Did Reddit Break the U.S. Securities Markets?
The GameStop frenzy raises questions about plumbing adequacy in the securities market.
Recent market dexterity in GameStop and other “meme stocks” has cast a national spotlight on certain practices of Wall Street firms and sparked discussion about the evolving role of technology in regulating US capital markets.
In response to this market volatility, some broker dealers temporarily chose limit trading meme shares. The Financial Services Committee of the United States House of Representatives responded quickly convene a hearing to discuss the circumstances surrounding the trading frenzy. Retail investors turned on the market volatility when they jointly executed an investment strategy using the “WallStreetBets” subchannel of the social media site Reddit to identify securities in which hedge funds had accumulated significant short-term interest positions.
In a follow-up hearing, members of Congress noted that recent market events raise critical questions about how U.S. capital markets work, including: conflicts of interest related to a practice known as payment for order flow; the adequacy of short sale disclosures; the market dominance of certain participants; the impact of gamification on US capital markets; and whether regulators should speed up settlement times.
In his testimony to Congress, Vlad Tenev, the Chief Executive Officer of Robinhood Markets Inc., one of the broker-dealers involved, noted that the Company’s decision to impose temporary trading restrictions on certain securities was solely to “facilitate compliance with the clearinghouse’s deposit requirements” and to comply with all trading rules. In addition, the CEO of Robinhood claimed that real-time settlement of securities would have avoided the need for trading restrictions and reduced the overall congestion of the securities clearing system.
That feeling was reflected in statements and questions from representatives Warren Davidson (R-Ohio), David Kustoff (R-Tenn.), Barry Loudermilk (R-Ga.), Blaine Luetkemeyer (R-Mo.), And John Rose (R-Tenn.), All of whom questioned whether a same-day settlement cycle would have resolved the issues in this situation, and what unintended consequences might arise if the settlement deadline is shortened to real-time. James J. Angel, a professor of finance at Georgetown University, concluded that the trade restrictions were the result of “a crazy flight to fix the leaks in our outdated market pipelines.”
But in late January 2021, the acting chairman and all commissioners of the U.S. Securities and Exchange Commission (SEC) issued a statement on recent market volatility confirming that “core market infrastructure has proven resilient under the weight of this week’s extraordinary trading volumes.” Days later, during an exchange between Elon Musk and Robinhood’s CEO of the social networking app Clubhouse, Musk questioned the motive behind the trading restrictions, whether certain hedge funds have pressured broker-dealerships to stop trading.
Did outdated plumbing in the securities trading infrastructure indeed cause the trade restriction? Or, like Musk suggested, “Did something shady go down?” In either case, the SEC must respond to the long-standing calls to speed up the process of clearing and settlement of securities transactions.
Securities “approval” is the method of calculating the securities and money participants owe each other from a securities trade. “Settlement” refers until the completion of a securities transaction – where the seller transfers securities to the buyer and the buyer transfers money to the seller. Today the standard clearance and settlement bicycle for most securities transactions, this is two business days after the transaction is executed (T + 2). The current national clearing and settlement system for securities transactions is largely a product of the difficulties encountered in U.S. securities markets in the late 1960s and early 1970s – known as the ‘Paperwork crisis. “
The Depository Trust & Clearing Corporation (DTCC) is at the center of most securities transactions in the US securities markets. The subsidiaries of DTCC, the Depository Trust Company (DTC) and the National Securities Clearing Corporation (NSCC), clear and settle nearly all securities transactions in the United States. NSCC serves as the central counterparty for almost all US stock trading. It becomes the buyer for every seller and the seller for every buyer.
When a party sells a share, the clearing system electronically transfers the shares from the seller’s broker’s account to NSCC and credits them to the buyer’s broker’s NSCC account. Through compensation a company’s buy orders for a particular security versus sell orders for that security – a process known as ‘netting’ – NSCC is able to reduce the total number of daily trading obligations requiring financial settlement by 98 percent.
The Continuous net settlement system (CNS) is NSCC’s main clearing system. CNS bets each security on one position for each participant on a daily basis, meaning that each broker-dealer owes or is owed only one block of shares for each security at the end of each day. NSCC is the central counterpart of any broker-dealer through the legal concept of “novation. CNS owes either shares of a security to the broker-dealer or the broker-dealer owes shares of that security to CNS. customers are invisible to CNS.
Parties to a securities transaction are faced with counterparty risk during the period between execution of the transaction and settlement. On the sell side, NSCC and the clearing members assume the risk of counterparty default. Be broker dealers responsible for holding capital with NSCC to protect both NSCC and its members from this risk. In addition, both institutional and retail investors run the risk of default between brokers and traders. To protect you against a possible default by the buyer or seller, NSCC maintains a multi-billion dollar clearing fund funded by affiliated broker-dealers in accordance with the rules approved by the SEC.
Events such as “Black MondayIn 1987 resulted in calls to reduce credit, market and liquidity risks by shortening the settlement cycle. It would significantly reduce the time between transaction execution and settlement by one business day Reduce the risk of default of a counterparty. Reducing counterparty risk would, among other things, reduce the capital requirements that the NSCC, as a self-regulatory organization, imposes on its affiliated broker-dealers to mitigate this risk.
DTCC has joined the chorus, which favors regulatory improvement by releasing a white paper outlining a two-year industry roadmap to shorten the settlement cycle for US stocks to one business day after the trade is executed (T + 1). As the frequency and intensity of market volatility has increased, so have advancements in technology and core business processes.
Given the potential benefits of accelerated settlement, regulators should carefully consider improvements to DTCC. An example is Project ION, a series of initiatives proposed by DTCC, including the implementation of distributed ledger technology to accelerate and optimize the settlement process.
New technology platforms, such as Reddit and Robinhood, have created unprecedented volatility in the securities markets. The SEC and DTCC must act quickly to ensure that the market leadership system that supports this trade can keep up.
This essay is part of an 11-part series entitled Regulation in the Age of Fintech.
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