The surprising limitations of the modern financial system
I’ve spent my career working on what some might consider the plumbing of the U.S. financial markets — the pipes that move trades from one account to another.
Those pipes handle billions to trillions of dollars in trading every day, and yet most of us never think about them or are even aware that they exist. That is, until a few weeks ago.
By now, you’re all probably a little tired of hearing the word GameStop. I hope that you’ll bear with me for one last story. This one isn’t about buyers and short sellers, or any regulatory bias for that matter. It’s about the pipes that move trades from one account to another and what happens when those pipes get backed up, so to speak.
The capital markets have evolved over hundreds of years — and we’ve still got a long way to go. The majority of the infrastructure used today to process trades was built 30 to 40 years ago. It still runs on mainframe computers. They still do what they were designed to do, just not what we need them to do today.
“Real-time” settlement meets reality
In a blog post explaining the company’s decision to pause trading on GameStop, Vlad Tenev, the CEO of Robinhood, challenged the financial industry to move to real-time (T+0) trade settlement. He made the case that the industry’s current standard settlement period of two days (T+2) is the underlying reason why his company needed to throttle trading on a handful of stocks, including GameStop’s.
Why is a two-day settlement period a problem? Because everyone involved in clearing and settling trades has money tied up until the settlement process completes. That’s why.
There’s a lot riding on those pipes
Every trade that’s executed needs to be settled. Think about it: What would happen if you sold 100 shares of stock at the top of the market and two days later, when the price had fallen, you learned that the trade had fallen through? Now, imagine that happening not just to you, but to everyone else who had bought and sold in that two-day period. It would be pandemonium. There’s a lot riding on the smooth functioning of the pipes.
Everyone involved in the clearing and settlement process — brokers, clearing agents, clearing houses, etc. — has a responsibility to make sure that trades make it all the way through the system. It’s not just the right thing to do. It’s also what’s required by federal regulators.
The rules require brokers to make deposits with clearing agents, clearing houses, and other parties in order to offset the risk of their clients’ trades. Those deposits change daily, as risk levels change. In Robinhood’s case, that risk escalated quickly as its customers bought and sold a volatile stock.
As Vlad notes in his blog post, “Clearinghouse deposit requirements skyrocketed overnight. People were unable to buy some of the securities they wanted. Investors were angry and concerned, an unintended byproduct of the antiquated settlement process.”
In other words, either the trading was moving too fast or the pipes were moving too slow. You decide.
Fixing the pipes
At Clear Street, we see a related problem across the capital markets. The financial industry has outgrown its infrastructure.
Our clients are sophisticated traders, the type trading multiple asset classes (equities, options, derivatives, etc.) in high volumes. They typically have a difficult time executing complicated trades, simply because of the outdated technology most banks and brokerages use to move trades from one account to another.
We’re solving this problem today at Clear Street. Our new infrastructure is built for real-time settlement today. When the rest of the industry catches up, all we’ll need to do is change a few lines of code to make real-time settlement a reality.
I should note as well that the DTC, the clearing house that processes trades of U.S. securities, has a serious initiative underway to accelerate the speed of settlement. According to a recent interview with one of the leaders of that project:
“Although DTCC’s current infrastructure supports T+1 and limited T+0 settlement cycles, market behavior, legacy infrastructure and operational processes at client firms make it difficult to accelerate further without a lengthy coordinated industry effort.”
In other words, real-time settlement could take a while. Until then, those of us at Clear Street will do our part to fix the pipes and make trading a bit better for everyone.
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