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I've been reading this page on the recent GameStop short squeeeze.

It mentions that at one point Robinhood and other brokers prevented their clients from purchasing shares of GameStop (GME):

On January 28, some brokerages, including Robinhood, halted the buying of GameStop and other securities, later citing their inability to post sufficient collateral at clearing houses to execute their clients' orders.

I don't understand why a purchase would require collateral. I understand why short-selling requires collateral, and I understand why options require collateral - in either case you could end up with obligations exceeding your initial investment.

However, if I give a broker cash money and ask for a share of a stock in return, why would this need anyone to have collateral?

Metamorphic
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    Most day-traders buy with margin, not with cash. Probably their App/backend didn't support to block only margin-buying (while allowing cash-buying), so they blocked all buying. – Aganju Feb 09 '21 at 09:35
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    @Aganju Moreover: Robinhood accounts are margin by default: "When you sign up for a new account, you’ll automatically start with a Robinhood Instant account, which is a margin account." – JimmyJames Feb 11 '21 at 16:47

4 Answers4

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However, if I give a broker cash money and ask for a share of a stock in return, why would this need anyone to have collateral?

The seller's broker needs to get paid by the buyer's broker. Because this is a legal obligation of the buyer's broker, the buyer's broker must use their own funds to settle this obligation. A broker cannot commingle their own funds with their customer's funds or use customer's funds to settle their own obligations.

So the buyer's broker must have collateral somewhere to ensure that there is money to pay the seller's broker for the stock. This is a legal obligation of the buyer's broker and is not the buyer's responsibility.

If you give your broker $10,000, the broker must store that in an account that only holds customer's funds. Then if you buy $5,000 worth of stock, your broker immediately incurs a legal obligation to deliver $5,000 to the seller's broker. To protect the seller's broker against any issues with your broker failing to settle that obligation, your broker has to have sufficient collateral of their own at a clearing house.

