Asiff Hirji, the former President of Coinbase and President and COO of TD Ameritrade, dissects the problems with the current market structure in equities. Mr. Hirji, the current President of Figure Technologies, believes that blockchain is the answer to create a decentralized exchange with bilateral, real-time clearing. This would level the playing field for all investors and reduce risk in the system, he writes.
The recent GameStop volatility that caused Robinhood and other online brokers to halt trading of the stock exposed how antiquated and risky our current equities trading capability is.
The conspiracy theorists are saying Citadel, who buys Robinhood order flow, told the brokerage to disable trading in GME to save Melvin Capital, who Citadel themselves just bailed out. That’s not what caused Robinhood to limit trading in GME. The reality is that our archaic two day trade settlement process, massive volumes, price volatility, poor regulation, and Robinhood’s own credit extension policies pushed the online broker to the brink of closure.
Some of these issues – the amount of credit Robinhood extended to customers – were self inflicted but at the core is the antiquated two day settlement system for equities and our poor market structure and regulation.
US equity trades need to ultimately be settled at the Depository Trust & Clearing Corporation (DTCC), a utility with roots back to the early 1970s. DTCC’s predecessors were created to deal with the increased trade settlement work that came from rising trade volumes in the 1960s. Back then, trade settlement meant moving paper share certificates from one broker to another and updating multiple registries. Work piled up to the point that exchanges shut every Wednesday and shortened trading hours when volumes increased. The solution was to create a central entity that stored the paper certificates (no need to move them anymore) and kept a master electronic registry plus allowing brokers to nets settle funds – thus speeding up the process to 2 days. This is the system that is still in place today.
The two day settlement process exposes brokers and settlement agents to significant risk (e.g. failure of buyer to produce the funds). Therefore, to protect the system, brokers are required to post capital with their settlement agent, capital that is calibrated based on the value of trades to be settled and share price volatility (the more volatile a stock, the more capital required). Essentially the settlement agent is extending credit to the broker who in turn is extending credit to their customers.
With increasing volumes of GME trades and increasing volatility of GME pricing, plus the erosion of Robinhood’s own creditworthiness (given the increasing credit it was extending to customers), capital requirements spiked to the point that Robinhood risked being shut out – hence the emergency capital raise and pulling of available credit lines.
This is really just the most obvious of the flaws in our current system. Poor market structure and regulation allow brokers to sell customer orders to market makers (thus risking the customer orders being front run by the high frequency trading algorithms of the market maker), allow exchanges a monopoly on market data (which account for the bulk of their profits), allow large institutions to trade exclusively with each other in dark pool venues outside of the exchanges, and mandate a trade process that necessitate at least five participants – increasing cost and complexity.
It is past time that equities trading enters the 21st century. We have the ability to deliver 24×7 markets with instant settlement – a change that would drastically reduce costs, free up literally billions of dollars of capital, and eliminate settlement risk. It would also level the playing field between retail investors and institutions.
Delivering 24×7 markets with instant settlement
A blockchain is simply a decentralized, immutable, and trustless ledger. An asset on blockchain cannot be double pledged, double sold or double represented. Coupled with stablecoin, which is just another asset on the chain that can be converted to fiat currency through an issuing bank, blockchain can deliver bilateral, real time settlement risk free trading. These attributes enable enforceable digital contracts (eliminating the need for intermediaries) and establish clear ownership. Making the blockchain public allows anyone to see the registry of ownership and the entire transaction history (market data without the monopoly).
Billions of dollars of crypto token transactions already happen today on decentralized blockchain based exchanges. These transactions are typically buying and selling crypto tokens like Bitcoin and Ethereum or borrowing and lending such tokens – all done 24×7 with instant settlement.
Crypto trading and speculation may seem a far fetched or irrelevant example to institutions and regulators in the so called “real” financial markets so let’s use an example closer to home for them – the purchase and sale of debt instruments, the largest trading markets in the world (multiples in size to the equities markets).
Imagine a seller owns a pool of loans on blockchain and lists them for sale in a marketplace for $1M. Now imagine a buyer wants to purchase those loans. The buyer simply deposits $1M into a stablecoin issuing bank, the bank places $1M worth of stablecoin in the buyer’s digital wallet, and the buyer then goes into the marketplace and accepts the seller’s ask. The blockchain knows the seller owns the loans, that the buyer owns the stablecoin and that a trade has been agreed. It registers the transfer of the loans from seller to buyer and the stablecoin from buyer to seller. They just completed a bilateral transaction in real time, with no counterparty or settlement risk.
