Retail trading has surged in the U.S. since November 2019 when Charles Schwab led most discount brokers in slashing commissions on U.S.-listed stocks and options transactions to zero. With millions of individuals confined at home, the pandemic has amplified this trend. According to some measures, retail trading now represents close to 25% of total equity trading in the U.S. on some days, versus less than 15%, at most, just two years ago.

More recently, many individual investors banded together through social media to take on hedge funds that had been short-selling some stocks (e.g., GameStop). The retail traders' cumulative long positions drove up prices on these stocks and increased volatility, causing large losses for some hedge funds that had taken short positions on those stocks. The rapid run up in the price of these stocks and elevated market volatility increased the risk posed to brokerage firms and clearinghouses.

As a result and in line with their protocols, the clearinghouses raised margin requirements, and many brokers--facing increasing liquidity needs and losses on their clients' positions--moved to curtail exposure to these stocks, including restricting clients' ability to buy them. This triggered lawsuits and vociferous responses online and in the press, and the issue has gained the attention of many politicians. On Feb. 1, some individual investors seemed to have shifted interest to other products such as silver futures, contributing to an 8% upswing that day--very large by historical standards.

For the most part, we do not expect short-term jumps in volatility to affect our issuer credit ratings because our ratings incorporate a firm's long-term ability to withstand stress and are not overly reliant on short-term factors. Whether the surge in U.S. retail trading will eventually lead us to change ratings will depend in part on our evaluation of several factors, including whether we think the surge in retail trading is structural, the nature of industry consolidation, and regulatory response. That said, the current trend does have short-term consequences for entities across the industry.

Were The Trading Restrictions Imposed Unusual And Did They Favor One Group Over Another?

In the week of Jan. 25, the National Securities Clearing Corp. (NSCC), which clears cash equity transactions in the U.S., and to a lesser extent the Options Clearing Corp. (OCC), did what they usually do to address increased volatility--raise margin requirements on clearing members to strengthen their financial safeguards and ensure financial stability. Because stock transactions in the U.S. do not settle instantaneously (they settle two days after the trade), NSCC faces the risk of a clearing member defaulting in the interval. In the case of a retail broker with large net long positions across its customer base, the risk for the clearinghouse is that it will have to pay for the stocks at the time of settlement (i.e., take on the financial obligations of the clearing member if it were to default) and then liquidate the portfolio of the defaulted party at a time when the value of the stocks may have collapsed.

To hedge against this risk, central counterparty clearinghouses (CCPs) around the world (including NSCC) request clearing members post margins (or collateral) to them commensurate to the risks they pose. If a member defaults, this collateral is used as the first layer of defense to absorb potential losses for the clearinghouse. The risk of a clearing member default in a volatile trading environment is not purely theoretical: in March 2020, two U.S. clearinghouses (Fixed Income Clearing Corp. and CME Clearing) had to cope with the default of a midsize U.S. broker-dealer, Ronin Capital. According to our estimations, NSCC margin requirements surged by more than 50% between the morning of Jan. 27 and the morning of Jan. 28, through a combination of intraday and regular margin calls. OCC margin requirements also increased, but by a much lower degree.

Confronted with these large margin calls on Jan. 27 and Jan. 28, many retail brokers implemented trading restrictions to reduce their liquidity needs at the CCPs. The most common trading restriction was to make some stocks (such as GameStop or AMC) nonmarginable, meaning retail clients could only buy these stocks using their own money and could no longer borrow money from their broker to buy them. Still facing elevated liquidity needs and potential losses on their customers' positions, some retail brokers went even further and capped the number of stocks (and equity options) customers could trade.

With retail customers less able to buy the stocks, total net long demand for these stocks fell, and so did retail brokers' liquidity needs. Better-capitalized retail brokers (such as Interactive Brokers or Schwab) could handle the CCPs' margin hikes better (given their ample capital and liquidity) and did not have to implement some of the more drastic trading restrictions. According to reports, Robinhood Securities (non-rated) is said to have met incremental liquidity needs by a combination of trading restrictions, a draw on lines of credit, and by raising capital from shareholders.

