The January 2021 trading frenzy surrounding GameStop and other meme stocks was driven by the collective mob mentality of people on a social media channel – not by Wall Street-aligned firms or a substantive news event. People with online monikers like “Roaring Kitty” and “BowlerGuy92” tried to take on Wall Street, and, in the end, showed the collective power that distributed investing can have on the securities market.
Since the initial epic rally, the GameStop saga has become more than a David-and-Goliath story or an opportunity for congressional sound bites. The event has left open substantive questions about market volatility, the implications of distributed investing, and most importantly, the potential for a disruptive firm to prevent or at least alter the outcome of the next GameStop-like event.
As part of a postmortem to the GameStop controversies, an initial regulatory review found that core market infrastructure acted in a resilient fashion and managed the volatility and trading volume properly. While the regulators’ assessment that things worked well is correct, their initial statements leave out, perhaps purposely, fundamental flaws in business models and firm liquidity and settlement procedures that are antiquated relative to technological capability.
Among these critical issues, a fierce debate has emerged over the use of pay-for-flow arrangements. The term refers the compensation that a broker receives, not from clients, but from third parties that want to influence how the broker routes its clients’ orders for execution. In recent years, fintech brokerage firms have been paving a new road for people to trade securities, one that is commission-free but by no means completely “free” to the customer. Pay-for-flow, as retail investors have recently come to discover, is one of the methods that allow commission-free trading houses to pay their bills – and the reason these investors don’t see a charge to their accounts for commissions. The controversial practice raises potential conflict of interest issues and concerns over brokers providing sub-par execution for customers. In a recent hearing on GameStop, it was disclosed that about 40% of retail volume in pay-for-flow arrangements is managed by a single third party. This and other revelations have thrown into question the paradigm of a single entity providing better transaction speed and price when compared to fair and open market concepts.
Firm liquidity and settlement procedures are other inextricably linked concerns that have drawn significant attention. Trades in GameStop required increased margin, and some brokerage firms may have limited the trading of the stock through their systems to save on capital requirements. In one case, a brokerage firm’s discussion of its margin requirements tangentially exposed its relationship with investment firms reportedly caught in a “short squeeze” on GameStop stock. While the exposure fueled the anger and suspicions of anti-Wall Street retail investors on social media, the brokerage firm insisted that its decision to restrict trades was largely based on a margin call, one with an order of magnitude that was appreciably higher than forecasted, and one that would have been greatly diminished if trades could have been settled in real time.
In the early days of equity trading, the time it took to settle a trade was driven by the time it took to move a physical security or cash between institutions. The standard period for settlements in those early days was around two weeks. By the 1980s, markets had moved to a T+7 (trade date plus 7 days) settlement timeframe. Today, the financial industry operates on a T+2 settlement timeframe. The concept of real-time settlement has been elusive, with T+1 being the present goal of the industry.
According to some estimates, a settlement time of T+1 (a one-day settlement period) would drive margin requirements lower by roughly 41% from present settlement timeframes, saving over $5 billion in margin held by the Depository Trust & Clearing Corporation (DTCC) on a daily basis. Despite the hype around things like blockchain technology and other real-time enablement methods, the ability to settle trades in real time is hard and requires alignment with many moving parts. Frankly, it would also take a significant amount of capital out the market.
Clearly, the trade settlement timeframe issue exposed by the GameStop events reveals a huge fintech opportunity: the need for a disruptor to reduce inefficiencies and enable near real-time settlement. This may sound farfetched to some but shouldn’t be. Remember the GameStop events revolved around a disruptive social networking site, an equity trading platform that claimed to have better pricing capability than standard exchanges, and a retail broker that pioneered zero fee-based commissions. Few thought these events were possible – until now. In these remarkable times, the emergence of a disruptor that can develop an industry-based, real-time clearing and settlement process and help to streamline market liquidity and firm capital requirements might just be the cure investors and firms need.
Until then, firms should consider the following practical steps:
- Ensure they understand the potential for new market volatility drivers and the associated capital requirements of extreme but plausible events.
- Confirm that customer disclosures provide clear and explicit information on fees and the actions a firm may take.