Systemic Risk? Pffft! THIS, My Friends, Is Systemic Risk

Capitalist Exploits's picture

By Chris at www.CapitalistExploits.at

Have you ever asked yourself what happens when you place a trade?

I hadn't given it much thought until about 10 years ago when something happened which opened my eyes to a single company that holds what is probably the most concentrated risk position in the US market.

Here's what happened...

So, I took a position in a private placement. The shares came free trading after a 6-month lockup, and the stock had been running like the cops were after it.

It had a half warrant attached, which was deep deep in the money, and I wanted to scoop a healthy chunk of money off the table. Heck, this was a bloody drill play which, as you probably know, are more often than not burning matches. Bright and brilliant until they burn your fingers.

So, I'm busy scrambling to get the stock placed with a broker so that I can trade it.

First up was a very well known broker whose name I'll keep out of the spotlight (I like the guys and gals there and it's not that important). I'll call them broker X.

I have an account with them and they said, "Sure, no problem." A week later, "Ah sorry Sir, we're having some questions from compliance." And then another week passes and "No, so sorry, we can't take that one."

I can't remember the reason now but at this point I'm two weeks down, the stock's "en fuego," and I'm getting antsy. I quickly call my broker at Sprott and they took the stock. This took only a couple of days.

Now, with the stock placed I'm free to trade it. And I do. The same day, I pull up my account at broker X and looky here. There is the original stock sitting in my account. Wait! What?! That can't be. So I pull up my online account at Sprott thinking someone slipped my something in my drink but no...there she is. This is voodoo, or magic, or a cock up. It's in two places at once.

I'm sure if I hit the sell button at broker X their back office will spasm, and before the bean counters can have a heart attack the system will vomit up the true position. Plus, I'm not an ass and knowing the truth I can't in good conscience do that. I only own a certain position, not double it as much as I might wish that was the case.

Down the Rabbit Hole

And so this is what led me down the rabbit hole of actually looking at what takes place when you place a trade.

I contacted broker X and we finally sorted out the problem. They performed their accounting magic and the position disappeared from my account but this is where it scared the isht out of me.

When I asked my broker how did they typically account for client positions I was told that the Depository Trust & Clearing Corporation (DTC) holds the securities.

All securities, I asked?

Yes, all. Or at least 99.99% of all outstanding securities. So broker X (and indeed all brokers) have an account with the DTC, and the two accounting systems need to match, showing "brokers' clients'" securities, which need to reflect the securities held at the DTC on a netted basis.

Ok, I got it. It's a central clearing house. Duh. I'd just never really given it any thought until that day... and it was then that I instantly realised the truly massive concentrated risk.

Massive Concentrated Risk

When you buy a stock, you think you own it. But you don't. What you own is an IOU to your broker dealer. Much like your bank deposit isn't yours because that, too, is an IOU from your bank. Anyone who's ever been caught in a bank run gets this. And anyone who's even read about one gets it.

So like a traditional bank the DTC acts in a similar way. By the way, in Europe Euroclear and Clearstream perform exactly the same function as the DTC does in the land of apple pie.

The DTC was actually formed back in the 70's after the back-office scandals at that time. It was a solution for the increased trading volume on Wall Street, which had become too much to handle, with brokerage firms falling behind with mountains of paperwork, and trades taking forever to clear, and counter-parties not knowing when, where, or who.

The result was that the Wall Street firms could more easily track shares by having to deal only with themselves and the DTC. Companies were and still are eliminated from the process.

So now when a listed company you own look at their share registry, they don't see your name in there. They only see the DTC. And when brokers trade stock, all that happens is a ledger entry at the DTC with a netting taking place. You just own a derivative. Lucky you.

In fact, if you own an option contract, or a warrant, or any sort of derivative, you own a derivative of a derivate. Fun heh!

But That's Not All

Lots of crazy isht can take place here. For example, instead of executing a trade in the market (where it's transparent) brokers can transfer shares between clients and book the trade as a sale.

Transparent? Not so much. Sure, they've an obligation to get you the "best" price in the market, but how's that possible without actually putting it up for sale in the market?

Brokers can and do also lend out your shares to someone who wants a borrow in order to sell short the stock. Often you don't even know about it....small print, being...well small.

Imagine someone borrowed your car because the car park attendant lent it out to them. His job being the safe keeping of your car, and here he is making money by lending it out. If that doesn't make you livid, you're a weirdo. For the rest of us we're none too happy.

Now, this brings up another super crazy setup.

Imagine this: You buy some Tesla stock (silly I know, but let's play the game). You think you own it. You even report it to the tax man. Your broker reports it on his balance sheet, too.

But then he lends it out to a short seller who goes through another broker who, too, reports it on his balance sheet. One security is being reported by multiple parties on their balance sheets. Fractional reserve banking in the securities market.

In fact, there are 5 separate institutions in each trade. Your broker, who processes to the custodian, then from the custodian to the DTC, who then process to the next custodian, who then process to the broker on the other side. No wonder it takes 3 days to settle a trade.

Thank heavens these institutions in this daisy chain aren't levered and at risk of failing. Imagine they were levered.

Oh wait... What am I saying? I'm sorry, I've not had my medication.

So we buy and sell with our fingers crossed that in the trade settlement process (either T+2 or T+3, which I dare say is horse and buggy slow) nothing goes wrong to screw up our trade, leaving us with an IOU from the next Bear Stearns, Lehman Brothers, or MF Global.

