How much wealth can US securities markets transfer in one settlement period?
On February 4, 2021, top financial regulators including Janet Yellen said “the markets were resilient” through the volatility experienced last week because of stocks such as GME, AMC, NOK, and BB. It’s been stuck in my brain lately how some of the early GME hype was describing the squeeze as “the greatest wealth transfer of the 21st century” or some extraordinary claim like that. And that got me thinking — could the financial markets even support such a large wealth transfer from one party to another, in any scenario? What’s the upper limit on wealth transfer in American securities markets?
Let’s assume that to call such an event a wealth transfer it must happen “relatively instantly,” in a single settlement period (I’ll explain this more later), and wealth must transfer from one set of shareholders to another distinct set of shareholders. One such scenario is the set up to a short squeeze — many short sellers who must buy a share to close their position, and a horde of buyers ready to open long positions. There may be other examples. I think the general case would involve a significant number of long or short positions closing while simultaneously a significant number of long positions opening.
What happens in this scenario is that the market is flooded with buy orders that consume a significant portion of the order book (why high short interest generates big squeezes, in theory). Those buy orders are placed through brokerages that route orders through clearing firms that ultimately settle funds at a regulatory-mandated firm like NSCC. The clearing firms all have margin accounts at NSCC, and there are Required Fund Deposits for each Member of NSCC, essentially a minimum account balance to cover the risk of the clearing firm defaulting on its margin.
I’ve seen numbers floating around that the average security on an average day has a maintenance requirement of around 2% of the value of the trade — so if there’s $1B in buy volume coming from a clearing firm, the clearing firm has to put up $20M as collateral for settlement. But those are average securities on average days, and the formulas used for calculating those margin requirements don’t properly account for the once-in-a-decade trading days where the price goes haywire. So NSCC has a rather arbitrary fudge factor, called the Margin Liquidity Adjustment, “to address the risk presented to NSCC when a Member’s portfolio contains large Net Unsettled Positions in a particular group of securities with a similar risk profile or in a particular asset type” (page 55).
The US has T+2 settlement, meaning collateral at NSCC must be posted for two days after the trade until settlement occurs. In the days leading up to GME’s peak price of $483, trading volume was approximately $17B on 1/26 and $29B on 1/27 (volume * price = dollars). This $46B would still be settling on 1/28, when NSCC called up its members very early in the morning and asked them to deposit significantly more collateral, on the order of billions, because of the risk of certain securities (GME, AMC, NOK, BB, etc.) significantly moving in price during the T+2 settlement period, which increases the risk of default for NSCC members. Small clearing firms simply don’t have the balance sheets to move that kind of money: Apex Clearing has $5B in assets and $58M in deposits with the NSCC as of 2019; Robinhood has $3.3B in assets and $122M in deposits with the NSCC as of 2019. Even Fidelity’s clearing firm only has $65B in assets on their FY2019 balance sheet (I can’t tell what their clearing house deposits are). So what happened? The smaller clearing firms restricted trading, or they would’ve gone bankrupt posting collateral. Notably they only restricted buying, because buying requires posting collateral for the cash to settle. Selling a security requires no collateral.
So what’s the maximum amount of money that can realistically move through this system in one T+2 settlement period before someone halts the flow to prevent cascading defaults? The NSCC Clearing Fund, the sum of all participating clearing firms’ required and excess deposits, had a balance of $10.5B as of September 30, 2020. Total notional volume across all market participants on September 30, 2020 was about $504B according to Cboe’s historical data, corroborating the average maintenance requirement with the NSCC around 2% (10.5 / (504+504) is about 1%). In a pathological case where the tail risk of default materializes, NSCC will respond, as they likely did last week, by raising the requirement to 100% to minimize risk of default. Assuming all securities have the same 100% requirement, the daily cash volume would be capped at ~$5.25B (10.5 / (5.25 + 5.25) = 100%), the sum of collateral deposits at the NSCC, maybe $10B if brokers are willing to cough up additional cash. That’s the hard cap on the amount of money that can move through US securities markets in one settlement period, assuming NSCC will respond by raising required deposits to minimize risk of default. This system feeds on leverage to settle 100x the notional value of collateral every two days, and relies on tail risk never materializing, or it intentionally grinds to a halt. This is why regulators said “the markets were resilient” and protected investors, because… they did, if you subscribe to this way of thinking.
If you want to read more, I learned a lot about the DTCC and the plumbing of Wall Street by following @KralcTrebor on Twitter. They dive more into the SEC regulations that govern these organizations (remember I called NSCC’s existence “regulatory-mandated”?), and what sort of reform we might hope to see come out of this situation.
Feel free to comment on this story if I got something wrong. Seven days ago, I thought NSCC was a state college in Tennessee, not a Wall Street back office corporation, so I’m learning and revising my thinking quickly!
Disclosures: I hold long positions in GME. Only invest what you can afford to lose. I’m not a financial advisor nor should any language in this article be interpreted as financial advice.