NSCC and OCC raised margins to protect themselves in a time of volatility and to ensure financial stability. Additional margin requirements were calibrated according to the clearinghouses' rulebooks. For example, NSCC charges margins largely on value-at-risk (VaR) numbers (a measure of risk for members' portfolio). VaR numbers for some players (including retail brokers, but also prime brokers that clear hedge funds transactions) surged the week of Jan. 25 in the face of increasing directional positions, heightened volatility and higher trading volumes. CME Clearing did the same the week of Feb. 1 by raising margin requirements on silver futures contracts.

Who Are The Principal Beneficiaries Of This Retail Trading Surge?

In our view, the main short-term beneficiaries of the retail trading surge from a revenue standpoint are entities that are not usually in the spotlight: the large wholesale brokers that execute most retail transactions in the U.S. and the high-frequency trading firms. The trend is mostly neutral for retail brokers, and only a modest positive for exchanges. That said, we believe the complexity and nuance in the retail trading ecosystem may not render these short-term benefits meaningful in the long-term.

Retail brokers: Neutral as growth in assets is largely offset by rising risks

When most discount brokers followed Schwab to zero commissions for U.S.-listed stocks, exchange-traded funds, and options, the loss of transaction fees coupled with close-to-zero interest rates triggered a wave of consolidation in the sector (Schwab acquired TD Ameritrade and Morgan Stanley acquired E*Trade) and increased reliance on payment for order flows (PFOF, i.e. selling their clients' orders to wholesale market makers, who eventually execute them). According to Bloomberg, wholesale brokers collectively paid a little under $3 billion to retail brokers in PFOF in 2020--about $1.1 billion for stocks and the rest for options.

The remaining, now mostly much larger, discount brokers are adding new clients and assets. This will likely be more profitable for them when interest rates go up, especially for those that are able to grow asset-based fee accounts. That said, regulatory and headline risks have almost certainly increased as regulators reexamine whether they still ensure the best execution price for their customers despite the selling of order flows to third parties. Moreover, volatility spikes and the potential to exhibit large directional positions (for example, an excess of long over short positions) at times (depending on social media trends) have translated into large liquidity needs, prompting some to beef up their capital and liquidity buffers.

Individuals: Difficult to assess

With the advent of zero-commission trading, individuals now pay less in trading commissions. This enables individuals to trade more easily but also puts some at risk of losing money from risky trading strategies in a very volatile environment.

Retail brokers, who sell their customers' order flows to wholesale brokers, need to demonstrate to regulators that their individual customers are better off, from a price execution standpoint, as opposed to a situation where transactions are directly routed to exchanges (skipping wholesale brokers). This is what the industry calls "price improvements." In a zero-commission world, retail investors still benefit from price improvements, but calculating the precise magnitude of such improvement is not standardized across firms and therefore not easily comparable. Moreover, it is very difficult to determine whether price improvement (if any) changed following the implementation of zero commissions.

For example, Citadel Securities discloses its customers benefited collectively from $1.5 billion in price improvements last year on stock transactions, more than three times the amount it paid to retail brokers. Interactive Brokers, a large discount broker, does not sell its order flows to wholesale brokers for clients of its main offering ("IBKR Pro") and charges a fee for equity and options trades. It reports that its price improvement for its customers is four times higher than average for the industry.

PFOF has been an established practice in the U.S for a long time. Both wholesale brokers, which pay PFOF, and retail brokers that receive payments, must disclose the practices to regulators and investors. Since 2020, the SEC has required retail and wholesale brokers to disclose certain routing and execution metrics ("SEC 606 report"). We believe wholesale brokers are mostly agnostic with respect to the split between price improvements and PFOF: they view both as expenses (one paid to retail brokers' clients and one to the retail brokers themselves). What matters for them is only the sum of the two, in our view. The allocation between the two is mostly up to retail brokers. Some, impacted more than others by the loss of trading commissions, may decide to increase PFOF at the expense of price improvement, translating into worse execution prices for customers. But we believe measuring and comparing price improvements across firms is a difficult task. Moreover, discount brokers have the ability to pass on benefits to retail customers in a variety of non-cash ways, such as mobile apps, high-quality customer support, research reports, and free streaming real-time quotes.

