You may have heard: Yesterday, in the midst of a huge rise in stocks and rising trading volumes, Robinhood interrupted its users’ ability to trade GameStop (GME) shares. Chaos ensued. Retail traders around the world complained, accusing the initial broker of protecting hedge funds and the establishment at its expense. US politicians across the spectrum, from Rep. AOC to Senator Ted Cruz, met to criticize the decision on Twitter. Venture capitalists and technologists questioned the morality of Robinhood’s founders and proclaimed that the moment of decentralization had finally arrived.
Robinhood did not interrupt the GameStop trade to punish the insurgent mass of retailers. Not out of a paternalistic impulse to try to protect them. Robinhood stopped selling GameStop because he was forced to do so, thanks to a set of standards set by upstream market participants. Clearing firm Robinhood, the company that facilitates the settlement of brokerage negotiations, was unable to keep up with the risk it was being asked to take.
Jill Carlson, a columnist for CoinDesk, is a co-founder of the Open Money Initiative, a nonprofit research organization that works to guarantee the right to a free and open financial system. She is also an investor in early-stage startups at Slow Ventures.
Clearing firms exist in part to mitigate the consequences if a broker-dealer fails to meet its obligations. Clearing firms therefore need to maintain tight control over risk. This means that they need to put more money to profit from trading as markets get more and more crazy (that is, as volatility increases). The GameStop market was as crazy as possible. The clearing firm could not take any more risks. Robinhood was unable to pass on more funds to the clearing firm. The music had to stop.
These are precisely the types of controls that have become so clearly important in the wake of the 2008 financial crisis: strict risk management, transparency, liquidity limits and capital requirements. These standards are designed to avoid reckless behavior and mitigate the consequences if a financial company becomes overexposed. When retailers demanded that these rules be implemented in large institutions ten years ago, they could not imagine that these rules would ever exclude them from the market.
Yesterday highlights the importance of understanding all the tedious nuances of commercial backoffices and the standards, rules, regulations and protocols that accompany them. Settlement of a trade takes two days. Thus, clearing firms have two days of exposure to the counterparty firm.
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 that. The reality is that, as with so many things that people claim that blockchains can fix, this problem is almost entirely one of process and regulation. Perhaps the new technology can be a catalyst for revisiting them, but it is certainly not the limiting factor.
The Securities and Exchange Commission determines securities settlement periods to keep processes between counterparties running smoothly. There are many short-term securities that are settled on the same day, such as certificates of deposit and commercial paper. Actions take as long as partly due to historical precedents, which date back to the time when technology was in fact the constraint. Each financial institution got used to the processes involved in settlement periods of several days. Financial institutions are usually creatures of slow evolution, which means that they are used to prefer. Since their processes are built around multi-day settlement, they continue to choose multi-day settlement. The solution to this is no more a blockchain than a centralized database.
Robinhood stopped selling GameStop because he was forced to do so, thanks to a set of standards set by upstream market participants.
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 we had shares on a blockchain, we would be saved from two-day settlement periods and the risks and inefficiencies they impose.
But the problem is not with technology. They are in the way the protocols, processes, rules and laws of the market were developed. And that kind of problem doesn’t go away, no matter how decentralized your trading location is or how many blockchains you are using.
There are, of course, many archaic and obsolete practices that market leaders continue to adhere to. But it is very easy to protest blindly against them or to blame them on technology without examining where these practices come from or why they exist. In the most extreme cases, these processes prevail for reasons of risk management. In more innocuous cases, these practices simply emerged from the human behavior of those who interact with the markets.
See also: Preston Byrne – ‘The Squeezening’: how GameStop Backlash will reduce freedom
When XRP was decentralized earlier this month by Coinbase and many others, there was no sudden increase in liquidity and activity on the decentralized exchanges that list the asset. This is because traders do not would you like to touch the asset, given the regulatory concerns surrounding the asset.
Also consider whether markets should be open and active 24 hours, 7 days a week, 365 days a year. This is another area where I often hear people saying that new technologies would solve this, pointing to cryptocurrency markets that are always open. But there are already many conventional markets that are always open. All over-the-counter markets work like this on Wall Street. If I want to do a counter operation, I can theoretically call a market maker at any time and ask for a price. In all likelihood, though, I don’t want to. I want to wait for the moments when there is liquidity.
Much of how the financial market works is based on historical human behavior, whether it is coding them in market standards or erecting barriers against their natural tendencies. Certainly, the events of the past few weeks and years demonstrate that many of these policies and procedures are worth reviewing. Cryptocurrency markets have proven that there may be demand for markets 24 hours a day, 7 days a week, at least in some asset classes. GameStop has shown that certain retail brokers may need to be better capitalized to anticipate the type of wave behavior we saw this week.
Innovations like blockchains and decentralized exchanges can continue to prove that more of these assumptions and behaviors are wrong in the 21st century. And for that, they are important. But technology itself is not the solution.