This change could help keep the GameStop fiasco from happening again

Part of what made last month’s GameStop trading frenzy such a mess: Right as the stock was hitting its peak, Robinhood and other brokerages placed restrictions on traders’ ability to buy it (and other surging “meme” stocks like AMC).

Traders were furious and some have filed lawsuits. Lawmakers ranging from Representative Alexandria Ocasio Cortez to Senator Ted Cruz were also concerned — the trading restrictions are among the reasons why Robinhood CEO Vlad Tenev was called to appear in a congressional hearing about the debacle earlier this month.

Many said the episode demonstrated that individual retail investors are at a disadvantage compared to hedge funds and other large Wall Street institutions.

Now, clearing firm The Depository Trust and Clearing Corporation (DTCC) — which provides, basically, underlying infrastructure for equities markets — has proposed shortening the settlement cycle for stock trades, which would reduce the likelihood of brokerages having to restrict trading during future periods of volatility.

To understand why this change would help, it’s useful to look back at what went wrong last month.

Why Robinhood restricted trading

As soon as a trader presses “buy” on a stock on Robinhood, that stock appears in their portfolio. But they actually don’t own it yet — there is a two-day stock settlement period (referred to as “T+2”) before that purchase is finalized.

During that time, Robinhood (or another brokerage) must make a deposit to a clearinghouse to account for any risks that could occur during that two-day period. To protect investors, regulators require brokerages to keep a certain amount of capital on hand. The greater the volatility in trading, and thus the greater the risk, the larger that deposit has to be.

That’s why, during the GameStop surge, Tenev received a 3:30 a.m. phone call on January 28 from Robinhood’s clearinghouse asking the free trading app to put up a staggering $3 billion, which the CEO has said was “an order of magnitude” larger than its normal deposits.

Robinhood implemented the buying restrictions that day to help reduce volatility, risk and the need for such a massive deposit. Hours later, it raised $1 billion, signaling a cash crunch as it sought to meet the deposit requirements. Ultimately, Tenev has said the Robinhood team was able to persuade the clearinghouse to lower its capital request from $3 billion to $1.4 billion.

“We had no choice in this case,” Tenev told Tesla boss Elon Musk in an interview on Clubhouse earlier this month. “We had to conform to our regulatory requirements.”

Shortening settlement cycles

Experts say cutting down the time between when someone initiates a buy and when that transaction is settled would reduce risk and the need for such large cash deposits. That would make it less likely that brokerages would have to take risk-mitigating steps like restricting buying in the future.

In the days following the GameStop chaos, Tenev wrote a blog post calling for the end of two-day settlements.

“The existing two-day period to settle trades exposes investors and the industry to unnecessary risk and is ripe for change,” Tenev said. “There is no reason why the greatest financial system the world has ever seen cannot settle trades in real time. Doing so would greatly mitigate the risk that such processing poses.”

On Wednesday, DTCC, the clearing firm, laid out a two-year roadmap for reducing the settlement cycle from two days to one, a process it agrees would lead to cost savings, reduced market risk and lower deposit requirements. It also explained a number of reasons why making the settlement process real-time would be tricky, including the likelihood of more “failed” transactions.

The firm says there is growing desire among market participants for such a change.

The settlement cycle was last shortened in 2017, when it moved from three days (T+3) to two days (T+2).

By the end of March, DTCC anticipates having completed development of a prototype for a one-day settlement system, and it hopes that industry players and regulators can officially make the switch to T+1 by 2023.

“We remain committed to working with the industry, regulators and key stakeholders to shape the future of clearance systems and all the exciting possibilities they could bring — from reduced risk and costs, to improved business resilience and increased operational efficiencies,” DTCC Managing Director Michael McClain said in a statement.

The pressure may be on now as GameStop and other meme stocks appear to be on the rise again. GameStop had risen about 65% midday Thursday after closing Wednesday up nearly 104%. Koss, another company popular with Redditors, climbed nearly 47% Thursday.