The backdrop to this scenario is of course retail brokerages imposing trading restrictions on Gamestop and other heavily shorted names at the height of short squeeze insanity 2021. The natural response of Redditors was righteous fury, lots of internet bullets being fired, and even a class action lawsuit against Robinhood, a retail broker who is surely regretting their choice of name.  

However, a better understanding of the pressures caused by the stampeding of retail investors into the same stocks will shed light on the actions of retail brokers.

First and foremost is the fact that, as the short squeeze exploded in intensity, retail brokers had to race to keep up with increasing margin requirements imposed on them by clearing houses. Margin requirements exist to protect the clearinghouse from a counterparty being unable to fulfil their end of a trade, in this case retail brokers having enough capital to pay for the massive amount of stocks their clients were purchasing.

Simply put, the more people piled into the same stocks, the more margin requirements had to be raised because ALL retail brokers were facing increasingly concentrated risk exposures in the same few stocks. This meant that should prices make a sharp move lower, thereby reducing the value of client accounts, ALL retail brokers would be on the hook for the difference. On the hook to whom? The clearing house.

If even a handful of retail brokers found themselves in such a situation and were unable to fork out the difference to the clearing house, the broker would be, well, broke. What’s worse, given the size of exposures in these stocks (and their related derivative markets), any retail broker going belly up would almost certainly have systemic consequences. That is, the whole system could have blown up in a massive chain reaction of defaults, fear, and hoarding of capital. 

Ultimately, margin requirements are in place to ensure the core of the financial system can function smoothly without blowing up, and are a regulatory reality. Retail brokers must comply as a matter of law. Not a choice, this.

At the end of the day, the best way retail brokers had to relieve some of the pressure was to impose trading restrictions on the Reddit horde, which in turn bought them some time to bolster their own balance sheets with capital. Hence Robinhood scrambling to raise massive amounts of cash in a matter of days.

Therefore, from a financial perspective, nothing nefarious happened; just retail brokers fighting for their own survival in the face of capital calls that were growing too large too quickly.

But think of it from the standpoint of retail investors. No one likes being told that they can’t do something. It’s worse when what they are being told they cannot do is make money; and infinitely worse when FOMO is everywhere and it seems like everyone else can make money but them. Adding insult to injury is the fact that, in this whole saga, retail investors are the clients.    

Given all this, can anyone really blame retail investors for feeling a burning sense of injustice, even though it really isn’t their brokers’ fault?

To be continued…