David Schwartz
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    In short, the answer is "because middle are the ones actually making the trade, not you" – TylerH Feb 10 '21 at 15:24
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    "A broker cannot commingle their own funds with their customer's funds or use customer's funds to settle their own obligations." Is this really true? If you deposit money at a bank, the bank can (and does, because it's the entire point of banking) loan that money to someone else to buy a house, car, etc. Can a brokerage not lend the cash or securities in customer's accounts at all? – Phil Frost Feb 10 '21 at 20:39
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    @PhilFrost A broker can indirectly lend customer funds so long as they can do it without commingling customer assets with broker assets and without using customer assets to settle their obligations. For example, they can hold customer funds in an interest-bearing account at a bank if that account only holds customer funds. Obviously, they have to store the customer funds somewhere. A broker can lend customer securities. – David Schwartz Feb 10 '21 at 21:00
  • Hm, so are you saying if I buy shares, the money I agreed to pay for that doesn't become the broker's money until after settlement? That's certainly interesting, I had no idea. – Phil Frost Feb 10 '21 at 22:57
  • @PhilFrost The problem is not when, it's where. The money is in a segregated account that only holds customer funds. The customer's funds can't be at the clearinghouse when the transaction is made. The clearinghouse won't want to see a thousand payments a day from a single broker. – David Schwartz Feb 10 '21 at 22:58
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    By "when the transaction is made" do you mean when the trade executes or when it settles? I had figured when the trade executes the funds come out of my account, and then (at end of day perhaps, aggregated with all other customer activity) the brokerage sends those funds to the clearinghouse. Your first paragraph makes me wonder if this is actually how it works, but if it is, I'm not sure I follow your explanation. If the brokerage can't "mingle" my funds then they should certainly be available, so why could they not be deliverable to the clearinghouse before settlement? – Phil Frost Feb 10 '21 at 23:10
  • @PhilFrost Nobody is willing to trust someone else's broker to do that. What happens if they don't get the funds there on time? You run the risk of cascading failures as the brokers that didn't get paid also can't pay. – David Schwartz Feb 10 '21 at 23:15
  • Let us continue this discussion in chat. – Phil Frost Feb 10 '21 at 23:18
  • Wait, why can't the buyer's broker use the buyer's funds to buy the stock? Isn't that, like, the whole point of buying a stock? That your funds get used? – user253751 Feb 11 '21 at 10:26
  • @user253751 The legal obligation to provide funds to the seller is the broker's legal obligation. The broker can only use their own funds to settle their own obligations. The buyer's funds are earned by the broker in this process, but the broker cannot take them out of a segregated account until they're earned. So they can't be in the clearinghouse account used to settle the broker's legal obligations. – David Schwartz Feb 11 '21 at 16:08
  • @DavidSchwartz You're saying the broker has to buy the stock with their own money and then recover the money from the customer later, instead of using the customer's money to buy the stock. What a broken system. – user253751 Feb 11 '21 at 18:32
  • @user253751 Not quite. I'm saying the broker has to have their own collateral at the exchange to place a buy order to protect everyone else against a systemic collapse due to one broker failing to deliver funds when they are legally required to do so, causing other brokers to also fail to deliver funds because they didn't receive what they were due. It's not about how the broker actually pays for the stock (likely they use almost entirely offsets from sells from their customers) it's about how the system is protected from collapse. – David Schwartz Feb 11 '21 at 19:00
  • @DavidSchwartz why wouldn't having the customer's funds already protect from a systemic collapse? As long as the funds corresponding to the stock purchase are somewhere, it's fine, right? – user253751 Feb 11 '21 at 19:04
  • @user253751 No, not at all. The funds being somewhere is of no use whatsoever. They have to be delivered to the seller's broker on time or the seller's broker won't be able to deliver funds to other brokers and you have a systemic collapse. The broker has to guarantee that the funds will be at the clearinghouse come settlement time or cascading default is possible. The broker's collateral at the clearinghouse, at an amount calculated to not be much less than the maximum asymmetry in buy/sells they might have, serves as that guarantee. – David Schwartz Feb 11 '21 at 19:06
  • @DavidSchwartz so why can't they be delivered from the buyer's funds? Are brokers really so badly behaved that clearinghouses are worried they might just run off with the shares and the money? – user253751 Feb 11 '21 at 19:10
  • @user253751 They can be delivered from the buyer's funds once the broker takes possession of them. One of the primary purposes of clearinghouses is to protect against brokers that fail to make settlements. There are major broker bankruptcies every few years. In 2019, Halifax Investment Services went bankrupt with $200 million in limbo and ultimately $25 million missing. These protections prevent such problems from causing systemic collapses. – David Schwartz Feb 11 '21 at 19:17
  • @user253751 the system could be re-setup to eliminate the delay and need for collateral, the current setup is largely just inertia from the time when we didn't have instant transfers, computers, and shares physically changed hands. if you think it's silly, that's because it largely is. – eps Feb 11 '21 at 23:04
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This was explained on a very recent NPR Planet Money podcast: https://www.npr.org/transcripts/963466346

Here's a brief summary:

There is a two day window between when a stock transaction executed and it is actually settled. So if we were to agree this instant that I will sell you x shares of y stock for z price the transaction would be executed. However the settlement, where the shares and money actually change hands, takes a couple more days to complete. The collateral is meant to make sure that the money is there when the settlement occurs.

Note: the two day window is an remnant of a time where physical shares were actually changing hands. It could be remade to be nearly instantaneous which should eliminate the need for such a window. Many exchanges already do this -- the transaction occurs, your account is immediately debited and the other account instantly credited.

