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It was in the news recently that RobinHood had to prohibit some customer orders due to a lack of liquidity. The explanation was that because brokers like RobinHood take orders today which are fulfilled after some delay, they are at risk if the investor refuses to pay, and need to enough cash in reserve to cover that risk. e.g. Matt Levine said:

You don’t think about it much, but every stock trade involves an extension of credit. You see a price on the stock exchange and push a button and instantaneously get back a confirmation that you bought some shares of stock, but you actually get the shares, and pay the money for them, two business days later. This is called “T+2 settlement,” and it might seem a little silly in an age when a “share of stock” is an entry in an electronic database and “money” is also an entry in an electronic database.

I understand how that could cause problems for brokers, but I don't understand why a single broker can't unilaterally fix it. Why does RobinHood not simply take payment when an order is placed, and hold it for the 2 business days until the order is completed? This seems like it would reduce their risk, remove the scaling bottleneck of needing to find cash on short notice, and give them a nice buffer of cash.

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  • My guess is that the SEC says to do it the way it's done. – RonJohn Feb 8 at 17:20
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    What happens if Robinhood goes bankrupt in the two days between taking your money and delivering your shares? – Mike Scott Feb 8 at 17:25
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    @MikeScott Presumably the same thing as if Amazon goes bankrupt between taking my money and delivering my order. As long as transactions aren't immediate then someone has to take risk, but trusting a business seems easier than trusting a million retail investors. – MikeFHay Feb 8 at 17:40
  • There are two differences. One is the scale of money involved. Amazon typically involves orders smaller than 100€ while stock trading involves a lot of money. The other difference is that one is immediately the new owner of a share. It is not the broker's share until delivered (like with a lot of E-commerce) but it is yours. If they bankrupt you can claim your shares and transfer them to another account. If you order something on the internet and the seller files for bankruptcy early the next day, you can try to claim your money and will receive a tiny fractional share of what you paid – Manziel Feb 8 at 17:50
  • @MikeScott: SIPC takes possession and cleans up. Since the money was put as collateral to buy the shares, the shares are bought and you get them. – Joshua Feb 9 at 23:24
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Especially for day traders with a margin account - which is probably the majority of the traders in this context - the money wouldn’t be there yet to take, because it comes from another sale.
That previous sale will settle before or same day, but it’s not yet there yet, and with the high activity, there is some risk of parts being missing when needed: If a trader’s account runs into negative, he gets an immediate margin call, but maybe he isn’t willing or able to produce the additional cash right that day. As a result, the brokerage ends up holding the bag, and will have to pay up (until they successfully go after the trader and get their money back - which can take months, if ever). Therefore, they are required to show a certain cash to be able to cover such cases.

If you wonder how an account can run into negative: if you sold for example naked options (fulfilling the margin requirement), and the underlying does a ‘GameStop’, you could end up with a hundred times the loss of your cost basis, far exceeding all your cash and long positions.

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    Clearly wrong. They blocked fully funded cash buys. – Joshua Feb 9 at 18:04
  • @Joshua - but that's what I explained: they weren't able to block only margin buys, so they blocked all buys, including cash buys. – Aganju Feb 9 at 19:49
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    That's not what you wrote, and it's not believable that they couldn't block only margin buys (blocking margin buys makes perfect sense when people are buying into a bubble the brokerage wants no part of). – Joshua Feb 9 at 20:08
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Why does RobinHood not simply take payment when an order is placed, and hold it for the 2 business days until the order is completed? This seems like it would reduce their risk, remove the scaling bottleneck of needing to find cash on short notice, and give them a nice buffer of cash.

You misunderstand something very important. The obligation to pay for the stock within two days is not the customer's obligation. If it was, then a customer failing to make payment could cause another broker (or their customer) to lose money. It is Robinhood's obligation to make payment to the seller's broker when their customers buy securities. It is illegal for a broker to use customer funds to settle their own obligations.

Robinhood has to have enough of their own money on deposit to cover any risk that they might fail to meet their obligations to pay the seller for stocks their customers buy. This is to protect other brokers and their customers from Robinhood's failure to meet Robinhood's obligations.

If the money isn't owned by Robinhood free and clear, it can't be used to settle any payments Robinhood might need to make to sellers and their brokers. And Robinhood definitely can't just mix their money and their customer's money or use commingled funds to settle their own obligations.

I understand how that could cause problems for brokers, but I don't understand why a single broker can't unilaterally fix it. Why does RobinHood not simply take payment when an order is placed, and hold it for the 2 business days until the order is completed? This seems like it would reduce their risk, remove the scaling bottleneck of needing to find cash on short notice, and give them a nice buffer of cash.

