorter clearing (T+1, or T+0) might have solved the problem, but immediate clearing could have exacerbated it.

The second problem is that the vast majority of trading turnover does not come from retail customers but rather from large institutions. 

T+2 clearing as a tool allows them to manage their risk more effectively, resulting in more efficient capital markets. Switching to immediate clearing could hurt the efficiency of the capital markets and the performance of investors.

Take, for example, a Market Maker on one of the stock exchanges. Generally speaking, market makers stand ready to buy and sell high-volume stocks at any given moment. A very large percentage of trades are done with a market maker as the second party in the transaction.

On a typical trading day, the market maker buys and sells a very large amount of shares, with its profit being the spread (the price difference at a given moment between the bid and the ask). The smaller this spread, the more efficient the market is, as it allows all participants to buy and sell high-volume stocks at a similar price without paying expensive "brokerage fees".

At the end of a typical trading day, a similar amount of stocks are being bought and sold. In our example, the market maker bought 2 million and sold 1.9 million shares of XYZ. At the time of clearing, the market maker will have to transfer funds to purchase only 100,000 shares, which they will pay for by liquidating assets in their possession or by taking out a short-term loan.

If the clearing were to take place in real-time, the market maker would have to hold a large "stock" of stocks to meet its obligation to buy and sell shares at any time, which would expose them to market risk, as well as large cash balances, on which they lose potential return.

To compensate for this, market makers would require much higher margins - and market efficiency would suffer.

As another example, let's consider a foreign investor who trades in shares on the US stock exchanges, like, pretty much, any pension fund in the world. This pension fund is not interested in holding large amounts of dollars because it (2) pays your pension in local currency and (b) is interested in reducing foreign exchange risk.

Because clearing is currently T+2, the fund can buy and sell shares in the US, plan future dollar payments in two days, and execute spot transactions to purchase foreign currency (a transaction whose clearing time, too, is T+2).

A shorter, or even immediate, clearing would require this pension fund to hold a large dollar position to allow it to make occasional purchases of US stocks. These dollars would sit idle in a bank account, hurting your pension's return.

One could hope that, in the future, we'll have a real-time clearing system that would allow the buying and selling of shares instantly, without compromising market efficiency, and without requiring brokers and institutions to hold mountains of cash in their bank accounts. 

However, such as system would require to change of the financial system as a whole. The good news is that it is possible and likely to occur but will probably take a long time.

Going back to Robinhood's CEO's call for immediate clearing - he's essentially asking for a better faucet by replacing the country's entire plumbing.

To grant his request will require a fundamental change to the way the financial world operates. Following up with our plumbing analogy, it's safe to assume that a lot of water will flow through the pipes before the US stock market moves to immediate stock clearance.

This post was translated, with permission from the "Marginal Benefit" blog by Itai Ci (Hebrew).