Jill Carlson: GameStop shutdown is not a tech issue

You may have heard it said: Yesterday, in the midst of a huge rally in stocks and surging trading volumes, Robinhood interrupted its users’ ability to trade GameStop (GME) stocks. Chaos ensued. Retail traders everywhere have cried foul, accusing the startup brokerage of protecting hedge funds and the establishment at their expense. American politicians from all walks of life, from AOC Representative to Senator Ted Cruz, have come together to castigate the move on Twitter. Venture capitalists and technologists have questioned the morality of Robinhood’s founders and proclaimed that the time for decentralization has finally come.

Robinhood did not halt the GameStop business to punish the insurgent mass of retail traders. Neither did he do it out of paternalistic impulse to try to protect them. Robinhood halted GameStop trading because it was necessary, thanks to a set of standards put in place by upstream market players. Robinhood’s clearing house, the company that facilitates the settlement of the broker’s trades, could not cope with the risk they were asked to take.

Clearing houses exist in part to mitigate the consequences if a broker fails to meet his obligations. Clearing companies must therefore tightly control risks. This means that they have to invest more money to do good on trades as the markets become more temperamental (i.e. as volatility increases). The GameStop market was about as chaotic as it gets. The clearing house could no longer take any risk. Robinhood could no longer remit funds to the clearing house. The music had to stop.

It is precisely these types of controls that have become so obviously important in the aftermath of the 2008 financial crisis: strict risk management, transparency, liquidity thresholds and capital requirements. These standards were designed to prevent reckless behavior and to mitigate the fallout from overexposure of a financial firm. When retail traders demanded that these rules be implemented on large institutions 10 years ago, they could not have imagined that these rules would one day exclude them from the market.

Yesterday highlights the importance of understanding all the boring nuances of business back offices and the standards, rules, regulations and protocols that go with them. It takes two days for a transaction to settle. Thus, clearing companies have two days of exposure to their counterparty.

See also: Jill Carlson – GameStop and the real market manipulators

Why does it take two days? People love to say that this is a technological problem and that innovations like blockchains can solve this problem. The reality is, as with so many things that people claim blockchains can solve, this problem is almost entirely a process and regulatory one. New technology can perhaps be a catalyst to re-examine them, but that is certainly not the limiting factor.

The Securities and Exchange Commission imposes settlement deadlines for securities to ensure the proper functioning of processes between counterparties. There are many short-term securities that settle on the same day, such as certificates of deposit and commercial paper. Stocks take as long as they take in part because of historical precedents, dating back to when technology was indeed the constraint. Every financial institution has become accustomed to the processes involved in multi-day settlement periods. Financial institutions are generally slow-growing creatures, which means what they’re used to is what they prefer. Because their processes are built around a multi-day settlement, they continue to choose a multi-day settlement. The solution to this is no longer a blockchain than a centralized database.

See also: Preston Byrne – ‘The Squeezening’: How GameStop Game Will Reduce Freedom

When XRP was dismantled earlier this month by Coinbase and many others, there was no sudden rush of liquidity and activity on the decentralized exchanges that list the asset. This is because traders do not have want to affect the asset given the regulatory concerns surrounding the asset.

Also take the question of whether the markets should be open and active 24 hours a day, 7 days a week, 365 days a year. This is another area where I frequently hear people say that new technology would solve this problem, indicating cryptocurrency markets that are still open. But there are already many mainstream markets that are still open. All over-the-counter markets work this way on Wall Street. If I want to do an OTC transaction, I can theoretically call a market maker at any time and ask for a price. In all likelihood, however, I don’t want to. I want to wait for the times when there is cash.

Much of the functioning of the financial market is based on historical human behaviors, either by codifying them into market norms or by erecting guardrails against their natural tendencies. Certainly, the developments of recent weeks and years show that many of these policies and procedures deserve to be reviewed. Cryptocurrency markets have proven that there may be a demand for markets 24/7, at least in certain asset classes. GameStop has shown that some retail brokers may need to be better capitalized to anticipate the kind of bottom wave behavior we’ve seen this week.

Innovations such as blockchains and decentralized exchanges may continue to prove more of these mistaken assumptions and behaviors in the 21st century. And for that, they are important. But technology itself is not the solution.