- prior the 1980s, when you bought a stock a physical stock certificate was passed back and forth between your broker and the broker selling the stock
- as you can imagine, as trading volumes increased this became unmanageable. In fact, at one point, the exchanges would close every Wednesday just to give people time to catch up on all of the exchange of certificates
- everyone, rightly, agreed that there needed to be a better way and the idea of a clearing house emerged. In this model, all of the physical certificates lived in one place. Ownership was tracked via a central "database" (originally not electronic). This made it MUCH easier to transfer ownership aka "settle". This is very similar to how gold is traded e.g. the NY Fed holds it for other countries etc
- An added benefit of a clearing house: it's easy to see how much everyone owns of everything. e.g. if one party is over leveraged or has gone extremely short, in theory, the clearing house can choose to not deal with that party or, more flexibly, request additional capital etc.
Here is also a specific example about settlement risk:
- let's say you report all of your trades to your clearing broker (think of them as a mini-clearinghouse)
- a data file gets lost or corrupted and the clearing broker says "Wait! Something is wrong! We are not letting you trade until we get this figured out!"
- EVEN IF YOU ARE CORRECT and they are wrong, you now have market risk because you may be holding a position that is losing you money. So much money in fact that it might drive you out of business.
The above is an actual answer to a settlement expert when asked "What is your nightmare scenario?". This in turn, could have ripple effects to other clearing brokers and trading firms and is generally all part of "settlement" or "clearing' risk.
Source: have worked in fintech trading for many years.
Also, couldn't a broker eliminate this risk by just making assets "unavailable to trade" until they've been settled? Granted, I understand why brokers wouldn't want to do that under normal circumstances, but it seems like something they should be able to enable when liquidity becomes a problem.
To me, "Your cash can't be spent yet because the TSLA sale you just made hasn't settled" would seem a lot more understandable than "We're halting GME purchases".
The legacy systems reason is a big one. There are banks with mainframes built in the 80's as part of the critical infrastructure. Another reason is that everyone doesn't communicate directly with the main clearing house. e.g. brokers clear with other brokers who then clear with the clearing house etc.
> To me, "Your cash can't be spent yet because the TSLA sale you just made hasn't settled" would seem a lot more understandable than "We're halting GME purchases".
There have been interesting solutions to disputes. e.g. I think it was NYMEX that had a rule for floor traders along the lines of "If Trader A and Trader B have a clearing issue, NEITHER of them gets to trade till it is taken care of." Given that these traders traded with each other multiple times a day coupled with they were making no money during this dispute, both parties were incentivized to come to an agreement.
The clearinghouse ultimately moves the security and money to their right place, and allows brokerages to let each side move on faith that everything will be right once the dust settles. On settlement risk, a key point is that there usually isn't a huge amount of risk. This is why DTCC is nearly imperceptible for retail players. In this case, the volume and short situation is so extreme that clearinghouses are getting antsy that there may not be enough of the securities available to actually make good in the end, so they're twisting arms at brokerages and requiring they have 100% of it on-hand so that there's no surprises when they go to officially give the buyer their security and the seller their money. This is obviously very expensive, which is why brokerages started limiting buying of volatile securities, have had to take out money to get 100% hedge on these trades, and why RH is allowing trading of volatile securities but only in volumes of 5.
Market makers buy stock for delta hedging because if they don't, they could get caught out and either deliver at a loss or not be able to deliver at all. Figuring out how much you need is a trick of the trade; if you or I knew what their strategy was, their position could be in danger.
Don't the settlement worries provide evidence of naked shorts? (Naked shorts being selling a share without being sure the share would be available at settlement? And naked shorts illegal?)
Wouldn't the normal procedure be to halt all trading until the issues had cleared up? As opposed to allowing positions to be closed, but not opened?
This situation is rare. Halting all trades is very scary for all parties involved. It's way worse for just about everybody than asking brokerages to have 100% collateral is.
On one hand we have Occam's Razor: "the simplest solution is almost always the best." On the other we have "For every complex problem there is an answer that is clear, simple, and wrong." How does one know which to apply?
Just like pi means different things in different contexts. It might be a permutation, projection, a function which counts prime numbers, or it might be half the period of sin. I might write π(10) = 4, or π ≈ 3.14…, or for π in P, etc. I might say that π is the right inverse of ι, in other words π∘ι = id, and point to some digram with a bunch of arrows.
Delta is not just “a change” in this context. It is specifically the rate of change of an option’s value with respect to the value of the underlying security. Just like pi, delta and gamma mean different things in different contexts.
There seem to be a lot of moving parts, and a lot of possible outcomes.
Trading and Exchanges: Market Microstructure for Practitioners (cost of this on Amazon seems to have more than doubled since I bought it 11 years ago)
Algorithmic Trading and DMA: An introduction to direct access trading strategies
From https://www.bloomberg.com/opinion/articles/2021-01-25/the-ga...:
The market maker has sold you an option that goes up in value as the stock goes up. The more the stock goes up, the more the market maker owes you. It hedges this by buying something else that goes up in value as the stock goes up—specifically, stock. Its option pricing model—the Black-Scholes formula or a related model—tellsit how much stock to buy; that output is a number called “delta” and ordinarily expressed as a percentage. Delta is the sensitivity of the option price to the stock price; the higher the delta, the more the option behaves like stock. The more in-the-money the option—for a call option, the higher the stock price is relative to the strike price—the higher the delta will be. A loose, nontechnical, incorrect but still sometimes helpful way to think about delta is as “the probability that an option will end up in the money.” A 100-delta option is so far in the money that it is sure to convert into stock, so it's just stock. A 0-delta option is so far out of the money that it can’t possibly convert into stock, so it’s just worthless. A 50-delta option is roughly at-the-money—a $50-strike call when the stock is trading at $50—and could go either way. The more stock-like an option is, the more stock the market maker will buy to hedge it. Here,Bloomberg’s OV page computes a 37.57% delta for the Jan. 29 $50 call as of last Tuesday; I rounded up for ease of use.
If you are remotely interested in these kinds of things I can heartily recommend reading Matt Levine (https://www.bloomberg.com/opinion/authors/ARbTQlRLRjE/matthe...). He's at the same time educating and entertaining and what is more leaves out all the bile and negativity that is connected to these topics in other places. Gamestop is covered in recent issues.
I will say that I’m not too busy for this at the moment, and getting to my very basic level of understanding has required me to sort through, at the very least, a fairly decent chunk of reference material and reading interpretations and explanations online.
Like, here’s some things I’ve been grappling with understanding recently:
How do settlement risk, clearing brokers, and clearinghouses work? Why does buying an ordinary stock carry so much settlement risk?
Why do market makers buy stock for delta hedging? How do they figure out how much stock to buy?
To make an analogy, it feels like I’m some kid in chemistry class who just learned how to draw bond diagrams, and then I watch a video of someone talking about how they figured out the structure of some chemical using Raman spectroscopy.