You may have heard: Yesterday, amid an enormous rally in the stock and surging trading volumes, Robinhood halted the ability of its users to trade GameStop (GME) stock. Chaos ensued. Retail traders everywhere cried foul, accusing the startup brokerage of protecting hedge funds and the establishment at their expense. U.S. politicians across the spectrum, from Rep. AOC to Sen. Ted Cruz, came together to lambast the move on Twitter. Venture capitalists and technologists called into question the morality of Robinhood’s founders and proclaimed that the moment for decentralization had finally arrived.
Robinhood did not halt trading of GameStop to punish the insurgent mass of retail traders. Nor did it do so out of a paternalistic impulse to try to protect them. Robinhood halted trading of GameStop because it had to, thanks to a set of standards put in place by market players upstream. Robinhood’s clearing firm, the company that facilitates the settlement of the broker-dealer’s trades, could not keep up with the risk it was being asked to take on.
Clearing firms exist in part to mitigate the consequences should a broker-dealer fail to meet its obligations. Clearing firms therefore need to keep a tight handle on risk. This means they need to put up more money to make good on trades as markets get wackier and wackier (that is, as volatility increases). The GameStop market was about as wacky as it gets. The clearing firm couldn’t take on any more risk. Robinhood couldn’t fork over any more funds to the clearing firm. The music had to stop.
These are precisely the type of controls that became so clearly important in the wake of the 2008 financial crisis: strict risk management, transparency, liquidity thresholds, and capital requirements. These standards were designed to prevent reckless behavior and to mitigate the fallout should a financial firm become overexposed. When retail traders demanded these rules be implemented on big institutions 10 years ago, they couldn’t have imagined those rules would someday shut them out of the market.
Yesterday highlights the importance of understanding all of the boring nuances of trading back offices and the standards, rules, regulations and protocols that go along with them. Settling a trade takes two days. Thus, clearing firms have two days of exposure to their counterparty firm.
Why does it take two days? People love to say this is a technology issue and that innovations like blockchains can fix this. The reality is, as with so many things that people claim blockchains can fix that this issue is almost entirely one of process and regulation. Perhaps new technology can be a catalyst to revisit these, but it is certainly not the limiting factor.
The Securities and Exchange Commission mandates settlement periods for securities to keep processes among counterparties running smoothly. There are plenty of short-term securities that do settle the same day like certificates of deposit and commercial paper. Equities take as long as they do in part because of historical precedent, dating from the times when technology was indeed the constraint. Every financial institution became accustomed to the processes involved in multi-day settlement periods. Financial institutions are generally slowly evolving creatures, meaning that which they are used to is that which they prefer. Because their processes are built around multi-day settlement, they continue to choose multi-day settlement. The solution to this is not a blockchain anymore than it is a centralized database.
It is so tempting to turn these conversations into conversations about technology. If only we had a decentralized financial trading platform, we would be saved from the censorship imposed by Robinhood or clearing firms or the SEC, the thinking goes. If only we had equities on a blockchain, we would be saved from two day settlement periods and the risks and inefficiencies they impose.
But the issues lie not with the technology. They lie with the way the protocols, processes, rules and laws around the market were designed. And these kinds of issues do not go away no matter how decentralized your trading venue is or how many blockchains you are using.
There are, to be sure, many archaic and obsolete practices that those in charge of the markets continue to adhere to. But it is all too easy to blindly rail against these or to blame them on technology without examining where these practices came from or why they exist. In the most extreme cases, these processes prevail for risk management reasons. In more innocuous cases, these practices simply emerged from the human behavior of those interacting with the markets.
When XRP was de-platformed earlier this month by Coinbase and many others there was not a sudden rush of liquidity and activity on decentralized exchanges that list the asset. That is because traders did not want to touch the asset given the regulatory concerns around the asset.
Take also the question of whether markets should be open and active 24 hours, 7 days per week, 365 days per year. This is another area where I frequently hear people saying that new technology would resolve this, pointing to cryptocurrency markets that are always open. But there are already plenty of mainstream markets that are always open. All over-the-counter markets work this way on Wall Street. If I want to do an over-the-counter trade, I can theoretically call up a market maker any time and ask for a price. In all likelihood, though, I don’t want to. I want to wait for times when there is liquidity.
So much of how the financial market works is based on historical human behaviors, either codifying them into market standards or erecting guardrails against their natural tendencies. To be sure, developments of the last weeks and years demonstrate that many of these policies and procedures are worth revisiting. Cryptocurrency markets have proven that there might be demand for 24/7 markets, at least in some asset classes. GameStop has shown that certain retail broker-dealers might need to be better capitalized to anticipate the kind of groundswell behavior we have seen this week.
Innovations like blockchains and decentralized exchanges may continue to prove more of these assumptions and behaviors wrong in the 21st century. And for that purpose, they are important. But technology itself is not the solution.
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