When an investor makes a trade through a broker like Robinhood (to buy or sell), the broker accepts the trade and sends it to an exchange like the Toronto Stock Exchange or the Nasdaq. Most people think it’s just done, but there are a lot of things going on in the background.

 

When the exchange accepts the trade, it is sent to a middleman (aka a clearing house). It is the clearing houses job to process the trade and update it on “the books”. I.e. saying we are moving 50 shares of XYZ from Robin Hood to Schwab. Once the trade is with the middleman, they don’t send millions of trade messages between the brokers every second, they consolidate them all together into one neat little package (i.e. all the Apple shares, with Robin Hood, settling January 24th). Because there are trillions of transactions and it takes time to move everything between the buying and selling parties, trades don’t “settle”/complete for 2 days.

After the settlement date, it is the middlemen’s job to send everyone their stuff. They send the buyer their stock and the seller their money.

 

So what happens if someone can’t pay up and can’t deliver the stock or the money?

 

This can’t happen because the clearing house GUARANTEES the transfer will happen eliminating the risk of a single broker going under rippling across the market.

 

How do they do it?

 

The middleman collects a fee every trade and requires that the buying broker puts up some cash as collateral. The amount of money required is based on a super complex formula but in general if you’re trading super big stocks like Apple and Microsoft you’ll need less collateral than a tiny penny stock. The more risk, the more collateral.

When people use margin to buy stocks (i.e. they borrow money to invest), you need even more collateral to be put up! This is because the cash isn’t being put up by the person buying it, it is being borrowed from the broker (i.e. Robin Hood).

So when a broker has a sudden spike of people buying on margin and there are infinitely more buyers than sellers, the middleman says “whoa! too much”… is the buyer’s broker going to give us the cash for this? If they don’t we’re on the hook”. That causes them to go back to the broker and say, you need to give us WAY more collateral if we’re going to do these trades for you.

If the broker doesn’t have billions of dollars in cash (which most don’t), they are forced into extreme actions. In Robin Hood’s case they needed to borrow over a $1 billion from investors to make sure they had the cash to put up for collateral for the trade from last week. To make sure it didn’t get worse, they had to stop people from buying the “high collateral names”. If they didn’t, they’d need to borrow even more money to meet the collateral requirements. So now they have the one share buy limit!

 

They’ll still let you sell because you’re just putting up shares, they can guarantee that (the shares are already in your account) but they can’t 100% guarantee the buys.

I would anticipate that brokers like Robin Hood will continue to restrict buys in these names until they can clear out their borrowing.

 

Here is the original article from Barrons that was condensed down