Did Reddit Break the U.S. Securities Markets?

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The GameStop frenzy raises questions about the adequacy of securities market plumbing.

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Recent market volatility in GameStop and other “meme stocks” has put a national spotlight on certain practices by Wall Street firms and prompted discussion about the evolving role of technology in regulating U.S. capital markets.

In response to this market volatility, some broker-dealers chose temporarily to restrict trading on meme stocks. The U.S. House of Representatives Committee on Financial Services quickly responded by convening a hearing to discuss the circumstances around the trading frenzy. Retail investors instigated the market volatility when they collectively executed an investment strategy using the social media site Reddit’s “WallStreetBets” subchannel to identify securities in which hedge funds had amassed significant short interest positions.

In a follow-up hearing, members of Congress noted that recent market events raised critical questions about how U.S. capital markets operate, including: conflicts of interest associated with a practice known as payment for order flow; the sufficiency of short sale disclosures; the market dominance of certain participants; the impact of gamification on U.S. capital markets; and the issue of whether regulators should accelerate settlement times.

In his testimony before Congress, Vlad Tenev, the Chief Executive Officer of Robinhood Markets Inc., one of the broker-dealers involved, noted that the firm’s decision to place temporary trading restrictions on certain securities was solely to “facilitate compliance with clearinghouse deposit requirements” and comply with all trading regulations. In addition, Robinhood’s CEO claimed that real-time settlement of securities would have prevented the need for trading restrictions and would reduce overall clogging in the securities clearing system.

That sentiment was echoed in statements and questions from Representatives Warren Davidson (R-Ohio), David Kustoff (R-Tenn.), Barry Loudermilk (R-Ga.), Blaine Luetkemeyer (R-Mo.), and John Rose (R-Tenn.), all of whom wondered whether a same-day settlement cycle would have solved the problems in this situation and what unintended consequences may occur from reducing the settlement period to real-time. James J. Angel, a professor of finance at Georgetown University, concluded that the restrictions on trading were due to “a mad dash to deal with the leaks in our antiquated market plumbing.”

Yet, in late January 2021, the Acting Chair and all Commissioners of the U.S. Securities and Exchange Commission (SEC) issued a statement about the recent market volatility affirming that the “core market infrastructure has proven resilient under the weight of this week’s extraordinary trading volumes.” Days later, during an exchange between Elon Musk and Robinhood’s CEO on social networking app Clubhouse, Musk questioned the motive behind the trading restrictions, asking whether certain hedge funds pressured broker-dealer firms to halt trading.

Did antiquated plumbing in the securities trading infrastructure indeed cause the trading restriction? Or, as Musk suggested, “did something maybe shady go down here?” In either case, the SEC should respond to the long-standing calls to speed up the process of clearing and settling securities trades.

Securities “clearance” is the process of calculating the securities and money that participants owe each other from a securities trade. “Settlement” refers to the completion of a securities transaction—where the seller transfers securities to the buyer and the buyer transfers money to the seller. Today, the standard clearance and settlement cycle for most securities transactions is two business days after the trade is executed (T+2). The national clearance and settlement system for securities transactions in place today is largely a product of the difficulties experienced in the U.S. securities markets in the late 1960s and early 1970s—known as the “Paperwork Crisis.”

The Depository Trust & Clearing Corporation (DTCC) stands at the center of most securities transactions in the U.S. securities markets. DTCC’s subsidiaries, the Depository Trust Company (DTC) and the National Securities Clearing Corporation (NSCC), clear and settle nearly all securities transactions in the United States. NSCC serves as the central counterparty to nearly all U.S. equity trades. It becomes the buyer for every seller and the seller for every buyer.

When a party sells a stock, the clearing system debits the shares electronically from the account of the seller’s broker at NSCC and credits them to the NSCC account of the buyer’s broker. By offsetting a firm’s buy orders for a particular security against its sell orders for that security—a process known as “netting”—NSCC is able to reduce by 98 percent the total number of daily trade obligations requiring financial settlement.

The Continuous Net Settlement System (CNS) is NSCC’s core netting system. CNS nets every security on a daily basis to one position for each participant, meaning that each broker-dealer only owes or is owed a single block of shares for each security at the end of every day. NSCC is the central counterparty to each broker-dealer through the legal concept of “novation.” CNS either owes shares of a security to the broker-dealer, or the broker-dealer owes shares of that security to CNS. Broker-dealer customers are invisible to CNS.

Parties in a securities transaction face counterparty risk during the time between trade execution and settlement. On the sell-side, NSCC and the clearing members assume the risk of counterparty default. Broker-dealers are responsible for maintaining capital with NSCC to protect both NSCC and its membership from this risk. In addition, both institutional and retail investors have broker-dealer default exposure. To safeguard against a potential default by either the buyer or seller, NSCC maintains a multibillion-dollar clearing fund, which is funded by member broker-dealers in accordance with rules approved by the SEC.

Events such as “Black Monday” in 1987 have resulted in calls to reduce credit, market, and liquidity risk by shortening the settlement cycle. Shortening the time between trade execution and settlement by one business day would significantly reduce the risk of counterparty default. Decreasing counterparty risk would, among other things, reduce the capital requirements the NSCC imposes as a self-regulatory organization on its member broker-dealers to mitigate this risk.

DTCC has joined the chorus, advocating regulatory enhancements by releasing a white paper that outlines a two-year industry roadmap for shortening the settlement cycle for U.S. equities to one business day after the trade is executed (T+1). As the frequency and intensity of market volatility has increased, so have advancements in technology and core business processes.

Given the potential benefits of accelerated settlement, regulators should carefully consider enhancements to DTCC. One example is Project ION, a set of initiatives proposed by DTCC that includes the implementation of distributed ledger technology to accelerate and optimize the settlement process.

New technology platforms, such as Reddit and Robinhood, have created unprecedented volatility in the securities markets. The SEC and DTCC must move fast to ensure that the market plumbing that supports this trading can keep up.

Marlon Paz

Marlon Paz is the head of the Broker-Dealer Regulation & Compliance practice at Mayer Brown LLP and a Lecturer in Law at the University of Pennsylvania Law School.

This essay is part of an 11-part series, entitled Regulation in the Era of Fintech.