Digital Technology — A Cure for Wall Street’s Problems
How digital securities will fix the Wall Street issues that occurred with Robinhood and GameStop
March 08, 2021; By Alan Konevsky, Chief Legal Officer at tZERO
With the latest development from Depository Trust & Clearing Corporation (DTCC) proposing a roadmap to shorten the U.S. settlement cycle from T+2 to T+1 within two years, as well as the recent developments regarding trading in GameStop and other securities, it’s important to underscore the importance of near-instant-settlement (T+0) and how blockchain technology can propel this solution forward.
We at tZERO have long believed there is a way to bring real-time settlement, efficiency, transparency, and inclusiveness to capital markets using blockchain technology. Since our inception, we have been a leader and advocate in the evolution of next-generation capital markets.
The events surrounding GameStop and other securities have made one thing crystal clear - this time, to a much broader audience - inefficiencies in capital markets need to be addressed.
To better understand these inefficiencies, let’s explore four problems we saw with GameStop and some other securities.
- Extreme price volatility in a select group of securities
- Broker-dealers imposing restrictions on buying of these volatile securities
- Increased negative perception and lack of public trust in Wall Street institutions
- Lack of transparency in securities lending activities that enable short positions
1. Extreme price volatility in a select group of securities
Based on market information, it appeared that individual market participants took GameStop shorting to more than 100% of the outstanding shares. Short selling is when an investor expects a stock’s price to drop, either as a trading strategy or as a hedge. Investors with a negative view sell borrowed shares with the expectation of repurchasing them at a lower price in the future. Short sellers or their brokers borrow stock to settle the trade two days later. Because of that delay in settlement and lack of transparency into available shares, overlending can occur, meaning that more shares are sold than issued. A well-known example of that is the Dole Food case, where the Delaware court received shareholder claims for more shares than were outstanding. Court records indicated that the cause of the discrepancy was likely short selling and the manner in which brokers hold shares for their customers through aggregated positions at the central depository and clearing system, DTCC.
With GameStop, certain other participants, including a group of Reddit users, discussed their conclusion that more than 100% of the outstanding shares were sold and started buying GameStop’s shares. This demand drove up the price, increasing the losses of short sellers and forced them to close their shorts by buying more shares to redeliver the shares they borrowed (which may have been borrowed several times due to the opaqueness of the securities lending market, as well as influenced by other potential factors, including the ability to rely on the expectation to borrow vs. actually borrowing the shares, market participants intentionally or in good faith relying on opaque/outdated information on hard to borrow/easy to borrow securities especially if the trader assumes it will never have to deliver the shares, and delayed settlement cycle we discussed). There is also the possibility of a naked short position, an illegal practice where the short seller never even attempts to borrow the shares, or determine that they can be borrowed, to begin with. This created a feedback loop resulting in significant increases in the price of GameStop shares.
How does the system allow you to sell more than 100% of a company’s shares? Don’t you have to borrow the stock before shorting it? As noted earlier, in the current U.S. capital market system, the master records for almost all U.S. stocks are held by a central depository and clearing system, with DTCC and its subsidiaries like the National Securities Clearing Corporation (NSCC) at the core of it. This system works on a delayed basis to allow its systems to process ownership changes. While it is an improvement on the physical settlement system it replaced, it needs to be overhauled in view of its flaws and availability of superior new digital technology. The existing NMS market lacks transparent and real-time methods of knowing how many shares are available. So, it assumes that shares will be available to borrow and allows a sale. Market intermediaries that enable securities lending are opaque. Sometimes this results, for various reasons (innocent and less innocent), in more shares being sold than exist.
Blockchain technology solves this problem. Blockchain-based digital securities are issued on a transparent database, with the ownership and transaction records visible in real-time in a secure and privacy-conscious way. Digital securities cannot be duplicated. There is always visibility into the number of shares outstanding, and there are automated controls (called smart contracts) that govern all transactions on-chain. There are also administrative functionalities, escrows, and other tools to protect from errors, unauthorized access, and fraud in ways that are more effective than traditional market practices and rules. Thus, the opaque market infrastructure that permitted the same shares to be borrowed and sold more than once are eliminated. This is assuming there is value in permitting users to sell shares that they don’t own, which is debatable and should be validated.
2. Broker-dealers imposing restrictions on buying individual shares
We are now familiar with the outrage against Robinhood and other trading platforms for prohibiting the buying of GameStop and certain other stocks. These platforms bore the brunt of the public’s anger, but the central issue most likely originated from the fundamental DNA of how Wall Street works and the centralized opaque custody and clearing model we mentioned above.
Legacy systems that necessitate the delayed settlement lead to further inefficiencies, including the need to manage the risks that delayed settlement creates in ways that introduce further inefficiency and potential for error/manipulation.
