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Clearing is not a word often encountered in the retail trading world. The minutiae of clearing: agreements, rules, confirms, reconfirms, reconciliations, margin calls, and mispricing can quail even the stoutest heart. Infrastructure can affect markets, it is part of the systemic risk iceberg that lies hidden, but could slash even the most watertight ocean liners and send them nose down into the depths of bankruptcy. As witnessed by the Lehman and Bear in 2008, loss of liquidity is an existential threat. A glimpse of that icy underwater kingdom was afforded even the most casual GME r/wallstreetbets dwelling retail trader when buy buttons grayed out on January 28.

In order to see how markets are subject to systemic risk from the current centralized post-trade infrastructure, it is necessary to understand at a basic level how it operates. Asset trading happens in venues like exchanges where a network of buyers and sellers are brought together through a variety of intermediaries, governed by a process that defines the procedures and obligations of a trade. Once executed, the assets have to be exchanged for payments. Payments, Clearing and Settlement (PCS) are post trade processes. At the heart of PCS is a Central Counter Party (CCP). Such an arrangement was created in the 1970s after physical delivery of securities and tracking of payments became nearly impossible. The CCP functions as a buyer to every seller & a seller to every buyer. This is the true definition of an intermediary. Every trade is legally changed to interpose an intermediary.

This arrangement was a huge step forward in eliminating risk in the seventies as it did away with sorting, storage and delivery of stock certificates; including bike messengers zipping back and forth carrying huge bundles of certificates and wads of cash or gold. The physical certificates were held at the CCP and switched between the cubby holes belonging to the big dealers. Better, but not ideal. Dematerialization of the assets, getting rid of physical certificates and making them book entries in a central ledger, all owned by the CCP, in the US the DTC entity called Cede & Co made matters even better. The process also made matters worse as described below.

What was fit for the 70s to the 90s are not appropriate for the 20s. The gap between program trading executing at microseconds at the front end and the creaky settlement world at the back was most evident recently through the breakdown of the smooth functioning of markets during the GME saga. The core of GME problem lies in the payment and settlement function. In the main, there are three types of settlement systems. One is RTGS or Real Time Gross Settlement, another is Deferred Net Settlement (DNS) and the third is a hybrid model. RTGS is immediate payment in central bank money for the gross amount, this is the safest but makes the most demands on liquidity, that dreaded existential word. All types of settlement ultimately results in RTGS. The central bank money has to be in the account to pay. This is mimicked in the crypto-world in DvP (delivery versus payment), immediate irrevocable settlement.

DNS the prescribed method used by Robinhood and all others, where settlement happens on a net amount, the trades and payments that the parties owe from and to each other is cancelled out, what remains is settled. DNS is implemented with a pause in trading at the end of the day. DNS stretched out to the end of day has lower demands on liquidity and achieves a netting ratio of 200 million gross transactions to 1 million net transactions as practiced at the DTC. In addition, the settlement period for most trades in T+2. Today cash trades are hanging out unsettled for 48 hours plus.

This delay brings with it two risks, replacement risk or the risk attached to the loss of gains in an asset which is amplified by the delay and asset volatility; another is credit risk or the risk that delivery of the asset takes place, but the payment cannot be made. In order to mitigate theses risks, a deposit from each party is taken by the CCP and sits in a common pot to be used as insurance for all. On top of this another mechanism follows the market. The CCP dynamically calculates the money owed by any party based on the market valuation of unsettled assets and compares it to their money in the pot, if the funds are found lacking, more is demanded.


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In the case of Robinhood with a flow of buy orders for GME whose value was rising rapidly, the CCP pulled the plug when capital inadequacy was detected, stopping the mounting buy orders until capital was found to unlock the freeze. Robinhood ultimately had to come up with $700 Million overnight. Such demands for all counterparties rose from an average of $25 Billion to $33.5 Billion on that day. Financial Market Infrastructure processes and conventions interfered with the smooth functioning of the market and stopped the short squeeze dead in its tracks. Such an event resulted in a perception of a system skewed against the little guy.

The reaction to the GME related ructions are increased scrutiny of the clearing infrastructure, hearings in the legislature, self-examination by CCP’s, and justification and explanations from established market players and pundits, including: this is how it is supposed to work. Demand for change is in the air. The crypto-currency market has shown that a 24/7 trading and settlement is possible through increased automation. However, much work is needed to introduce some notion of safe bilateral netting, confining risk to the counterparties, and settling using a relatively non-volatile payment method.

Many have been looking at modernizing the payment, clearing and settlement systems even before this highly publicized failure of orderly markets and what seemed like a deliberate blow at the short squeeze that was roiling GME and rapidly spreading in the market drawing attention to the man behind the curtain. The inefficiency and risk of the system had been in evidence for long. The problem is not just DNS related settlement delay, but the way trades are transformed to depend on the CCP and risk of contagion, converting a bilateral risk into systemic risk. If the payment systems are frictionless and netting performed dynamically then 24/7 trading can be had. Plus a way to be found to keep advantages of the liquidity savings through deferred settlement with dynamic cycles with enough slosh in the system. A return to a peer-to-peer trading and risk management, without a CCP.

All FMI sitting on a shared infrastructure

Ecosystem 2030

cropped from custody reimagined WP Northern Trust

In a vision of 2030 as envisioned by Northern Trust NTRS , one of the largest custodians in the world, all intermediaries disappear, except for global custodian and securities services, stand-ins for the now defunct CCP. They are all on shared infrastructure, a blockchain or a network of interoperable blockchains powered by smart contracts. It is interesting how the FMIs of the world look at the future and see everyone but themselves disappearing. Many alternate futures have been proposed, all contain shared payment rails, ways to save liquidity, 24/7 trading, a modern custodianship, ambient regulatory monitoring and reporting and AI to prevent fraud sitting on shared infrastructure usually a network of blockchains, interoperable and humming away, the financial market infrastructure completely decentralized. dFMI or decentralized Financial Market Infrastructure.

Bank of International settlements (BIS), The Federal Reserve, Project Stella, Fnality and other important players are working on a dFMI future. Some others are actively building it. The most important facets of dFMI are the removal of systemic risk, a 24/7 market, confining risk to just the counterparties, resilient infrastructure, ambient legal and regulatory compliance, faster but liquidity preserving settlement, the preservation of anonymity and privacy and the removal of asset silos. Most projects focus on a subset of these facets. The choice is to do incremental transformation or a more radical change. It is evident that the dominant FMIs and market players are resistant to change as their very existence and fat margins are threatened by the new world and they will be compelled by a combination of forces to transform or be replaced. The time is ripe, the 70s are coming around again.