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The Brown Political Review is a non-partisan political publication that seeks to promote ideological diversity. All of the views reflected in BPR’s content are views held by authors and not reflective of the views held by the wider organization or the Executive Board.

How to Reform the Broken Brokerage Industry

I walked into a bank the other day and tried to apply for a credit card. It did not go well. Apparently, my income is too low, my student loan balance too high, and even extending a $300 per month line of credit is too much of an ask.

None of that should be surprising. If anything, it should inspire trust in the soundness of our financial system. It’s not necessarily in a bank’s fiduciary best interest to extend college juniors like me large swaths of free money without first scrutinizing my credit history. Yet, why is it that 

I can open an online brokerage account, answer a couple good-faith multiple-choice questions on my trading history and income, deposit $1,000, and have instant access to $2,000 with which I can start trading. The second $1,000 is called margin. It’s essentially a line of credit from your brokerage account with which you can trade securities. Say the price of a stock goes up by 10%. With 50% margin, I’d make a 20% return on my initial investment. Buying on margin amplifies profits.

That’s if your stock goes up. The contrapositive also holds: Margin amplifies losses. If your position falls low enough, your brokerage account will likely hit you with a margin call. They force you to close out your position (sell), or to deposit more funds to hold, therefore covering potential future losses. On top of this, they charge interest on the margin (the loan) that they’ve extended you. This can even lead to a situation where you lose more money than you deposited in the first place, in which case you’ll soon be getting a bill in the mail.

So why is this a problem? At the end of the day, there are banks with don’t-ask-too-many-questions credit cards (one of which just approved me today). Why can’t brokerage accounts do the same thing?

To explain the distinction between these two bad loans, I’m going to use myself as an example.

1. Credit Card

My Discover credit card arrives in the mail, and instantly I start using it. I get a little carried away. Beers are always on me, UberEats tri-daily, and I develop a taste for expensive shoes. Come the end of the month, I’ve emptied my bank account, and completely drawn out the $500 of credit I have on my new card. I can’t pay the bill. 

Now say 50,000 people follow my example. We all default, and Discover loses $25 million. Discover either files for bankruptcy, refinances, or draws from other savings to cover these losses. Even if they go under, people who hold accounts with Discover bank are covered up to $250,000 by the US government because Discover is FDIC insured. Not ideal, but not the end of the world. Importantly, the only vulnerable people who get hurt are those who defaulted on their credit cards. They now owe $500, plus interest, and their credit ratings plummet. But they haven’t necessarily lost any money

2. Brokerage Account

I stumble across WallStreetBets on Reddit one day, and read an incredibly well-researched dissertation by a user named DeepF*ckingValue that GameStop (GME) is going to the moon. In two minutes I’ve downloaded Robinhood, and within another two minutes I’ve got $2,000 of buying power (using margin), after initiating a transfer of only $1,000. I buy, all in.

Let’s say 50,000 people do this (in reality it was over 500,000 people). For a fleeting moment, GME appears to continue on its lunar course. It soars for several days. 

Eventually, reality sets in. Valuation analysts and the like see that the company cannot possibly be worth this much, and, slowly, the small retail investors start to realise this too. The big institutional investors sell, the proprietary trading firms sell, then the smarter reddit users who see the writing on the wall sell too. All of a sudden, GameStop is tanking. Who is holding? The 50,000 Robinhood investors who keep reading Reddit posts that tell them to, “ride the f-ing dip”. Those 50,000 people end up losing 90% of their money, plus a large proportion of the money that Robinhood loaned them through margin. Robinhood then sends out bills to thousands of people, most of whom can’t pay. In the end, Robinhood, much like the good people at Discover, is in trouble. Furthermore, there are 50,000 people who have now lost not only their $1,000, but thousands more in margin debts.

Here’s what actually happened. 

A few days into GME’s rocket trip, Robinhood CEO, Vlad Tenev, got a call at 4am from the Depository Trust and Clearing Company (DTCC). They told him that his company would need to post $3 billion in collateral. The mechanics behind this are a little complicated. To simplify, when brokerage users book trades, the broker has to temporarily put up a lot of money to the clearing houses where the stocks are actually exchanged. Legislation dictates that brokerage firms have to post collateral with their own money, not their customers’. To make matters worse, the stocks being traded were becoming extremely volatile, and volatility is one of the most important inputs used to calculate the daily collateral requirement. Robinhood hadn’t previously conceived it being possible to receive a $3b bill, due immediately.

