My college friend Ed. Maybe I shouldn’t use his real name….meh, his name is Ed. Anyway, back in the day Ed was a floor trader on one of the Chicago exchanges. A far cry from today’s electronic marketplace. These were the days traders stood in pits wearing colorful jackets and shouted their bids and offers. Ed took on a big position with his own money. Things were looking good and Ed was daydreaming how he would spend part of his winnings. And then the market suddenly lurched the wrong way. A quiet market quickly turned into a fast market, and a fast market into a blistering fast market.
Looking down at the tickets in his hand, Ed knew he just lost everything. Everything.
But then Ed looked up and saw how fast the market was moving. Ed knew it was too fast for his clearing firm to account for his imminent bankruptcy – too much paper and volume. No one knew Ed was bust. You know what else? This man had nothing to lose. Do you know what the difference is between being bankrupt and being 10X bankrupt? Nothing.
So, what’d Ed do? He jumped back into that pit and started trading like his life depended on it. Because it did. Ed traded like he had never traded before and crawled his way back. After tallying up his paper trade tickets, he ended the day flat.
There is a big lesson in this story that applies to the Gamestop debacle. Like any debacle there are many pressing issues to it: naked short selling, manipulation, market making…the list goes on. This post is just going to touch on one part – the Ed part. The need for margin and settlement systems to keep up with market conditions.
Maybe you are thinking Ed’s story is a cute throwback of “ the good old days” of pit trading with hand signals and mainframes used by the futures marketplace. Guess again. The pit is gone and the technology has changed, but the problems are exactly the same.
The thing is that Ed should have never been able to trade his way out of the hole. He really could have lost 10x more and it would be the clearing broker/clearinghouse taking the hit. If there are too many Eds trading out of holes, then this systemic risk can collapse that market. Not kidding – Long Term Capital, Lehman, and credit default swaps are just a few examples.
The take-away is: the delay between the trade and settlement is a known risk factor. In Ed’s case the trade starts a series of complex events and processes that can only be described as the“Old Spaghetti Worx.” An aging complex data tubes and processes that are laborious and slow. That’s why Ed, literally bankrupt, could jump back into the pit and keep trading. But that Old Spaghetti Worx has been overhauled since the open outcry days right? Right!??
Not really. Even on Wall Street, very few know how the Old Spaghetti Worx really works. It’s not pretty.
Let’s Talk Gamestop ($GME)
Why is RobinHood, the newest and technologically advanced platform, limiting trading to one share? The reason is, you guessed it, the Old Spaghetti Worx. Instead of forcing you to suffer through long diatribe, here is the bullet points:
You click Buy 100 $GME.
A ledger entry “cash for shares” is made by your broker into your account.
That’s right. “Your” shares are titled in your broker’s name.
On pressing “buy” it only looks like you bought shares.
Behind the scenes, you only started a chain of events with the Old Spaghetti Worx.
When I say Old Spaghetti Worx I mean old technology, margin and settlement process.
We are talking data tubes that include file exchanges, mainframes, and the network of legacy apps used by Wall Street’s ops folks.
Not kidding…green screens are still the way into the Old Spaghetti Worx.
Old Spaghetti Worx figures out what brokers get what.
Who gets shares, who gets option assignments, who gets cash, and how much?
Which broker has to post more margin and who gets some back.
This process is T+2. (Trade plus 2.) That’s right. It takes TWO DAYS.
Your broker takes this info and now reconciles it to their ledger notation in your account.
Maybe you owe margin. Maybe you are owed cash. Maybe you are Ed. Maybe you were bankrupt two days ago.
Sounds terrible right? Really this is a gross, gross summarization. But, it is actually far worse than this summary. To give you a sense of how cruddy this settlement system is, the SEC moved from T+5 (trade date plus 5 days) to T+3 back in 1996. (Windows 95 was still state of the art!)
They did not get to T+2 until 2017. This is the speed of improvement running the settlement of the stock market.
So, what happened with Gamestop?
Easy. Old Spaghetti Worx is old but not stupid. It knows that brokers may not be great at managing accounts. Maybe they loaned Ed way too much money. Maybe Ed is bankrupt and can’t pay back all the money we lent him. Maybe there are a few thousand Eds hiding within the brokers. The market is moving at a blistering pace and we know the brokers’ customers are not all winners. They are 2 days behind the present. Old Spaghetti Worx has no idea if they are solvent or being carried out on a stretcher.
“No more trades until you start coughing up cash!!! Lots of it. We are not going to get caught by your overextended punters…excuse me, customers.”
So your broker, the one that promised it was a new kind of broker that was built from the ground up for retail investors, has to come up with bales of cash. If your broker (or its founding VCs) don’t come up with the cash, their only remedy is to limit trading in $GME and the other cohort of highly shorted stocks. This may sound like a scene out of the Godfather, but it’s true. The Old Spaghetti Worx made the brokers an offer they couldn’t refuse. Pay up or limit trading. If your broker has limited you it means:
Your broker is running out of cash;
Your broker is limiting non-important accounts in favor of important accounts; or
The Old Spaghetti Worx is the real game that has to stop
Distributed computing, algo trading, faster processors, markets have never been faster. It’s just too easy to blow the fuse box of the Old Spaghetti Worx. Some safeguards can be put in place, but those all center around slowing things down, not improving the Spaghetti Worx to accommodate higher speeds and volumes.
If your creative mind is thinking…gosh couldn’t we use blockchain to exchange money and shares circumventing this whole Spaghetti Worx nonsense?
This is why it’s important to keep a close eye on the first movers in this category. This has nothing to do with bitcoin, crypto or anything like that. This is about exchanging shares for cash on a blockchain. Recently, the SEC and FINRA allowed a few trading systems to register and begin. These are not just exchanges. These are exchanges with an entire Spaghetti Works replacement. Just imagine, instead of T+3 days or T+2 days settlement could be T+.00001(days).
This new registration (ATS/Broker-Dealer for digital assets) is not easy and there are some significant compliance hurdles to it up and running. It has not been not an easy road for the few brave soles that did what many said could not be done (register a blockchain broker/ATS). However, few have been approved.
Listen. It’s early early days but I’ll give you a prediction:
No amount of money or effort can make the Old Spaghetti Worx change with any kind of speed. The new Blockchain ATS/BD leaders will begin to offer a wider and wider array of securities. In a sense they are an exchange, broker and Old Spaghetti Worx Replacement rolled into one registered provider. Over time, these self sustaining islands will eventually overtake and displace the Old Spaghetti Worx. In other words, we are betting that DLT will truly deliver a distributed market. It will take years. But, we have to start envisioning a marketplace that eliminates Ed’s systemic risk once and for all.
BroadPeak operates K3, which is a leading integration and ETL platform. We connect to all financial markets including CFTC and FINRA trade repositories and a host of international ones. We are always happy to share what we know. For blockchain and digital asset initiatives, CoinRegTech is our premier compliance partner. You can look them up at www.CoinRegTech.com. Until next time. Best, Gordon