You may have heard: yesterday, in the face of a huge rally in its stock and increasing trading volume, Robinhood halted its users’ ability to trade GameStop (GME) stocks. Chaos followed. Retailers everywhere were crying badly, accusing the startup broker of protecting hedge funds and the facility at their own expense. US politicians from across the spectrum, from Rep. AOC to Senator Ted Cruz, came together to lambast the move on Twitter. Venture capitalists and technologists challenged the morale of the Robinhood founders, proclaiming that the moment for decentralization had finally come.
Robinhood did not cease trading with GameStop to punish the insurgent mass of retailers. Nor was it for paternalistic reasons to try to protect them. Robinhood stopped trading GameStop because it was required to do so thanks to a number of standards put in place by the upstream market participants. Robinhood’s clearing firm, which makes it easier for the broker-dealer to run its business, has not been able to keep up with the risk it was supposed to take.
Jill Carlson, a CoinDesk columnist, is a co-founder of the Open Money Initiative, a nonprofit research organization that advocates the right to a free and open financial system. She is also an investor in start-ups with slow ventures.
Clearing firms exist in part to mitigate the consequences if a broker-dealer fails to meet their obligations. Clearing firms must therefore have the risk firmly under control. This means that they will have to raise more money to make amends for trades as the markets get crazier (i.e., when volatility increases). The GameStop market was as crazy as it gets. The clearing company couldn’t take any more risks. Robinhood was unable to provide the clearing company with any further funds. The music had to stop.
These are exactly the types of controls that became so clearly important after the 2008 financial crisis: strict risk management, transparency, liquidity thresholds and capital requirements. These standards should prevent reckless behavior and mitigate the effects of an overexposed financial company. When retailers asked large institutions to implement these rules 10 years ago, they couldn’t imagine that one day these rules would ban them from the market.
Yesterday highlighted the importance of understanding all the boring nuances of back office trading and the standards, rules, regulations and protocols that go with it. A trade takes two days to complete. This gives clearing firms two days’ exposure to their counterparty.
See also: Jill Carlson – GameStop and the Real Market Manipulators
Why does it take two days? People love to say that this is a technology problem and that innovations like blockchains can fix it. The reality is, like so many things that people claim blockchains can fix the problem, it is almost entirely a process and regulation. Perhaps a new technology can be a catalyst to rethink this, but it is certainly not the limiting factor.
The Securities and Exchange Commission stipulates settlement deadlines for securities to ensure that processes between counterparties run smoothly. There are many short-term securities that are settled the same day such as certificates of deposit and commercial papers. Stocks take as long as they do because of historical precedents dating back to when technology was actually the barrier. Every financial institution has got used to the processes in multi-day billing periods. Financial institutions are generally slow moving, which means what they’re used to is what they prefer. Since their processes are based on multi-day billing, they still opt for multi-day billing. The solution for this is no longer a blockchain, but a centralized database.
Robinhood stopped trading GameStop because it was required to do so thanks to a number of standards put in place by the upstream market participants.
It’s so tempting to turn those conversations into conversations about technology. If we only had a decentralized financial trading platform, we would be saved from censorship by Robinhood, clearing firms, or the SEC. If we only had stocks on a blockchain, we would be protected from two-day billing cycles and the associated risks and inefficiencies.
However, the problems are not in the technology. They lie in the way the protocols, processes, rules and laws are designed in the marketplace. And these types of problems won’t go away no matter how decentralized your trading venue is or how many blockchains you use.
There are, of course, many archaic and outdated practices that market leaders continue to adhere to. But it is all too easy to blindly rail against them or to attribute them to technology without examining where these practices came from or why they exist. In the most extreme cases, these processes predominate for reasons of risk management. In more innocuous cases, these practices simply emerged from the human behavior of those interacting with the markets.
See also: Preston Byrne – ‘The Squeezening’: How the GameStop Backlash Restrains Freedom
When XRP was de-platformed by Coinbase and many others earlier this month, there was no sudden surge in liquidity and activity on decentralized exchanges where the asset is listed. This is because traders did not want to touch the asset given the regulatory concerns surrounding the asset.
Also ask yourself whether the markets should be open and active 24 hours, 7 days a week and 365 days a year. This is another area where I often hear people say that new technology would solve this problem, indicating cryptocurrency markets that are always open. But there are already many mainstream markets that are always open. All of the over-the-counter markets on Wall Street work this way. If I want to trade over the counter, I can theoretically call a market maker at any time and ask for a price. Most likely I don’t want that. I want to wait for times when there is liquidity.
So much of the way the financial market works is based on historical human behaviors either codified into market standards or guardrails erected against their natural tendencies. However, developments in recent weeks and years show that many of these guidelines and procedures are worth revising. Cryptocurrency markets have proven that there is a demand for 24/7 markets in at least some asset classes. GameStop has shown that certain broker-dealers may need to be better capitalized to anticipate the fundamental wave behavior that we saw this week.
Innovations like blockchains and decentralized exchanges could further prove that more of these assumptions and behaviors are wrong in the 21st century. And that’s why they’re important. However, the technology itself is not the solution.