Most investors can only really invest in securities like GameStop (NYSE: GME) through a broker-dealer that participates in DTCC. DTCC, as part of its risk management rules, requires its participant financial firms to hold certain clearing deposits/other financial guarantees to ensure that the transactions settle to give the firms on the other side of the trade comfort that a trade done today will settle in two business days’ time. The required amount of the deposit varies based on the volume and volatility of the securities purchased by a broker-dealer’s customers awaiting settlement.
When the volume and volatility in GameStop rose, broker-dealers were required to increase their corresponding cash on deposit with DTCC by more than ~10x overnight. Deposits required by the DTCC for the trading of GameStop on Robinhood were seemingly arbitrarily apparently increased by ~10x to $3 billion, and over the next day negotiated down to $1.4 billion, then to $700 million according to media reports. Broker-dealers cannot use client funds for this deposit and don’t necessarily have that kind of cash lying around -- they have to draw down on credit lines or raise equity capital or stop trading the security. So, many broker-dealer platforms just banned buying in the affected shares. Sell orders don’t increase the required amount of a broker-dealer's deposit so the selling was permitted to continue. Again, a flawed system attracts flawed fixes that produce a cascade of further bad results. You don't necessarily need nefarious motives or actions -- just a system that does not work well by design.
But why does the DTCC require a deposit? Hasn’t the buyer already paid its broker before executing the trade? Remember the delayed settlement we discussed as one of the first principles problems? In the T+2 system of settlement, the exchange of cash for stock ownership (settlement) happens two days after the execution of the trade. If a broker-dealer defaults and DTCC ceases to act for that broker-dealer in the clearance and settlement process, DTCC will liquidate the broker-dealer’s portfolio and use the proceeds and the broker-dealer’s deposit to cover its costs.
Blockchain solves this problem. With blockchain technology, the trade is the settlement, meaning settlement is instant (T+0), not trade date, plus two business days (T+2). Blockchain technology eliminates the risk exposure associated with unsettled positions. Further, market participants can settle directly with each other on a distributed ledger on a trade-by-trade basis. These trading records will be available to the public, eliminating the gaps in transparency that harbor distrust and create the potential for mischief. The DTCC’s recent roadmap acknowledged the benefits of shortening the T+2 settlement, but noted that, “the hurdles to netted T+0 and especially to instantaneous, real-time gross settlement are too great at this time.” Reasons cited for this view, among others, included that moving to a real-time settlement model would eliminate the benefits of netting. While we acknowledge the liquidity and risk-mitigating benefit of netting in the current market infrastructure, a blockchain-based market infrastructure would largely address or eliminate many of the concerns raised by participants - and the movement to a blockchain-based setting could support a netted T+0 settlement cycle (to the extent beneficial) and avoid the need to fix the flaws or a flawed system with flawed solutions. We plan to take a dive deeper into the points raised in the DTCC’s white paper in an upcoming blog post.
At tZERO, we have been working on the solution to risk associated with the settlement lag in traditional capital markets for years - we believe widespread adoption of digital securities is the path forward to address these risks. We already use digital securities for same-day settlement, and in the near future, we are launching an instant settlement solution.
3. Increased negative public perception and lack of trust in Wall Street institutions
Many note that they do not trust the current system. Income inequality has grown in the country.The economy has been in a major downturn, but the stock market has continued to boom and is at all-time highs. This divergence between reality on Main Street and high-times on Wall Street has led to the widespread belief that Wall Street plays dirty.
Blockchain solves this problem. Transparency is the antidote to all mistrust. Blockchain technology allows information to stay secure and yet remain public. Asymmetry of access and information are significantly curtailed. So, the public doesn’t have to simply trust an institution or guess what it’s doing in the shadows of delayed settlement and layers of obscure and self-interested intermediation. Interested parties can verify the movement of money and securities by themselves.
4. Lack of transparency in securities lending activities that enable short positions
Brokers often run a securities lending business where they lend out shares owned by their customers to short sellers and pocket the gains. Even on Wall Street, this business is still regarded by insiders as particularly clubby, opaque, anti-competitive, and hostile to innovation. It is also generally highly profitable for such firms.
How can I see if my shares have been lent out? The actual owners of the shares often never even find out if their securities were lent out, let alone see the proceeds from the lending business that makes money for the trusted middlemen off their customer's assets in ways. Litigation by major pension plans and other institutional investors against Wall Street prime brokers and other firms gave voice to these frustrations. As the public has targeted buying of stocks impacted by short sellers, the short sellers have been trying to buy the shorted stocks and the rates for securities lending have shot up to 200% for some stocks resulting in increased profits for intermediaries and increased risk that some borrows aren't real borrows.
Blockchain addresses this. With blockchain, stock owners would know where their assets are held and if they have been lent out. This would open the door for a fair distribution of any securities lending profits to the actual shareholders. Note, however, at this time I am not convinced short selling, even if it worked correctly, adds value to a trading ecosystem.
At tZERO, we are committed to democratizing access to capital markets through blockchain technology, which includes the real-time settlement of securities. Blockchain technology can resolve the issues we witnessed with GameStop and other securities and prevent this from occurring in the future.
For more information, visit https://www.tzero.com/.