Systemic Risk Rears Its Head

“If you owe the bank $100 that’s your problem. If you owe the bank $100 million, that’s the bank’s problem.” – J. Paul Getty

This famous quote, the spirit of which predates Mr. Getty, has been flipped on its head.  We now see that it is similarly problematic when a million people each owe the bank $100 when it’s all backed by the same volatile collateral.

There is something important to remember about the brokerage industry – a clearing broker is exposed to movements in its customers’ holdings.  This is not about proprietary trading, by the way. 

When a broker lends a customer money to buy a stock on margin, it makes a loan collateralized by the stock itself.  SEC rules state that broker is required to lend no more than 50% of the initial purchase, and require that a customer maintain at least 25% of the current value of the security as funds in the account.  These are minimums, and the individual broker can impose more stringent requirements than those statutory requirements.

Ask yourself what happens to a broker if the value of the collateral moves by 50% or more.  At that point the shares that are held as collateral are no longer sufficient to collateralize the loan.  That means that the collateralized loan has effectively become uncollateralized.  There is now a significant risk to a broker that it can’t be paid back by its customers.

Brokers are also exposed to their customers who short stocks.  In a short sale – which is both legal and ethical – a broker borrows shares that it delivers on behalf of the short selling customer.  The broker has effectively taken out a loan on its customer’s behalf, collateralized by the proceeds of the short sale.  The customer now has a liability to buy back the shares, hopefully at a lower price.  If the stock rises so far that the customer can no longer afford to buy back the shares, the liability passes to the broker.  In the case of stocks that have sequential double or triple-digit percentage rises, that becomes an immediate problem.

As if that is not enough, brokers are exposed to their customers via the options markets.  The risk that accrues to brokers whose customers write options that have open-ended exposures is self-evident.  Someone who writes a naked call on a stock that moves higher is subject to potentially infinite risk.  As before, if the customer lacks sufficient funds, that risk becomes the broker’s. 

But you might ask “what is the risk if I buy a call with available cash?”  That does seem innocuous.  If I buy $1,000 worth of calls with cash on hand and those are now worth $2,000, that’s a good thing for both customer and broker. (Brokers want their customers to make money.  They really do. That’s how they remain good customers.)  But what happens if that customer holds the options until expiration, causing him to take delivery on the underlying shares?  In the prior example, let’s say those were a 10 lot of calls with a $20 strike.  That means that the customer would have to come up with $20,000 to take delivery of 1,000 shares of stock at $20/share. (Each options contract represents 100 shares)  What if that customer only has the $2,000 that is now in his account?  That other $18,000 becomes a risk to the broker. 

The same applies in reverse to a put holder who exercises a position, and with an extra wrinkle.  Not only does the broker have a concern that the collateral in the account is insufficient, the broker also has to be concerned with being able to borrow the shares on the customer’s behalf.  Again, it is quite possible for a profitable trade done with cash on hand to turn into a risk for the broker.

With that in mind, let’s look at the very real world situation involving GameStop (GME) options.  As of last night’s data – the most recent available to us – there were 92,457 calls outstanding with strikes below $320 (The stock is about $325 when I write this.  Who knows where it will be when you read this?)  That represents over 9 million shares of GME that will be subject to delivery.  The available float of GME is just over 50 million shares.  Although the numbers are highly subject to change today, there is a real likelihood that over 18% of the GME float could pass through the settlement process.  Do all those long call holders have sufficient funds to pay for their deliveries? 

Finally, it is important to understand the nature of the clearing houses.  They are mutually owned by their members.  If one member is unable to meet its obligations, those pass to the other members as a whole.  No responsible clearing bank or broker wants to be liable for a less responsible counterpart’s failings.  Yet it is impossible to know what a competitor’s books look like.  A brokerage firm may have its own house in order but be exposed to unknown liabilities on a competitor’s books.

This piece wasn’t designed to scare, it was designed to illuminate a somewhat opaque part of the brokerage industry.  Hopefully this provides some sort of explanation to the decisions that investors saw over the past few days.