The Key Players

• Retail Investors — non-professional, individual investors

• Institutional Investors — an institution that pools money to invest (pension funds, mutual funds, endowment funds, hedge funds, etc.)

• Publicly Traded Companies — companies generally decide to go public to raise money to fund future growth.

• Depository Trust & Clearing Corporation ( DTCC) — provides clearing and settlement services for the financial market.

• Options Clearing Corporation ( OCC) — provides a similar service as DTCC but for options.

The Process

Many traders use margin accounts (as opposed to cash accounts). While I won’t get into all the details of a margin account, it’s important to note that, practically speaking, the investor doesn’t own securities in the margin account; they own a promise from their broker.

When a decision is made to buy a security, the buyer doesn’t know who the seller is, so a third party has the important role of matching the transactions or clearing (transferring ownership from one broker to another broker). That’s where DTCC comes in. Trades must be settled two business days after the trade, known as T+2, but most trades reflect immediately on the investor’s account. Lending occurring in the background to account for this difference. Anytime there is lending, there is also credit risk.

DTCC uses its balance sheet to guarantee settlement. Since their balance sheet isn’t massive, they must tightly manage counterparty risk to ensure accurate and timely settlements. When business is happening, as usual, the risk is minimal, but when things go haywire, as we recently saw, it gets a little buggy.

Typically, DTCC maintains the “physical title” to the stock, which speeds up the settlement. To comply with the SEC’s T+2 rule, this makes things simpler. As needed, DTCC assigns the title from one client (broker) to another, clearing the transaction.

Let’s take a look at a stock purchase:

1. You choose the security and execute a purchase

2. At the end of the day, the broker nets out all trades from that day(buys and sells) and determines if they are net senders or receivers.

3. If they are a net sender, they borrow that money (using inter-institution short-term borrowing) and send it to DTCC.

4. DTCC then sends money to those brokers that are net receivers

5. Formal settlement occurs within 2 days

Where’s the Risk?

There are several times when credit risk might come into play:

1. Between the time the trade is executed until the end of the business day (when the broker nets with DTCC).

2. Between DTCC sending net proceeds and formally settling the transaction

3. When the selling broker allows the selling client access to the funds from the sale before the trade has settled

4. Between the sell and when DTCC settles with the selling broker at the day’s end

Other things behind the scenes make this plumbing even more complicated (selling order flow, short interest, price correlation, etc.), but we’ll revisit those another time for the sake of simplicity.

Since DTCC’s role in ensuring smooth transactions across a massive financial system is critical, they require brokers to keep collateral on deposit (like banks are required to keep cash reserves). These reserves are based on the amount of risk each broker incurs. When something unusual happens, and DTCC finds its customers (the brokers) increasing risk, they require more collateral (cash).

Cash in these cases is like batteries; you can never find them when you need them. According to the Wall Street Journal on Friday, January 29th, “industrywide, collateral requirements rose to $33.5 billion from $26 billion on Thursday, an increase of nearly 30%.”

This problem is magnified by advanced trading instruments like options and traders who trade on borrowed money (margin). It would take a series of posts to explain the role of options adequately, but Mr. Peterffy touched on the role they played in the recent debacle by saying:

“When some options holders, sellers, or buyers on their own side lose money we have to collect money from them and give it to the clearing house. If our customers are unable to pay for their losses we have to put up our own money.”

In short, brokers are on the hook for their client’s losses. If they don’t have adequate reserves, there’s a problem. Now consider this situation; what if a broker had a client base that was hyper-focused on a small group of highly correlated securities and mostly on the same side of the trade? That broker’s risk is further elevated because they aren’t receiving funds from the other side of the deal. When everyone scrambles to get in (or out), the pipes can become clogged, and if that clog occurs in the middle of the pipe, it’s going to affect the whole infrastructure.

What Now?

No one seems to care about plumbing until there is a clog. The spotlight on this often-ignored part of our financial system presents an opportunity to scan for threats to our financial system, identify weaknesses, and find ways to ensure we have a fair, balanced, and safe system that allows everyone to invest on a level playing field. Congress, regulatory authorities, brokers, and other experts need to seize this opportunity to collaborate and modernize the American system.

*This article is provided for general information and illustration purposes only. Nothing contained in the material constitutes tax advice, a recommendation for purchase or sale of any security, or investment advisory services. I encourage you to consult a financial planner, accountant, and/or legal counsel for advice specific to your situation. Reproduction of this material is prohibited without written permission from James Vermillion, and all rights are reserved.