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1/ This week in financial infrastructure will end up in the history books/future case studies.
"The week that clearing/settlement caused a financial, cultural and political crisis"
"The week that clearing/settlement caused a financial, cultural and political crisis"
2/ For 7 years, I have taught a class @MScDigital called "DFIN-513: Open Financial Systems" where, broadly, we looked at how the underlying infrastructure of the financial system works, if/how it can be replicated in a decentralized manner and what the tradeoffs would be
3/ The executive summary takeaway of the current financial system is that the system is built in layers and that most of what you interact with as a consumer is not the underlying system, but a 'skin'/layer above it.
4/ At the absolute root layer in each currency zone are the RTGS - Real Time Gross Settlement systems - Fedwire in the USD zone, TARGET2 in the Eurozone.
These are the systems that give transaction finality.
These are the systems that give transaction finality.
5/ As a consumer, you do not have access to these systems - only qualified financial institutions do. So when you make an 'instant' credit card payment, that is happening at least 2 levels above the RTGS which is why, for example, credit card payments can be reversed.
6/ When you are buying a stock "instantly" on Charles Schwab or Robinhood, something similar is happening. It might look like it happened instantly, but it is not yet "cleared" and "settled".
7/ What are these things (roughly)?
"Clearing" is matching up the order - confirming that the buyer and seller are in agreement, the funds are in place and so on
"Settlement" is the actual exchange of the cash for the security
"Clearing" is matching up the order - confirming that the buyer and seller are in agreement, the funds are in place and so on
"Settlement" is the actual exchange of the cash for the security
8/ For US securities markets, the current clearing/settlement time is "T+2" where "T" means "the day of the trade" + 2 additional days.
In other words, that 'instant' trade takes *minimum* 48 hours to settle (actually longer depending on time of the trade, etc)
In other words, that 'instant' trade takes *minimum* 48 hours to settle (actually longer depending on time of the trade, etc)
9/ One previously very boring, esoteric topic that no civilian cared about is that this period ("T+2") costs money to someone because it requires working capital. Simplified, the buyer has to post the money, but the seller does not get it.
10/ So, normally, there are a couple days worth of trades +/- tied up there in settlement x the respective capital requirements x the cost of capital which in this day and age and for short-term items like this is miniscule.
11/ So the aggregate assessment was that "of course, it would be better if T+2 was faster" - in fact, T+2 is the faster version - after a long industry / IT systems integration project - to drop from "T+3" BUT...
12/ ...ballpark it is OK. The cost of capital for clearing/settlement is a cost of doing business and it is a relatively small one and it is embedded in the cost structure of the financial system (at the end, the customers will pay for it, as with all costs)
13/ This week however it went from a 'cost of doing business' to a 'failure state'. As $GME goes from an unremarkable stop to the most traded equity in the world, a ton of trades pile up in this T+2 clearing/settlement period with the subsequent capital requirements
14/ The brokers like Robinhood need more working capital than they have, so they have to stop trades while they go raise money. How this translates into real-life is literally "they took away the buy bottom" from 1 of the parties in a big 'battle'.
15/ This is, let's say, suboptimal in any case, and particularly in the case where the 'average retail investor' might consider that the system is rigged against them.
Chaos ensues.
Chaos ensues.
16/ What is different in crypto/blockchain based systems?
One very important thing - everyone has access to the base layer infrastructure and, which in most cases, for most chains settles* in about an hour or so
One very important thing - everyone has access to the base layer infrastructure and, which in most cases, for most chains settles* in about an hour or so
17/ *Settlement in crypto is probabilistic, not binary so transactions get progressively more settled every few minutes. Eventually, the heat death of the universe would happen before they are reversed, but about an hour is a decent rule of thumb
18/ Because crypto is still a bit immature, the 'direct access to the blockchain' part tends to be a bit pooh-poohed by the traditional sector. "But our systems perform better, etc, etc".
What direct access gives you is that it unlocks individuals/orgs to proceed directly
What direct access gives you is that it unlocks individuals/orgs to proceed directly
19/ The reason "T+3" took years to go to "T+2" isn't because Wall Street hates making money and enjoys capital requirements.
It is because it is a coordination problem between many many enterprise IT and legal departments. That is always going to be slow.
It is because it is a coordination problem between many many enterprise IT and legal departments. That is always going to be slow.
20/ By given a standards-based, permissionless approach public blockchains (cryptocurrencies), vastly simplify the coordination problem.
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