On a final note, there's definitely a lot of controversy around this and I'm sure many would call the podcast overly sympathetic towards Robinhood's position. Robinhood makes money by working with the same hedge funds that were getting squeezed and in general the motto of "if it's free you aren't the customer, you are the product" very much applies. In particular, the CEO claiming that he only found out at 3 AM that they needed billions of dollars by 7 AM raises my skeptical eyebrow.

eps
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    If one opens a brokerage account with $1000 and places a market order for 10 shares of AcmeCo at a time when the ask price is $90, but only one share is available at that price and no other shares are available for less than $150, would one risk being stuck having to pay a bill for an extra $440 or $500, or would the order be partially fulfilled, or what? – supercat Feb 09 '21 at 23:40
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    @supercat: that is a different question. It should not be asked in a comment. – Ross Millikan Feb 10 '21 at 05:42
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    @RossMillikan: I'm trying to understand the nature of collateral requirements. If the effect of the scenario I described would be that the order would get cancelled, then the participants would face no risk, but if ten shares would get purchased then the person placing the market order would face a risk beyond the purchase price, and the broker would face a counter-party risk if the purchaser defaults, and collateral would seem necessary to cover those risks. Do the latter risks apply, or would the purchase simply be cancelled so as to nullify them? – supercat Feb 10 '21 at 15:54
  • If you place a limit order it will not be filled above the limit price. You can(could in the past?) also place an all-or-none order which requires you get the entire order filled. I think you can do both, so here you would get no stock at all. – Ross Millikan Feb 10 '21 at 16:24
  • Citadel Securities is a Market Maker and there's a hedge fund named Citadel. I just read that they used to be under the same LLC but had a Chinese Wall between them and now they're (supposedly) completely separate LLCs. It makes me wonder if Robinhood was in any way sympathetic to the hedge fund when they restricted GME trading or if it was completely about their capital requirement and liquidity. – Bob Baerker Feb 10 '21 at 16:30
  • @BobBaerker: Regardless of the reasons for RH's actions, they served to prevent a lot of suckers from getting fleeced in ways that would have further destabilized the market, and guard the interests of those who were acting to stabilize it. – supercat Feb 10 '21 at 20:57
  • @supercat - While I agree with your assessment, it's secondary to Robinhood's undercapitalization which required a $3.4 billion cash infusion in order to continue operations due to the GME short squeeze. And given recent fines settled with the SEC, I doubt that RH's primary consideration is their suckers. – Bob Baerker Feb 10 '21 at 21:02
  • @BobBaerker: Your suggestion that RH might have been "sympathetic to the hedge funds" sounded like you were implying that RH was acting to protect hedge funds at the expense of retail investors, when in reality it was protecting just about everyone from those hoping to fleece suckers for ever-increasing amounts. – supercat Feb 10 '21 at 21:11
  • @supercat - That's correct. I stated (not implied) that Robinhood MIGHT HAVE BEEN sympathetic to the hedge funds given the connection b/t the two Citadels. MIGHT is a conditional verb suggesting the possibility unlike your declarative conclusion that in reality it was protecting just about everyone from those hoping to fleece suckers. That's merely your dogmatic opinion. – Bob Baerker Feb 10 '21 at 22:26
  • @BobBaerker: I slightly oversimplified, but the only reasons I can think of that a person would have have sought to buy GME shares at $200 would be: (1) the person was a sucker, (2) the person hoped to entice and fleece other suckers, (3) the person was willing to throw out large amounts of money to destabilize the market, or (4) the person needed to resolve a short. I don't think people in group #4 would be trying to purchase retail shares from RH. Are there any reasons I'm missing? – supercat Feb 11 '21 at 17:37
  • @supercat - Again, you're lost in the details. You buy shares if you think it's going higher or if you're covering a short. The multitude of reasons for making either of those 2 decisions is the process not the action. FWIW, 1/28 was the only day that GME traded at $200. So on the way from $483 to $112 it was bad if going long and good if covering a higher short sell. And when it then rose from $112 to $325, buying at $200 was a good idea. Also, when GME was trading 60 to 200 million shares a day (1/22 to 1/28), no one was going to destabilize the market, especially a Robinhood trader. – Bob Baerker Feb 11 '21 at 17:57
