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What Lehman Brothers, Gamestop and the Next Financial Crisis Have in Common

We are witnessing the fallout from an overwhelmed settlement system – but Paxos has a solution

Last week a dramatic David versus Goliath storyline played out with retail traders banding together to create a short squeeze on some of the most sophisticated hedge funds betting against Gamestop (GME). When retail brokers (like Robinhood, TD Ameritrade, etc.) responded by restricting trading on GME and other volatile stocks, they created an uproar. Many interpreted this as Wall Street favoring and protecting market insiders. But in reality, the true culprit was the creaking market infrastructure responsible for settling trades. Our settlement system is built to promote trading and liquidity, but cannot withstand the pressure of extreme events. In fact, the system that failed brokerages last week is the same system that exacerbated Lehman Brothers’ collapse. If we do not fix the current clearing and settlement infrastructure that underpins the stock market, it will fail us again.

As Robinhood explained, it halted buying for certain tickers because it needed to raise billions in margin to keep operating. It has continued to raise billions for this same reason–more money in days than the $2.2bn since its founding. The unexpected need to have additional billions on hand caught Robinhood and many other firms by surprise due to opaque margin calculations. Until they could meet the margin requirements, firms made the necessary decision to restrict trading of certain stocks. Many retail brokers and some of Wall Street’s biggest firms turned away business they could no longer afford.

But where did this margin requirement come from and why does it exist? There are three reasons for the absurdity – and danger – impacting everyone trading stocks.

  1. A too big to fail, monopolistic central counterparty is on the other side of every trade. The National Securities Clearing Corporation (NSCC), a subsidiary of the Depository Trust Clearing Corporation (DTCC), guarantees all trades, making it an immense power holding responsibility and risk. It has the unilateral ability to establish the margin required of each member bank or broker. When the NSCC says, “You need $3 billion more in margin to cover your extremely volatile trade volumes,” participants have no choice in the matter. They have no alternatives for trade settlement.
  1. Margin calculations are conducted in a black box. Margin is the cash required by the NSCC as collateral from both the buying broker and selling broker to guarantee the trade. The NSCC alone determines margin, so brokers executing trades are in the dark about their exposure. It’s not until the early hours of the next trading day that brokers are alerted to margin calls, leaving many blindsided when volatility peaks. It’s so opaque, that participants can find themselves negotiating down margin by billions to keep operations afloat. 
  1. The antiquated settlement system needs a two-day lag to process. The NSCC relies on 1970s mainframes running COBOL, the programming equivalent of Latin. Time from trade to settlement adds risk. Shortening settlement for US equities trades to same day (or even T+1) would drop margin requirements by billions as even the DTCC recognized a decade ago. Unfortunately, ancient technology and processes are holding back fairer markets. The batch processing by the NSCC will increase risks at shorter cycles. The market needs modern technology to provide a more real time view of risks. 

These factors create a perfect storm of extremely inefficient clearing and settlement which only the largest firms in the world can support. The central counterparty settlement monopoly is like a 19th century sewer system: it runs smoothly in good weather, but the streets flood when a storm hits. We’ve seen a larger storm before–when Lehman Brothers failed during the 2008 financial crisis, inefficient settlement created a domino effect of counterparties struggling to meet the margin obligations to the NSCC – owed first by Lehman Brothers, but then left with brokers down the line. All it takes is one unpredictable “Black Swan” event – whether Lehman or Gamestop – to throw the market into a cascade that the system cannot handle.

Why do we accept the status quo and why was this system put in place to begin with? There was good reason back in the late 1960s, when we traded physical stock certificates. As volumes increased and overwhelmed brokerages, we went through a Paperwork Crisis. It got so overwhelming for firms that to catch up the stock market was forced to close on Wednesday and trading hours were shortened. The industry created the DTC to hold and own all the shares in its name (Cede and Co), updating a single, universal, private ledger to reflect trades and enabling much greater efficiency and liquidity. At the time, it was a clever solution. But by creating one omnibus account for ownership of all stocks, we gave up transparency of clear ownership and chain of title. In the 50-plus years since, stock trading volume has again outpaced the current system.

It is time for a system upgrade. When we moved to the central counterparty system, we gave up clarity of ownership in the name of liquidity. However, modern technology can make the risks inherent in the current system obsolete, enabling greater trading liquidity while also increasing ownership transparency – ensuring that trading is both safe and fair. 

It is imperative that we modernize market infrastructure to move settlement into a digital future with greater market efficiency, transparency and democracy. Preventing the next financial crisis depends on it.

How Paxos Has Solved These Issues

Paxos has built the only live alternative solution that eliminates the risks posed by a central counterparty. Through the Paxos交割服务, our customers Credit Suisse, Instinet, Societe Generale, have settled real equities trades with each other on a daily basis for the past year, with more broker-dealers to soon join. Our modern market infrastructure uses blockchain technology to enable an improved and more efficient marketplace. We have a solution for each of the issues we identified. 

  1. A competitive offering to the DTCC monopoly is better for all customers. We are currently operating in a limited capacity within the bounds of no-action relief from the SEC staff, with a goal of becoming a registered clearing agency this year so we can remove that limit and present a true alternative to DTCC settlement. Competition will help drive down unnecessarily high costs and benefit all participants. And since we developed our innovations from the ground up with modern technology, we’ve also put more pressure on the DTCC to innovate and improve, to the benefit of the market.
  1. Margining is transparent and dramatically lower without a central counterparty guarantee. Our system removes the NSCC from the equation, allowing bilateral settlement between counterparties over the blockchain for true delivery versus payment (DvP) finality. Therefore, margin is assessed to protect against counterparty failure only, not to capitalize a too-big-to-fail central counterparty. By also incorporating multilateral netting, we increase efficiency and reduce margin even further. 
  1. Purpose-built technology for flexible settlement time frames as short as intraday. Paxos Settlement Service is designed to be able to reduce settlement times so participants can reach finality sooner and throughout the day. DTC’s current batch-based process traps tens of billions in liquidity for a full day, every day, because it doesn’t release participants’ assets until the end of settlement date. Intra-day settlement instead makes liquidity and proceeds available immediately. However, since most operations are currently tailored for T+2, we’ve made our system backwards compatible, so participants can evolve on their own timeline.

In sum, multilateral, intra-day transaction netting can reduce risk and calculate the exposure and margin directly between the trading brokers without the need for an expensive middleman. Without the middleman, we can shorten settlement times, margin becomes a lower, more predictable and transparent calculation, and we free up large amounts of capital while reducing costs.

Additionally, blockchain technology makes ownership transparent. Investors know exactly where shares are because the platform keeps a clear record of assets and obligations. With this transparency, the markets become fairer and it becomes possible to place limits on how many times shares can be lent and re-lent. Stocks would no longer have excess short interest. If any firm were to fail, the end investor would have clean title to their assets immediately, without a complex chain to unravel. 

The bottom line: we estimate that Paxos Settlement Service can cut capital and costs significantly while being safer, fairer and more resilient to pressure than what exists today. We believe it is imperative that the industry embraces a viable alternative to the legacy platform. We must prevent the next financial crisis by solidifying our market infrastructure today.

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