Capital Markets Efficiency, Fairness and Distributed Ledger Technology
By: Ajay Singh
Tags: Capital Markets, Digital Transformation, Distributed Ledgers, Trading, Risk Management

Among the variety of unique experiences we have had in recent years, the GameStop incident will also go down in history as a key event for financial markets. As we strip down the noise and focus on the core dynamics that are in place, there are a lesson or two to be learned. This post is not to defend or criticize any market participants or view (hedge funds, WallStreetBets, Robinhood, DeFi), but to highlight the limitations of the current financial markets infrastructure and making a case that the need to adopt new technologies are more than ever to manage various market risks.

Financial markets are evolving rapidly with the availability of free money (as a result of lower interest rates) and new technologies that enable new phenomena to emerge in the market. A summary of the GameStop incident is the following. Melvin Capital Management and Citron Research shorted GameStop shares. However, a few individual trades saw potential in the stock and took it to Reddit. The Reddit group WallStreetBets, which has around 6 million members, rallied behind the idea driving the stock price 16 fold in a few weeks. This created a short squeeze and both Melvin Capital Management and Citron Research had to exit their short positions with losses totaling billions. Citadel and Point72 Asset Management infused around $3 billion in Malvin Capital to manage the situation. Robinhood had to halt the trading of GameStop for a day and closed positions for several users without their permission. This created a nationwide backlash from traders, politicians, technologists, etc. Robinhood also had to raise more than $1 billion to manage the margin calls.

As Robinhood restricted retail traders from buying GameStop, the backlash was around the influence of hedge funds on Robinhood, the fairness of the market, and transparency. Several of these issues are human problems that technology alone cannot solve. It requires strict regulations and relentless pursuit to impose them on the market. However, there is a meaningful and fundamental aspect that technology does address to support fair and efficient markets.

The root cause of several of the issues in the GameStop incident is linked to the delayed settlement of cash and securities. In capital markets, cash and securities settle at T+2 or later. Amature traders deposit money at Robinhood that settles in two or more days. However, brokers like Robinhood will let traders use margin accounts to trade immediately. Such activity is generally financed by prime brokers (PB) that work with the broker and lend the money. The retail broker will execute trades on behalf of its users and manage the margin with clearinghouses. All of this in the hope that at T+2, both the securities and cash will exchange hands across the market participants!

Fig. 1: GME stock prices at the end of the day on January 27, 2020. Source: TradingView.

However, this harmony in the market breaks in incidents like GameStop or at higher volatility than we saw in the early months of Covid-19. I don’t know what exactly happened at Robinhood on the evening of Jan. 27, 2020, but one would be worried about scenarios that I am going to describe next. First, Robinhood will likely need to come up with a large margin payment to the clearinghouse to manage the settlement of heavily traded GME stocks. Several prime brokers (PBs) likely support the margin accounts of users at Robinhood and in exchange for lending money, PBs hold the custody of the stocks. However, PBs monitor multiple risk limits for Robinhood and will not breach those limits by lending larger amounts in volatile markets. So liquidity becomes an issue for Robinhood. Second, since GameStop’s stocks are so volatile, a large fluctuation in price can result in significant losses to its users the next day. Those losses may result in margin calls to traders and some of those traders may default. That will further worsen the liquidity issues at Robinhood.

Fig. 2: A risk scenario that market participants faced around the trading of GameStop on Jan. 27, 2020.

One of the factors at the core of the GameStop incident is that trading happens based on market conditions at T+0 but settlement and risk management takes place based on projected circumstances at T+2. At the point of trading, market players do not have an unchangeable view of liquidity and obligations that will last until settlement. This results in an inaccurate perception of risk and can impede the flow of assets and cash in the capital markets network, even for diligent investors. Basically, fair and efficient markets just cannot exist with T+n settlement of cash and securities.

The T+2 settlement is partially a reflection of market evolution and partially a limitation of the current market infrastructure. The incumbent database or cloud-based technology is such that it requires data hopping across organizations and leaves room for errors in the settlement process. There is no immutable, “shared truth” of obligations across capital market participants. The capital markets have reduced the settlement time over the period from several days to two days. However, the journey from T+2 settlement to immediate settlement demands a very high precision in processes. The existing market infrastructure cannot support such precision in the sense that the cost will be much higher compared to developing DLT solutions, which ensures the immutability of the data by definition. More details around this point are in the following blog post.

The efficiency in cash and securities settlement through DLT will get introduced gradually through specific use cases. Generally, the case for transformation through new technology is made based on the cost of specific processes at an individual organization and how much savings will be introduced. Robinhood lost millions of users in just a few days because of the GameStop incident and may have faced existential questions while trying to avert a default on margin calls and manage settlement risk. In our opinion, the value delivered by DLT solutions in risk management, ensuring business continuity, client engagement, and business growth outweigh the operational savings and cost of transformation by many multiples.

Thanks to Jean Desgagne for feedback and comments on the post.