  • @BobBaerker It makes me wonder if Robinhood was in any way sympathetic to the hedge fund when they restricted GME trading or if it was completely about their capital requirement and liquidity yeah that's a great question. like I said, RH has every incentive to act nice to these sorts of funds in general because their business model depends on it. so even if there isn't a direct connection (which the podcast points out) it should def raise some eyebrows. – eps Feb 11 '21 at 18:00
  • I think another thing that is missed is that there were also people buying small amounts of shares not because they thought they were going to make money, but simply because they thought people doing that collectively would cause significant damage to the hedge funds. How many knowingly were sacrificing some dollars vs thinking they were going to get rich is a good question. But from reading twitter there were definitely at least some who were knowingly burning cash to make a point. – eps Feb 11 '21 at 18:07
  • @eps - Good point. RH makes a lot of money from payment for order flow so they're likely to be sympathetic. However, whether sympathetic translated into affecting RH's decision making is one of those things that is rarely discovered unless some fool left a paper trail and the SEC finds it. Otherwise, there will be the truth as well as wad of conspiracy theories put out there by the disgruntled. Re point #2, some of this may have been reasoned decision making and some of it just speculative herd mentality. Neither really matters as long as you made money :->) – Bob Baerker Feb 11 '21 at 18:15
  • @BobBaerker: There would be no realistic set of circumstances by which those buying at prices over $200 could expect to on aggregate avoid losing more than 50 cents on the dollar. Even if one optimistically estimated that the price would bottom out at $100 rather than $50, a sale of a share at $200 guarantees a net loss of $100, whether the person who bought it at $200 loses $100, or whether that person sells it for $300 earning a $100 profit while the $300 purchaser loses $200. Someone who can monitor the order book in real time and respond instantly to changes therein... – supercat Feb 11 '21 at 18:21
  • ...might expect to be able to have enough advantage over other market participants to have a net positive expectation, but unless someone has a large identifiable advantage over other market participants, buying into a bubble market will on average be a severely losing play. – supercat Feb 11 '21 at 18:28
  • You can fabricate any set of what you believe to be realistic circumstances for yourself as well as offer your opinion of what expected losses would be if one bought at $200 but the cold hard fact is that the one day rise from $250 to $500 generated over $17 billion for physical share owners. The synthetic longs also gained $250 but that came out of the pockets of shorters. The run up from $20 to $500 generated over $33 billion for the physical share owners of which $5-6 billion came out of the pocket of Melvin Capital. Expected loss of 50 cents on the dollar? LOLOL. Try billions of gains – Bob Baerker Feb 11 '21 at 18:55
  • @BobBaerker: I'm sure people who bought the stock for under $50/share and sold it for $200+ made a lot of money off of people who bought it for $200+. Do you have any figures that would separate out how retail investors who bought retail shares at over $200 did? If some shareholders made $33B of which $6B came from MC, where did the other $27B come from if not from other people who bought at over $200/share. – supercat Feb 11 '21 at 21:38
  • It's important to differentiate paper gains versus money made. Paper gain on physical shares from $20 to $500 is $480 times the outstanding shares or $33 billion. That doesn't mean that the $33 billion was realized gains but it sure does mean that lots of people made lots of money on the up move (those that sold). And dropping $450 from the $500 peak is the mirror image (longs lost, shorts won). None of this includes the additional 140% (at its peak) of shorting because that's a zero sum game (whatever the shorters lost on the up move, someone else made). I have no retail/inst. stats. – Bob Baerker Feb 11 '21 at 22:15
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When you open a margin account, you sign a hypothecation agreement which pledges the securities bought on margin to the broker. loan. The broker rehypothecates these securities to a bank to secure a loan. IOW, your broker, who is the lender to you, then uses your assets for a loan to cover its own obligations.

