Robinhood users accused the broker of ceasing trading GameStop stock and other securities for the past month while retailers started a buying frenzy on a Reddit forum.
But Robinhood might not have had a choice. After all, Robinhood is just one player in a public securities market that has been built up over decades. In this system, brokerage apps like Robinhood are only the visible tips of an iceberg, but the actual transactions and settlements remain hidden from the public. Much control remains in the hands of a single central custodian: the Depository Trust and Clearing Corporation (DTCC).
Settlement occurs when inventory is delivered to the buyer and money is delivered to the seller. Often the intermediary – the DTCC – is responsible for facilitating this delivery, at least in the public securities market. The broker would send the client’s money to the DTCC through their clearing company.
The DTCC controls interest rates, acts as a counterparty to most transactions, and underpins the entire public securities market.
There is also a subsidiary called the National Securities Clearing Corporation (NSCC), which is responsible for clearing and settlement services, as well as a subsidiary called the Depository Trust Company (DTC), which is responsible for the maintenance and clearing of corporate and local securities.
The DTCC calculates the cash margin requirements for stocks and publishes the data on its website. Brokers can use this information to model what the markets are doing, said Carlos Domingo, CEO and founder of Securitize, a security token firm and a registered transfer agent with the Securities and Exchange Commission (SEC).
Clearing firms also use this information to determine margin requirements for brokers to ensure they have adequate cash.
If certain stocks become volatile, for example due to coordinated efforts to buy them and increase their price, the clearing house may charge more to run the trades. Apps like Webull, M1 and Public all reported clearing fees when they stopped trading stocks like GME last month.
Robinhood said in a blog post published in late January that trading in GME and other securities was also suspended due to company clearing costs.
history
Before we get into GameStop, we should take a look at why the DTCC exists in the first place and what decades of infrastructure the US securities market is based on.
Previously, business was done through transactions using physical slips of paper, Domingo said. In the 1960s, Wall Street back offices failed to keep pace with the daily volume of trade known as the Wall Street Paperwork Crisis.
“They had to close Wall Street on Wednesdays to do business,” he said. “They were looking for two ways to digitize or automate this system. One could be a peer-to-peer deal where brokers could compromise, or they could use a central custodian and so the DTCC was born. “
The settlement trades fell from five days (T + 5) to three days (T + 3) and later to two days (T + 2).
T + 2 has only emerged in the past few years, said Gautam Gujral, general counsel and co-founder of the digital asset management platform Vertalo.
“To make this minor move from T + 3 to T + 2, it took Wall Street about six years of unannounced effort to get there,” he said.
How are trades now processed?
While Robinhood primarily blamed clearing costs for the suspension of trades, CEO Vlad Tenev also pointed to settlement times as an issue, saying the two-day gap posed a risk to investors.
Let’s go over a hypothesis for the sake of simplicity. If I signed up for a brokerage app like Robinhood, Webull, or Cash App (as examples) I could buy and sell securities available in the public market. These include stocks like GME or Exchange Traded Funds (ETFs). Some brokers are now also allowing customers to purchase cryptocurrencies, although there may be restrictions on trading or transferring them to wallets outside of the platform. This is what this hypothetical process could look like:
- I would buy a stock in this app, let’s call it $ STOCK.
- The order is sent to the internal order management system (OMS) of the app.
- The OMS would route the order to an exchange or another broker-dealer.
- After the order is matched, the app would notify the exchange.
- All orders from the exchange would flow into the continuous net settlement process, in which all of a company’s trades are combined into a long and short position in the NSCC.
However, that does mean that if you buy a stock of Robinhood and it shows up in your portfolio, it doesn’t necessarily mean that you actually “own” it or that that transaction has gone through, Domingo said.
Some apps – Domingo pointed to JPMorgan as an example – show unresolved transactions, but “Robinhood doesn’t do that.”
“The fact that people are trading with Robinhood, they think it’s like buying bitcoin because they buy bitcoin and it shows up on their account,” he said. This is not a new problem either.
Robinhood could have taken steps to soften last month’s trading freeze, Domingo said. If the company had better modeled what happens to the GME market and other volatile stocks, it could have predicted cash needs.
“The fact that I think Robinhood missed this is a sign of mismanagement on their part,” he said. “They definitely resulted in people losing money because of a lack of planning.”
Why not T + 0?
Robinhood CEO Tenev claimed T + 0 would prevent volatile markets like those of GameStop and AMC.
“Investors are waiting for their trades to be closed and the clearing brokers have locked up their own cash until settlement occurs in the final days after the trade,” Tenev wrote on a blog post in February. “The clearinghouse deposit requirements are designed to mitigate risk. However, last week’s wildlife market activity has shown that these requirements, coupled with an unnecessarily long settlement cycle, can have unintended consequences that create new risks.”
However, the transition to shorter settlement requires a broad buy-in in the securities markets industry.
Moving from T + 3 to T + 2 will require industry approval, and further shortening the settlement cycle will also require participant approval, Gujral said.
A DTCC spokesperson referred CoinDesk to a blog post on its website when it was reached after a comment entitled “Why Shortening the Settlement Cycle Will Benefit the Industry and Investors”.
The Question, a question-and-answer session with CEO Michael McClain, also stated that industry participants are reluctant to further shorten the settlement cycle.
“Although DTCC’s equity clearing and settlement subsidiaries, NSCC and DTC, can support some T + 1 and even same day settlements with existing technology, many market participants take advantage of this option due to the complexity of the market structure, the existing business and operational processes do not. Said the post.
Switching to same-day settlement could reduce the liquidity the current market supports, according to the DTCC post.
The technology exists to further reduce turnaround time, Domingo said. The DTCC has even looked into whether security tokens or other decentralized solutions could be more efficient. A similar study was carried out by the Bank of Canada.
“The conclusion was the same. It is possible from a technological point of view, but these people are trading with more money than they have, ”he said.
There are tradeoffs in moving to a shorter turnaround time. The current T + 2 model allows customers and brokers to send transactions on credit. However, this would be more difficult and risky at T + 1 or T + 0.
“You can do that with the current model because it’s not an immediate solution,” Domingo said.
Can blockchain fix that?
The DTCC’s post also stated that the company was investigating whether distributed ledger technology was a solution to reduce turnaround times.
“We know there [are] Processing efficiency when using blockchain. It is already developing in the private securities market. [though] Not at all in the public securities market, ”said Gujral. “At the very least, the market needs to start looking into how to use either a private or a public blockchain to do this, with pretty much instant execution.”
However, these benefits appear to largely apply only to private securities markets, which are smaller and less liquid.
Tenev wrote in his blog post “Technology is the answer” and advocated faster processing. Third party elimination of intermediaries could streamline parts of the process, but it could also introduce financial risks to agents and clients.
“You’re introducing credit risk elsewhere,” Domingo said.
The question also arises of whether a currently functioning blockchain can support the US public securities market and the sheer volume of transactions required.
“Blockchain fixes a lot of these things, but we’re still developing the architecture and ecosystem to do that,” Gujral said.
