Gamestop, Blockchain, and the Cluster of Clearing
A case for blockchain in the modern brokerage firm
Every day on the stock market, over 1 trillion dollars of value canges hands between traders across the globe. There have always been essential arguments to make for blockchain in the markets, but the past couple of weeks were a little different.
Within the past few months, Cryptocurrency reached 1/10th of the market cap of gold.
If you’re in finance or technology, you have almost definitely heard about GameStop ($GME) lately. Gamestop trading rapidly increased due to an opportunity to profit from short-sellers and market-makers and a low percentage of floating shares. At one point, GameStop’s trading volume encompassed about 1/6th of the entire financial sector.
Power to the players
Social media traders realized they could leverage market makers and short-sellers against each other and inflate the stock price. This worked because short interest was over 100% of the available shares on the market for some of these stocks. The prices of $GME and $AMC shot to new highs and could have triggered the shorts to buy-in.
At one point GameStop trading volume encompassed about 1/6th of the entire financial sector.
On January 28th, at the height of the frenzy around Gamestop shares, Robinhood and other brokerage firms put out statements restricting their customers from buying shares of AMC, GME, and several other companies. The reason was that clearing firms could not continue offering customers the ability to purchase those highly volatile stocks without the brokerage placing massive capital deposit requirements to hedge against the risk the clearing firms were taking on by allowing these stocks to be traded. Many users blamed the brokerage firms for attempting to influence the share price.
The clearing process
To understand why the brokerages had to stop selling, we have to understand the clearing process when we buy stocks.
There are a few entities involved when a customer purchases stock in a typical transaction:
- A brokerage itself
- A clearing corporation
A clearinghouse acts as an intermediate party for transactions between two customers of brokerage firms. This reduces risk and ensures that trades are correctly settled. Most of the time when a stock is purchased, the clearing firm holds the collateral on both sides of the trade, and the business is considered “settled” when both parties have the correct assets they intended to receive. This settlement typically takes two days. As an aside, the broker is only a custodian of your shares in a company. They are never the owner at any point in the process.
This is commonly referred to in the industry as “T+2 settlement”. You can find more on stock settlements on Investopedia.
GME, AMC, and others have become incredibly volatile. Some of these stocks had swings of 50% or more in a given day. GME experienced every single call option becoming in-the-money, which was historic. When things like this happen, you can see why a clearing firm can be in a difficult position — they may be holding that stock during the clearing process for one or two business days for settlement to occur. If the clearing firm can lose massive amounts of money from market volatility in those days, that’s a big problem. That’s why they required brokerages to post colossal capital margin requirements to ensure the trades clear.
Because this cost was passed to zero-fee brokers, the brokers were in a difficult position to limit trading because they couldn’t post the required capital to enable the trades to clear.
You’re probably wondering just what is it about the clearing process that makes settlement take so long?
Settlement with a blockchain
The original reasons for settlement times seem to be reasonable from a regulatory perspective. There are many reasons you wouldn’t want trades to happen instantly.
A common allegory compares settlement with buying a house in 1800. There’s a lot of money involved; it takes a certain amount of time to get the message across to the other party and to ensure no one reneges on the deal; sometimes people buy houses and then change their minds, sometimes people hope to get lucky and get a free home and try to manipulate the process. These are concerns at the broker level but get sorted out by the clearinghouse at the end of the settlement period.
You’d imagine this should be immediate in the software-rich environment we live in today. We’ve had various famous investors and entrepreneurs including the CEO of Robinhood calling for precisely that in light of all this.
“It’s time for zero day settlement, and maybe we’ve found the first use case for blockchain — @chamath”
So could we do this with a blockchain? Absolutely.
It’s entirely possible for settlement to be based on a shared blockchain ledger between all brokerages with a solution like Corda.
The modeling for this is relatively intuitive: you could create Corda states to represent shares in a company and tokens representing derivatives like futures and options. Once you model your assets in Corda, you’d have each brokerage run a Corda node. Every transaction would write to the shared ledger and have to be agreed upon by all parties. There’d be no need for a clearinghouse to have any uncertainty, as each transaction can require the signature of all parties to it.
We’ve already built this. In fact, I’d highly recommend looking at our open-source corda settler to see how a more mature version of this solution could look like in production.
As a practical matter, Corda is no ordinary blockchain. It is designed to run at scale to enable larger enterprise institutions to leverage blockchain. Deploying Corda in an organization like the depository trust and clearing corporation, which handles quadrillions in assets per year, would create fascinating use cases.
Issues like what the brokers experienced could be entirely avoided with blockchain. Purchasing, clearing, and settlement of stock trades should be instant and available to the free market at the tap of a finger. We believe blockchain is the tool for the job, and we look forward to the challenge.
Want to learn more about building rock-solid distributed blockchains on Corda? Be sure to visit corda.net, check out our community page to learn how to connect with other Corda developers, and sign up for one of our newsletters for the latest updates.
— David Awad is a Developer Evangelist at R3, an enterprise blockchain software firm working with a global ecosystem of more than 350 participants across multiple industries from both the private and public sectors to develop on Corda, its open-source blockchain platform, and Corda Enterprise, a commercial version of Corda for enterprise usage.
Follow David on Twitter here.
