How And Why Did The Stock Market Crack This Week?

During one of the most intense earnings weeks of the season, all of Wall Street and most of America has been focused on another incredible investing drama unfolding on an hour-by-hour basis.

The WallStreetBets Reddit community sent shares of stocks like GameStop Corp. GME and AMC Entertainment Holdings Inc AMC soaring in recent days, and Robinhood and several other major trading platforms barred traders from buying the stocks on Thursday with very little explanation.

See also: How to Buy Stocks on Robinhood

What Happened: On Thursday, Robinhood users voiced their outrage on social media when they found they could not buy shares of AMD, GameStop and 11 other popular WallStreetBets stocks. Robinhood’s initial explanation was extremely vague, indicating these stocks were being restricted “in light of current market volatility.”

E*Trade, Interactive Brokers Group, Inc. IBKR, WeBull, Merrill Lynch and other brokers also restricted trading in these stocks in some form on Thursday.

Webull CEO Anthony Denier told the Benzinga Power Hour on Thursday that the decision to restrict GameStop buying was out of his hands.

When $250 or $300 billion in shares are trading, hundreds of billions in cash must be held in cash for two business days, he said. 

"And to be frank, the clearing firms are not that well-capitalized, they cannot do that," Denier said. 

"So in order to stop the clearing firm from going out of business, they stop the settlement of those shares, resulting in firms like Webull not being able to allow customers to trade those stocks.”

Related Link: How Retail Option Traders Are 'Supercharging The Short Squeeze' In GameStop And Other Potential Bubble Stocks

How It Works: A clearing firm or clearing house is a market middleman that stands between a buyer and a seller in the market. Stock and option trades seemingly take place instantly in your trading account, but the clearing house is responsible for making sure both the buyer and seller actually get what they bargained for. Leading clearing houses include Apex Clearing, Pershing LLC and J.P. Morgan Clearing Corp. WeBull, for example, uses Apex to clear its trades.

Robinhood and some other brokers, on the other hand, are self-clearing, meaning they perform their own internal clearing.

Without the clearing houses, traders could be in a position where they can’t sell stocks that they buy, which would be a much worse position to be in than the one they were temporarily in on Thursday when they couldn’t buy, Denier said. 

In light of the controversial decisions made on Thursday, the Depository Trust & Clearing Corporation (DTCC) issued the following statement explaining the measures taken by its clearing house, National Securities Clearing Corporation (NSCC).

"In recent days, certain securities, including GME, AMC and others, have experienced extreme volatility that have generated substantial risk exposures at firms that clear these trades at NSCC, particularly if the clearing member or its clients are predominantly on one side of the market.

"Because NSCC guarantees settlement of trades among its clearing members, NSCC collects margin according to calculations that are set forth in its rules. When volatility increases, portfolio margin requirements increase too, and NSCC clearing members may pass on these costs to their clients, including brokerages that clear through them. Margin requirements protect the entire industry against defaults and systemic risk in volatile markets."

Gamma Squeeze: Robinhood users also laid blame on market maker Citadel Securities on Thursday. Market makers provide liquidity to financial markets by buying and selling shares of stock. Market makers don’t typically take a long or short position in individual stocks, so when they take one position they must offset it with an opposing position.

The WallStreetBets community took advantage of this dynamic by triggering a gamma squeeze in stocks like GameStop.

The first step in a gamma squeeze is that one large trader or a legion of small retail traders, such as the WallStreetBets community, buys short-dated call options in a stock such as GameStop.

When they buy these call options, the institutional brokers and investment banks that sell them essentially become short the underlying stock. The more call options the traders buy, the more shares of the underlying stock institutional brokers and market makers must buy to offset their short position.

When an appropriate stock is selected and the call buying is done on a large enough scale, a positive feedback loop is created that drives the share price higher and higher, triggering more and more buying.

Robinhood, Citadel Comment: Citadel was founded by billionaire Ken Griffin. The company includes both its market maker business and its own hedge fund, Citadel LLC.

Earlier this week, Citadel LLC and Point72 Asset Management were forced to bail out hedge fund Melvin Capital with a $2.75-billion investment due to losses Melvin suffered due to the GameStop gamma squeeze.

Both Robinhood and Citadel have denied colluding to restrict buying in GameStop and other WallStreetBets stocks.

“Citadel is not involved in, or responsible for, any retail brokers’ decision to stop trading in any way,” Citadel said in a statement.

“Citadel Securities has not instructed or otherwise caused any brokerage firm to stop, suspend, or limit trading or otherwise refuse to do business.”

Robinhood CEO Vlad Tenev also denied that Citadel pressured Robinhood to restrict GameStop buying.

“To be clear, this decision was not made on the direction of any market maker we route to or other market participants,” Tenev tweeted.

“As a brokerage firm, Robinhood has many financial requirements, including SEC net capital obligations and clearinghouse deposits. Some of these requirements fluctuate based on volatility in the markets and can be substantial in the current environment.”

Protecting The Marketplace? Interactive Brokers Chairman Thomas Peterffy told CNBC his decision to restrict GameStop trading was out of concern for the integrity of the market and clearing system.

“When some option holders make money, the clearing house has to give us the money to give it to our customers, while other option holders, sellers or buyers on their own side lose money, we have to collect money from them and give it to the clearing house. If our customers are unable to pay for their losses, we have to put up our own money,” Peterffy said.

See Also: A Short Seller Joins Benzinga's 'Power Hour' To Talk GameStop. The Rest Is History.

Hedge Funds Just Fine: WallStreetBets has gotten praise from high-profile supporters such as Barstool Sports founder Dave Portnoy, Tesla Inc TSLA CEO Elon Musk and venture capitalist Chamath Palihapitiya for sticking it to hedge funds.

Yet Benzinga PreMarket Prep co-host Dennis Dick said Friday that the current situation isn’t as black and white as retail traders versus hedge funds.

“I know people are like, 'let’s break these hedge funds. We’re going to change Wall Street and take it over!' I’ve got bad news, bad news, because I will tell you right now the hedge funds have already adjusted,” Dick said.

Algorithmic traders’ fingerprints are already all over stocks like GameStop, he said. 

“You’re not going to break Citadel ... you’re not going to break all these hedge funds. They all adjust. They just adjust.”

Instead of breaking hedge funds, Dick said what is broken at this point in the market is fundamental analysis.

“What matters now is a story and hype. It’s a sad market that we’ve come to this, but all I see is a bunch of mini pump-and-dumps throughout Twitter.”

Pump-and-dump schemes have been around on Wall Street for decades. Dick said the early pump-and-dump investors always make money and the later investors always lose money.

“Hedge funds will make more money in this market than they ever have before. That is my prediction. You will see more wealth transfer."

GameStop shares were up 65.8% at $370 at last check Friday. AMC shares were 83.66% higher at $15.85.