That's exactly what they do. The problem is that other brokers don't trust them. The problem isn't their risk, it's everyone else's risk. The broker has to execute the buy pretty much instantly, and they can't take the customer's money until after the order is placed. At that point, they can't teleport the money instantaneously to the seller's broker.

Another issue is that Robinhood doesn't charge commission so to have a viable business, they have to make every penny they possibly can. Having an extra billion dollars sitting around for two days doing nothing just in case this kind of event happens is pretty much a non-starter for them. That's one of the main reasons for the two day settlement time.

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    "It is Robinhood's obligation to make payment to the seller's broker..." Forgive me if I mangle terms as a novice, but this seems to suggest that the initial exchange between RH and the Seller's broker must be done with RH's money, and then a sort of internal sale between RH and the ultimate buyer takes place. But that RH cannot use the buyer's money to make that initial payment? Which is why, even through I'm quite sure retail accounts on RH have to make payment up front RH doesn't have the money it can legally use to cover the brokerage fees? – Jontia Feb 9 at 16:39
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    @Jontia That is correct. Robinhood cannot keep its customer's money in its clearinghouse account nor can it use customer's money to settle its own legal obligations. Segregation of funds is required by law to protect both Robinhood's customers and other brokers. The point of the funds at a clearinghouse is to ensure that Robinhood can meet its obligations -- if that account held funds that were owed to Robinhood's customers, it could not serve that purpose. And Robinhood is neither trusted nor permitted to maintain both customer funds and their funds in the same commingled account. – David Schwartz Feb 9 at 19:28
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`...every stock trade involves an extension of credit.

That's not true. For a cash account, the cash must be in the account in order to make the trade. There is no extension of credit since you're paying the full amount. T+2 is when the two brokers swap the cash for the security. How could Robinhood take money from your account immediately without giving you your security in return? In reality, once you make the trade, your cash is then tied up (making an additional purchase without available cash would be an account violation).

Extension of credit only occurs in a margin account.

It was in the news recently that RobinHood had to prohibit some customer orders due to a lack of liquidity. The explanation was that because brokers like RobinHood take orders today which are fulfilled after some delay, they are at risk if the investor refuses to pay, and need to enough cash in reserve to cover that risk.

Customers can't refuse to pay. As stated above, a cash account must have the full amount of cash in it to make a purchase. In margin accounts, one must have 50% of the trade's dollar amount in order to buy on margin or short (unless the broker requires more). However, the margined position can destroy account equity in which case there is insufficient account cash or marginable securities to cover the loss.

The short answer is that Robinhood is undercapitalized and had to implement restrictions in order to continue operate. Those restrictions unfairly affected some Robinhood traders and is just another reason why people should trade elsewhere.

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    What I'm saying is what I wrote. Speaking of sources, can you find one that says that cash accounts allow trading without the cash? Or one that says that cash is not exchanged for the security by T+2? Or one that says there is no extension of credit in a margin account? Or one that says that Robinhood didn't have to borrow one billion dollars because of its cash shortage during the GME short squeeze? And FWIW, that NPR story belongs in the popular series of 'Dummies' books. This one could be called: "Robinhood For Dunmmies". Better yet, a Homer Simpson episode. – Bob Baerker Feb 8 at 18:03
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    I think the answer is that I have misunderstood. A footnote in the article I linked implies that RobinHood does require the money up-front, but re-introduces some risk by allowing some customers to make trades with the proceeds of sales which are not yet completed ("Instant Settlement"). idk 🤷‍♂️ – MikeFHay Feb 8 at 18:29
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    I'm surprised that they let the no cash in the account trade go through because as you mentioned, it's a freeriding violation. In addition, many brokerage firms bust such trades and the broker involved can lose future allocation for problems like this. – Bob Baerker Feb 9 at 3:45
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    Not an answer. Robinhood blocked fully funded limit buys. – Joshua Feb 9 at 18:06
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    Yep, Robinhood suspended purchases because they, themselves, had to put up their own collateral they didn't happen to have and couldn't/didn't want to get their hands on. That's a matter between the brokerage and the clearinghouse. That impacts all orders, even fully funded ones. – Zach Lipton Feb 9 at 21:12
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For very large orders there will be an expectation of security. There may be a hold placed on a cash management account or other stock held. But it is a settlement, it could fail on either side. The NYSE has notoriously rolled back trades deemed to be obviously in error. The 2 days is for the dust to settle.

The actual cash flow can be grossed up into "gross settlement" payments in and out for the brokerages concerned.

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