Why would collateral be required to make a stock purchase?

Question

I've been reading this page on the recent GameStop short squeeeze.

It mentions that at one point Robinhood and other brokers prevented their clients from purchasing shares of GameStop (GME):

On January 28, some brokerages, including Robinhood, halted the buying of GameStop and other securities, later citing their inability to post sufficient collateral at clearing houses to execute their clients' orders.

I don't understand why a purchase would require collateral. I understand why short-selling requires collateral, and I understand why options require collateral - in either case you could end up with obligations exceeding your initial investment.

However, if I give a broker cash money and ask for a share of a stock in return, why would this need anyone to have collateral?

Answer 1

However, if I give a broker cash money and ask for a share of a stock in return, why would this need anyone to have collateral?

The seller's broker needs to get paid by the buyer's broker. Because this is a legal obligation of the buyer's broker, the buyer's broker must use their own funds to settle this obligation. A broker cannot commingle their own funds with their customer's funds or use customer's funds to settle their own obligations.

So the buyer's broker must have collateral somewhere to ensure that there is money to pay the seller's broker for the stock. This is a legal obligation of the buyer's broker and is not the buyer's responsibility.

If you give your broker $10,000, the broker must store that in an account that only holds customer's funds. Then if you buy $5,000 worth of stock, your broker immediately incurs a legal obligation to deliver $5,000 to the seller's broker. To protect the seller's broker against any issues with your broker failing to settle that obligation, your broker has to have sufficient collateral of their own at a clearing house.

Answer 2

This was explained on a very recent NPR Planet Money podcast: https://www.npr.org/transcripts/963466346

Here's a brief summary:

There is a two day window between when a stock transaction executed and it is actually settled. So if we were to agree this instant that I will sell you x shares of y stock for z price the transaction would be executed. However the settlement, where the shares and money actually change hands, takes a couple more days to complete. The collateral is meant to make sure that the money is there when the settlement occurs.

Note: the two day window is an remnant of a time where physical shares were actually changing hands. It could be remade to be nearly instantaneous which should eliminate the need for such a window. Many exchanges already do this -- the transaction occurs, your account is immediately debited and the other account instantly credited.

On a final note, there's definitely a lot of controversy around this and I'm sure many would call the podcast overly sympathetic towards Robinhood's position. Robinhood makes money by working with the same hedge funds that were getting squeezed and in general the motto of "if it's free you aren't the customer, you are the product" very much applies. In particular, the CEO claiming that he only found out at 3 AM that they needed billions of dollars by 7 AM raises my skeptical eyebrow.

Answer 3

When you open a margin account, you sign a hypothecation agreement which pledges the securities bought on margin to the broker. loan. The broker rehypothecates these securities to a bank to secure a loan. IOW, your broker, who is the lender to you, then uses your assets for a loan to cover its own obligations.

Reg U limits the amount of customer securities that can be pledged to 140% of the customer's debit balance. The remaining non pledged securities are called "excess margin securities" and must be segregated.

Here is A Hypothetical Example of Rehypothecation:

Imagine you have $100,000 worth of Coca-Cola shares parked in a brokerage account. You have opted for a margin account, meaning you can borrow against your stock if you desire, either to make a withdrawal without having to sell shares or to purchase additional investments. You decide you want to buy $100,000 worth of Procter and Gamble on top of your Coke shares and figure you'll be able to come up with the money over the next three or four months, paying off the margin debt that is created.

You put in the trade order and your account now consists of $200,000 in assets ($100,000 in Coke and $100,000 in P&G), with a $100,000 margin debt owed to the broker. You will pay interest on the margin loan in accordance with the account agreement governing your account and the thin-margin rates in effect for the size of the debt.

Your brokerage firm had to come up with the $100,000 in case you wanted to borrow in order to settle the trade when you bought P&G. In exchange, you've pledged 100% of the assets in your brokerage account, as well as your entire net worth, to back the loan as you've given a personal guarantee. That is, you and your broker have entered into an arrangement and your shares have been hypothecated. They are the collateral for the debt and you've given an effective lien on the shares.

How Brokers Get Margin Lending Funds

...Regardless of how the broker funds the loan, there is a good chance that, at some point, it will need working capital in excess of what its book value alone can provide.

For example, many brokerage houses work out a deal with a clearing agent, such as the Bank of New York Mellon, to have the bank lend them money to clear transactions, with the broker settling up with the bank later, making the whole system more efficient.

To protect its depositors and shareholders, the bank needs collateral. So the broker takes the Procter and Gamble and Coca-Cola shares you pledged to it and re-pledges it, or rehypothecates them to Bank of New York Mellon as collateral for the loan.

Answer 4

When you make a trade, you're only entering an agreement to trade. The money and the shares still have to change hands, a process called settlement.

After the trade executes, but before it has settled, the buyer's brokerage is holding money that doesn't technically belong to them, and the seller's brokerage is holding shares that don't technically belong to them. They've agreed to exchange them in a future date at a fixed price, so it's not unlike a futures contract.

If you want to trade futures your broker will require you maintain equity in a margin account. This guarantees you'll be able to meet your contractual obligations. The market wouldn't work if people could just bail on their futures contracts when they felt like it.

Likewise, settlement of trades between brokerages and other institutions are facilitated by clearing houses. Clearing houses require collateral from the institutions for the same reason. For every buy made by a customer there should be some money to pay for it in the customer's account. The brokerage should be able to withdraw money from customer accounts and deliver it to the clearing house before settlement. But should isn't good enough: a guarantee is needed. The collateral provides that guarantee.