Reg U limits the amount of customer securities that can be pledged to 140% of the customer's debit balance. The remaining non pledged securities are called "excess margin securities" and must be segregated.

Here is A Hypothetical Example of Rehypothecation:

Imagine you have $100,000 worth of Coca-Cola shares parked in a brokerage account. You have opted for a margin account, meaning you can borrow against your stock if you desire, either to make a withdrawal without having to sell shares or to purchase additional investments. You decide you want to buy $100,000 worth of Procter and Gamble on top of your Coke shares and figure you'll be able to come up with the money over the next three or four months, paying off the margin debt that is created.

You put in the trade order and your account now consists of $200,000 in assets ($100,000 in Coke and $100,000 in P&G), with a $100,000 margin debt owed to the broker. You will pay interest on the margin loan in accordance with the account agreement governing your account and the thin-margin rates in effect for the size of the debt.

Your brokerage firm had to come up with the $100,000 in case you wanted to borrow in order to settle the trade when you bought P&G. In exchange, you've pledged 100% of the assets in your brokerage account, as well as your entire net worth, to back the loan as you've given a personal guarantee. That is, you and your broker have entered into an arrangement and your shares have been hypothecated. They are the collateral for the debt and you've given an effective lien on the shares.

How Brokers Get Margin Lending Funds

...Regardless of how the broker funds the loan, there is a good chance that, at some point, it will need working capital in excess of what its book value alone can provide.

For example, many brokerage houses work out a deal with a clearing agent, such as the Bank of New York Mellon, to have the bank lend them money to clear transactions, with the broker settling up with the bank later, making the whole system more efficient.

To protect its depositors and shareholders, the bank needs collateral. So the broker takes the Procter and Gamble and Coca-Cola shares you pledged to it and re-pledges it, or rehypothecates them to Bank of New York Mellon as collateral for the loan.

Bob Baerker
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  • For those who haven't grasped it, hypothecation/rehypothecation addresses the OP's question about collateral. When the capital required for operation exceeds the loan amount that rehypothecation provides, the brokerage firm can't continue doing business. – Bob Baerker Feb 10 '21 at 16:34
  • tld;dr "Because short sales are made with borrowed money, and loans require collateral". – RonJohn Feb 10 '21 at 16:42
  • In case you missed it, my answer addressed the OP's question about why the GME short squeeze restrictions were implemented not the Captain Obvious answer that long margin buying and short selling require collateral. – Bob Baerker Feb 10 '21 at 16:53
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    Which is why I upvoted your answer. – RonJohn Feb 10 '21 at 16:58
  • In this case, upvoting my answer makes you a unicorn ;->) – Bob Baerker Feb 10 '21 at 17:26
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When you make a trade, you're only entering an agreement to trade. The money and the shares still have to change hands, a process called settlement.

After the trade executes, but before it has settled, the buyer's brokerage is holding money that doesn't technically belong to them, and the seller's brokerage is holding shares that don't technically belong to them. They've agreed to exchange them in a future date at a fixed price, so it's not unlike a futures contract.

If you want to trade futures your broker will require you maintain equity in a margin account. This guarantees you'll be able to meet your contractual obligations. The market wouldn't work if people could just bail on their futures contracts when they felt like it.

Likewise, settlement of trades between brokerages and other institutions are facilitated by clearing houses. Clearing houses require collateral from the institutions for the same reason. For every buy made by a customer there should be some money to pay for it in the customer's account. The brokerage should be able to withdraw money from customer accounts and deliver it to the clearing house before settlement. But should isn't good enough: a guarantee is needed. The collateral provides that guarantee.

Phil Frost
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  • I would think, based upon your description, that RH would need more collateral to sell stocks on behalf of its customers than to buy them. If RH buys 10 shares of stock for its customers at $120/share from CS, its liability to CS would be limited to $1200 no matter what the stock price does. If CS buys shares from RH, however, RH would have open-ended liability until it actually supplies the shares. – supercat Feb 10 '21 at 19:24
  • @supercat you're right, I rewrote it to address buying stock specifically, and shifted the timeframe the peak and decline, which is the part that's more relevant to the question. – Phil Frost Feb 10 '21 at 20:29