Counter party risk is something most people don’t really think about. Before we get into it, perhaps we should begin with a brief definition.
“Counter party risk is the likelihood that the other party in an investment, credit, or trading transaction may not fulfill its part of the deal and may default on the contractual obligations. It is the probability of nonperformance by the entity on the opposite side of any financial transaction from you, be it a trade, contract, credit or other financial relationship.”
This is no small thing. It is why we have lots of rules and regulations for exchanges and brokers to create certainty that that every transaction will actually go through as advertised. From the SEC to various stock exchanges to all the brokerage firms, from margin rules to net capital rules to settlement requirements, these rules and regs exist to ensure transactions are honored.
This encourages more trade, more business, more transactions.
Imagine if you had to negotiate a new contract every time you bought or sold an ETF, or if you needed to get lawyers involved each time you made any purchase. The entire economy becomes untenable. Nowhere in the world is this more important than in the buying and selling of financial assets. Buy a stock, and you do not even think about the person on the other side of the trade – you just know delivery will include the correct stock, the proper number of shares, at the agreed upon price, within a reasonable time. Sell a stock, you know the buyer will receive the cash at settlement (E.g., T+1, T+3, etc.).
We rarely think about counter party risk because most of the time, things work: brokerage firms make sure their clients have sufficient capital and stock to deliver what they’re supposed to, orders are reliably executed, and when a stock moves significantly, you have the ability to exit that trade or add more as you see fit.
But not this week.
They had no idea that their brokerage firms had to meet net capital rules, which may have led to issues. Last night, we learned Robinhood drew several hundred million dollars in credit lines (their lenders include JPMorgan Chase & Co. and Goldman Sachs Group Inc.). They never fathomed that they might not be able to hold onto a stock because their broker lacked sufficient capital. You may not think your trading platform is technically a counter party, but how are they any different? When it came to their counter party risk, they were wholly unaware that they were relying on the financial strength and stability of their brokerage firms.
It is the day trader’s version of Dunning Kruger: none of these folks seem to have the slightest idea WTF was happening. They were unaware of what was buried in the terms of service of the tech-stack they were using to trade. Robinhood users thought that despite FREE TRADES! they were somehow the firm’s customers. What they did not realize was they are its product, whose flows get sold to hedge funds like Citadel (actual, paying customers).
I’ll save the long war story for another time; Instead, if you are one of those people who are causally risking capital in the markets, ask yourself this:
Do you know what your risks are? Do you understand what risks lay among your counter parties, brokerage platforms, trading partners and technologies? Do you have back up plans and alternatives in case anything stops working?
It is a lesson that everyone who trades must learn, and it is why you always need a Plan B, and sometimes even a Plan C.
UPDATE: February 4. 2021
Why people love to hate Robinhood: Never has a company been so popular, and also so hated.
UPDATE: February 2. 2021
What happened this week; Robinhood explains the mechanics of trading and clearing
UPDATE: February 1. 2021
Why Brokers Had to Restrain Trading in GameStop Shares They were minimizing their own financial and regulatory risk, not trying to bail out hedge funds.
Cheap is Great, But Beware of Free (October 22, 2018)
When They Start to Lose, They Change the Rules! (Of Dollars and Data, January 29, 2021)
How Does the GameStop Saga End? (A Wealth of Common Sense, January 28, 2021)
Is this Legal? (The Irrelevant Investor, January 28, 2021)