Of course, once settled we're still left with this queasy feeling in our stomach because we've got this entity that holds trillions of dollars of stocks, bonds, and derivatives. One single entity. Think about that.

This entire fustercluck of a setup hasn't really changed since the early 70's. Think about what that actually means.  Here's technology from that time.

70's ground-breaking technology

There's a reason we no longer use this stuff. It's antiquated.

And this brings me to something else I've been harping on about here: Cyber security, where I showed you this:

Consider recent data hacks in the corporate sector:

  • eBay (NASDAQ:EBAY): 150 million passwords
  • JPMorgan Chase (NYSE:JPM): 73 million emails
  • Target (NYSE:TGT): 40 million credit card numbers
  • Yahoo (NASDAQ:YHOO): 1 billion accounts

So would someone, anyone potentially, be hacking the DTC? Is the Pope Catholic?

When every security is held in one centralised location, is this not the epitome of concentrated risk?

There is, however, an answer to all of this mess...

Stock depository poll
Cast your vote here and also see what others picked

- Chris

"Put all your eggs in one basket... the handle's going to break. Then all you've got is scrambled eggs." — Nora Roberts

 

 

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Liked this article? Then you'll probably like my other missives on

this topic as well. Go here to access them (free, of course).

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Downtoolong's picture

One day the world will wake up and everybody's Fidelity account will have a zero balance.

Fidelity's response to where it went will probably be taken from their old ads, "Follow The Green Line", while our government remains focused on Russians hacking elections.

 

ElTerco's picture

Agreed. Fidelity places the customer last.

Flankspeed60's picture

Sold my company in early '87. Bought an airplane and gave the rest of the cash to Bear Stearns. Since it was impossible to lose money in the market, I was persuaded to buy additional shares on margin. Not to worry though, 'cause my broker would automatically liquidate my position before it dropped 10%. When the SHTF, Stearns was not taking phone calls-until they called me to make margin. Bottom line - lost everything I had with them, my broker was nowhere to be found, and his boss denied that there was any such thing as an automatic stop-loss. Incredible.

Fortunately, the airplane sale bailed my stupid, ignorant ass out and I was able to start another company. But I have never put another f*king nickle in in that tribe-manipulated cesspool on Wall Street, and never will.

cosmyccowboy's picture

yep, it's called counter party risk... like you don't actually believe that all these banker gold shorts will ever have to come up with any gold do you?

Montani Semper Liberi's picture

 The rotary dial phone in the picture was groundbreaking technology in the 1950's. A touch-tone phone would have been more appropriate.

kwaremont's picture

don't worry, once the superintelligence takes over in that Singularity event you will be obsolete... just the Elite will think for a while that they own it... only to discover they are obsolete too (they are even today, just  don't know it yet and through the meidia they mindfcuked the sheeple into this narrative

gmak's picture

Suddenly being short seems the proper thing to do, no?

Fahq Yuhaad's picture

You don't explain what "NSCC" is.

fulliautomatix's picture

Is it possible to hack '70s tech?

ElTerco's picture

The solution is physical commodities/PMs/guns/ammo stored in your basement while living on a sizable plot of farmland that you own outright.

laser's picture

How do you plan to dispose of the twenty or thirty bodies of those who you think are coming to get your stuff? 

WakeUpPeeeeeople's picture

backhoe and then plant a tree

cosmyccowboy's picture

PPFFFFTTTTT.... buzzards gotta eat too!

laser's picture

Food for the alligators in the moat.

jonjon831983's picture

There have been some postings about DTCC on ZH over the years.

 

Remember that great flood in NYC where the DTCC vault was flooded and the physical stock certificates got wet?

 

Back almost decade ago when we were scared of counterparty risk, collapse in collateral, rehypothecation, etc word was we should have brokers convert our shares into physical certificates registered to our name instead of under the broker and in trust for us.

cosmyccowboy's picture

and don't forget the day after it flooded it caught on fire and destroyed the contents...

lasvegaspersona's picture

Real people do not buy stocks.

Stocks are only for pension plans.

Of course people on drugs do buy stocks...not they they are not real but...

kwaremont's picture

and pension plans... who gives a fcuk... people will die anyway, or al least get alzheimered with age so they won't even understand what's going on with "their" money, well, rather promises written on toilet paper

cat2005's picture

Fuck me. That was an eye-opening read. I need a drink.

Giant Meteor's picture

Gave it up many moons ago, but I applaud your sentiment good sir.

Cheers !

ebworthen's picture

NOTHING on the Internet is secure, NOTHING.

Not "block-chain", not "controls", not "security measures".

It's like leaving your back door open every night in the worst neighborhood in town.

Giant Meteor's picture

Also agreed. I was right there with him, right up until the close !

Umh's picture

The answer is none of the above.

Stackers's picture

I guess we really shouldnt bring up how the DTC flooded during Hurricane Sandy when lower NYC went under water either....

Giant Meteor's picture

Well this serves as a reminder. There are natural disasters, and then, there are unnatural disasters ..

MonetaryApostate's picture

It's really not hard to see the entire system is centrally controlled by the ultra wealthy who have unlimited fake money & can write infinite IOU notes...

Fake money, fake debt, fake value, fake news, fake investments, fake markets, fake history, fake leaders, fake events, fake elections, yes fake everything! 

https://plus.google.com/collection/QorNbB