The above scenario is not imaginary – institutions, including some of the largest on Wall Street, execute such trades every day on the 24×7 Marketplace on Provenance blockchain. While equity markets are stuck in the anachronistic two day settlement process, firms trade loans and settle risk free in real time on Provenance today. Anyone can use Provenance and the marketplace, and no one controls either. Provenance is public and decentralized – it has no owner, no headquarters, no employees. It cannot be shut down or limited in use. No one can buy order flow to the detriment of others. No dark pools exist to trade outside of the view of retail investors. It is a democratized, level playing field that has supported billions of dollars in non-crypto trading transactions – more than any other blockchain we know of.
Why can’t this be done for stocks?
Headwinds to Challenging the System
There are many current attempts to move stock trading to blockchain but these all use some form of synthetic asset since the actual security is still the certificate sitting in the DTCC. These attempts actually add to the complexity and risk of the system rather than eliminate it.
So why hasn’t blockchain made two day settlement, payment for order flow, dark pools, and exchange monopolies artifacts of the past? The answer is because the incumbent institutions involved in the current process have too much to lose. Stock exchanges obviously do not want a decentralized, public marketplace as then they have no role to play. Introducing, settlement and clearing brokers would lose their revenue streams when real time settlement eliminates much of their function. Hedge funds that buy order flow and trade in dark pools don’t want to lose their edge. And you can imagine no one at DTCC is thrilled about what blockchain really means for them.
While there are lots of forces working to keep blockchain out, there is one significant force that should be ushering it in: regulators. Blockchain should be embraced by the SEC for its transparency and equality. If stocks traded natively on blockchains like Provenance, not only would brokers not have to restrict trading on stocks due to settlement issues, there probably wouldn’t even be brokers. Banks that issue stablecoin can handle KYC/AML/BSA and investor suitability, and accounts can have a blockchain passport that travels with them to approve them for certain transactions. @Figure does this today for accredited investors accessing private equity and hedge funds on Marketplace on Provenance.
We have a small – but rapidly growing – product at Figure called Adnales. Adnales manages private company cap tables (private equities rather than public ones). While Adnales does it well and there is a need for a better solution than Shareworks or Carta, our motivation in launching Adnales is to move public equities trading to blockchain.
When companies issue stock on Adnales, stock certificates are native digital assets that live on blockchain (no more paper at the DTCC). It is very straightforward for a company to then use Marketplace on Provenance to run a secondary market for their equity. Trades settle real time, with no counterparty risk in a transparent and liquid manner thus transforming the cumbersome, opaque and illiquid private company secondary market. We believe as more companies use Adnales for secondary markets, institutional capital will follow. When these companies want to go public, why would they move from a liquid real time settlement environment to the archaic two day settlement process on the NYSE or the Nasdaq?
Adnales is a backdoor way for us to modernize equity trading, but with what has happened in the market, we now want to go through the front door as well. We are going to make a significant capital investment to work with our venture, private equity and sell side network to get more companies to start listing on Provenance. It’s time to stop supporting the antiquated system that harms retail investors.
Retail investors proved their power in toppling the hedge funds that sold GME short and these same investors and the regulators should be pushing to make securities native assets on blockchain. And, while we are at it, let’s also fix the Accredited Investor and Qualified Purchaser rule which serve only to keep some of the best performing investment opportunities out of reach of ordinary investors. Those designations incorrectly assume wealth and investment experience are related. Ask the hedge funds who shorted GME how true that assumption is.
This article,”Gamestop – Why We Need a Bilateral, Decentralized Stock Exchange,” first appeared on LinkedIn on February 2, 2021
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Asiff Hirji is President of Figure Technologies, a blockchain technology provider. He was previously President and COO of Coinbase, which he grew to over $1 billion in revenue; launched new businesses; built out the management team and achieved an $8 billion valuation. Prior to Coinbase, Mr. Hirji was an Operating Partner with Andreesen Horowitz focused on helping their best companies scale faster. He previously served as President and COO of TD Ameritrade, growing that business 6x into the nation’s largest online broker. He has also held senior leadership roles with TPG Capital, Saxo Bank, HP, and Bain Capital and has served on a number of public and private boards including Citrix and Advent Software.