Wholesale brokers/Market makers: Positive in the short term from a revenue standpoint

Bid-ask spreads widen and transaction volumes surge in volatile market conditions. This typically benefits technology-driven market makers. The surge in retail transactions also benefits the large wholesale brokers that execute retail clients' trades, such as Virtu and Citadel Securities (see chart 1).

Chart 1

Virtu's net trading income jumped to $1.8 billion in the first three quarters of 2020, versus $975 million for the entire year in 2019. Citadel Securities reported to investors $6.7 billion of net trading revenues in 2020, almost double its previous high in 2018.

In our view, recent events may lead to increased regulatory scrutiny. Virtu and Citadel Securities execute about two-thirds of total retail equity transactions in the U.S. and we believe could potentially be affected by changes in PFOF regulation. The surge in volatility and the increasing size of balance sheets has also reinforced the need for higher capital, more stable funding, and higher liquidity buffers.

High-frequency traders (HFTs): Positive in the short term from a revenue standpoint

HFTs such as Jane Street, DRW, or Hudson River Trading made record profits last year and this January, not so much by executing clients' trades (which is not their business model) but by taking advantage of market dislocations and the increase in bid-ask spreads. Thanks to their ultra-high speed, HFTs exploit arbitrage opportunities (such as when the price of an ETF deviates from the prices of its underlying components) and are in a position to react to company news (e.g. earnings or trading by management) in real-time. That said, the spike in trading positions has translated into increasing funding and liquidity needs, prompting some players to upsize (and refinance) their long-term funding lines recently. This has also elevated operational risk, especially for those with automated trading strategies since a retail trading surge is likely a difficult variable to program into their algorithms, in our view.

Exchanges: Only a modest positive because their market share has declined

U.S. exchanges are benefiting from the retail trading surge but not as much as the jump in total transactions would tend to indicate. This is because the wholesale brokers (that execute retail clients' trades) are internalizing most of the trades in their own dark pools (i.e. finding offsetting trades from other customer orders) and are only sending the residual to exchanges. As a consequence, the market share of the main U.S. players (Nasdaq, NYSE and Cboe Global Markets) in U.S. equity trading has plummeted from close to 65% in 2019 to just a little above 50% in January 2021 (see chart 2).

Chart 2

Previously, volatility spikes would translate into a higher market share for exchanges. In a high-volatility environment, large equity block sellers/buyers could get enough liquidity on exchanges, and transactions were generally routed to exchanges instead of taking place off-exchange. This time, exchanges are positioned differently because the uptick in trading is mostly caused by retail investors.

Clearinghouses: Slightly negative as CCP surveillance is more complex

Although the surge in transaction volumes translated into more revenues for NSCC and OCC, it is mostly irrelevant for these two players, which operate as quasi-utilities to the markets. For example, OCC passed most of the excess revenues (above its cost base) to market participants (in refunds) in third-quarter 2020. The jump in volatility and the potential for some clearing members to exhibit large directional positions at times (either massively long or massively short, depending on clients' choices and social media trends) has rendered CCP surveillance of clearing members (especially the small broker/dealers) more complex. Still, U.S. CCPs have navigated the heightened volatility since the pandemic very well (see "So Far, So Good For Clearinghouses Despite Oil And COVID-19 Market Volatility," April 16, 2020).

We believe the recent events may also increase pressure on NSCC to shorten the settlement cycle in the U.S. for cash equities from the current T+2 to T+1 or even end-of-day T. This could reduce liquidity needs for the system as a whole.

Hedge funds (and prime brokers that serve them): Negative for some niche players

The squeeze in short-selling translated into large losses for some hedge funds. For example, Melvin Capital (non-rated) lost 53% in January alone and had to be recapitalized. This prompted some hedge funds to reduce debt during the last week of January and may have contributed to the market draw-down that week. Some hedge funds announced that they will stop research on short-selling and could place limits on short-selling. It is also possible that some hedge funds could face restrictions on funding options as a result of reduced prime broker funding availability. Nevertheless, we think that hedge funds can sometimes act as market stabilizers in some circumstances by taking advantage of market dislocations, as they did last March and April.

In the long run, we will continue to consider whether repeated bouts of heightened volatility in the markets and the perception of susceptibility to social media trends or other factors, as opposed to fundamentals driving valuations, could pressure some ratings, especially if it led to lower retail allocation towards equities.