To avoid an even bigger bill the next day, Robinhood, along with a couple other online brokers, prevented users from buying any more GME stock. Specifically, they restricted buying on margin because this means a double contribution on the broker’s behalf – a loan to the investor and extra collateral to the DTCC. Additionally, they stopped granting temporary credit when people initiated bank transfers into their Robinhood accounts. This (effective) demand cut caused GME to tank, earlier than it otherwise would have. In the end, Robinhood drew over $600 million from revolvers with Goldman Sachs and JP Morgan, took out $2.75 billion in emergency loans, and ultimately survived the credit crunch. Many of the 500,000 investors didn’t. They lost thousands because the demand for their stock positions were artificially crippled by inhibitions on buying GME – though they would have lost anyways. And those who bought on margin went deep into debt.

Clearly, there is an issue here. No matter what brokers like Robinhood do in situations like this, people can get stung when they buy on margin. Additionally, margin increases the risk that brokers will become too illiquid to meet DTCC collateral. So we can see that margin is a problem for two reasons: It increases downside risk for vulnerable investors who often don’t understand what they’re getting into, and it destabilises the brokerage industry due to collateral requirements. Something clearly needs to change.

How to Reform the Broken Brokerage 

First and foremost, traders need to be initially restricted from using margin. If investors don’t understand the risk, then they cannot understand the trade-off. All brokerage accounts should require evidence of at least one year’s experience of investing to allow access to leverage. This could be evidenced through past statements from another broker, or using a new account for 12 months before margin approval.

Importantly, brokerage firms must not be allowed to offer initial capital when new users join their platform. The idea that you can download an app, initiate a bank transfer, and instantly have access to all your money (even though it hasn’t arrived), is insane. Think about it. It’s tailored to rash decision-making. It is a classic trap that works to get companies like Robinhood more users, not to mention their extensive gamification of trading  – they literally have little cartoons of kryptonite, or guys on rocket ships to categorise industries. It’s like candy at the checkout counter: bright colours, and no time to think. But this is thousands of dollars in the stock market, not your spare change. These instant deposits must be made illegal.

Additionally, Regulation T dictates that investors can never use more than 50% margin in a position. This should realistically be something like 30%. Leveraging that hard is incredibly dangerous, and should only be available to investors who’ve proven they can use margin successfully – possibly another year of investing.

Many would reasonably push back against the above proposals, pointing out that this would give more power to the “big guys” and inhibit the average American investor. Technically, they’d be right. However, this is a case where the difference between principle and practice is really important. Power isn’t always a good thing. Power means the ability to act, it doesn’t specify if that action will be good or bad for you. The democratisation argument has become a potent feature of misinformed discussion in the run up to every speculative crash – 1929, 1999, 2001, (2021). This obviously never turns out so well. Investment vehicles, trusts in the 20s, individual electronic trading with PCs starting in the late 80s, and commission free trading apps today have continuously revolutionised themselves to allow small retail investors to enter the market. Equity valuations eventually surge, and inevitably pop. When they pop, it’s not the big guys who lose their houses. The stock market is a complicated beast, and we should try to democratise it. But commission-free, leveraged, instantaneous, and gamified applications are not the answer.

Finally, on the institutional end, settlement time should be reduced to one day. The longer the settlement period of a trade, the more time there is for either side to renege on the deal. This creates inherent risk, and is why clearing companies ask for so much collateral. When speaking with Bradford Gibbs – an Economics lecturer at Brown University with 20 years’ experience in financial services – he made it clear that “there is really no reason why the current legal settlement should be T+2.” “It couldn’t quite be T+0, but T+1 is both preferable and possible.” This and some form of reserve-collateral requirement for brokers should be introduced. The reserve buffer would essentially force brokers to hold extra cash over expected collateral payments such that a similar situation in the future would result in a temporary breach of regulation rather than the complete shutdown of trading on particular stocks. It would also force brokers to spot these things sooner, and prepare in advance to find collateral funds that can ensure continued trading. We force banks to keep a reserve requirement for similar reasons – it’s a safety measure that protects the stability of the short-term debt market, and it’s exactly the type of protection the equity market needs right now.

If we don’t regulate, this will happen again. Regular people will get hurt again. It’s only a matter of time.

Image: Flickr (Cafe Credit)