Zou Chuanwei: Reflections on the Application of Blockchain in the Stock Market from the GameStop Incident and the Paxos Experiment

The author of this article is Zou Chuanwei.

Recently, two events have helped deepen our understanding of the application of blockchain in the stock market.

The first event is the widely discussed GameStop short squeeze incident in the first two months of 2021. However, the aspect most relevant to this article is not the role played by online broker Robinhood, social network Reddit, or KOLs like Elon Musk and Chamath Palihapitiya in the short squeeze, nor the narrative logic of the "retail investors vs. Wall Street" confrontation, but rather Robinhood's urgent financing of $3.4 billion within four days under pressure from the Depository Trust & Clearing Corporation (DTCC) to meet trading margin requirements. This event highlighted the risks to brokers posed by the surge in stock volatility and trading volume during the "T+2" settlement cycle.

The second event is in April 2021, when Credit Suisse and Nomura's brokerage Instinet completed "T+0" settlement and delivery versus payment (DvP) for U.S. listed stocks on the blockchain through Paxos settlement services. Although this event received little attention against the backdrop of the cryptocurrency market, it represents a promising blockchain innovation application led by market institutions that can be compatible with existing stock market infrastructure.

Next, this article will analyze the application of blockchain in the stock market from two aspects: first, the settlement process of the U.S. stock market and its performance during the GameStop incident; second, the mechanism and significance of Paxos blockchain settlement.

Settlement Process of the U.S. Stock Market and Its Performance During the GameStop Incident

DTCC is the central securities depository (CSD) in the United States. CSDs dematerialize securities, turning them into electronic book-entry items in CSD accounts, thereby immobilizing securities and eliminating the need for physical delivery of paper certificates in securities transactions. The U.S. stock market adopts an indirect holding model, where investors hold securities through intermediaries (including CSDs, brokers, custodians, and other market intermediaries), with the securities register showing the names of the intermediaries rather than the investors. Although the indirect holding model improves settlement efficiency, it fragments stock ownership information; DTCC only records the stock information held by intermediaries and does not penetrate to the ultimate investors.

The settlement process of the U.S. stock market is as follows:

1. Investors issue buy or sell orders for stocks to their brokers.
2. Brokers send the investors' orders to the stock exchange for execution.
3. Buy and sell orders are matched through the stock exchange.
4. The stock exchange sends the stock trading information to the National Securities Clearing Corporation (NSCC), a subsidiary of DTCC, for post-trade processing.
5. NSCC processes and records the stock trades and sends summary information to the brokers involved in the stock trades, including the net stock positions and net cash positions that need to be settled. "Net stock positions and net cash positions that need to be settled" reflect the netting of obligations, which significantly improves liquidity utilization efficiency. For example, if there are 100 trades to buy 60,000 shares of a stock and 80 trades to sell 50,000 shares of that stock, under netting, only the net difference of 10,000 shares needs to be paid for, rather than paying for the real-time settlement of 60,000 shares. However, netting extends the settlement cycle, and a longer settlement cycle means higher counterparty risk.
6. NSCC sends instructions regarding the net stock positions that need to be settled to the Depository Trust Company (DTC), a subsidiary of DTCC, while the net cash positions that need to be settled are simultaneously recorded in NSCC's settlement system.
7. DTC electronically transfers stock ownership: the net stock positions are first transferred from the selling broker's account to NSCC's account, and then from NSCC's account to the buying broker's account (the delivery side).
8. The settlement banks of the brokers involved in the stock trade receive funds from DTC or transfer funds to DTC (the payment side) to complete the stock settlement.

In the above process, steps 1-3 correspond to the trading phase (i.e., matching buy and sell orders), steps 4-6 correspond to the clearing phase (i.e., calculating the securities and cash payment obligations of the parties involved in the trades, with some obligations being offset or netted), and steps 7-8 correspond to the settlement phase (i.e., transferring ownership of securities and funds according to the agreement, divided into the delivery side and the payment side).

Under the "T+2" settlement cycle, it takes 2 business days from the trade to the completion of settlement (before 2017, it was "T+3"). From NSCC's perspective, if stock prices drop significantly during the "T+2" settlement cycle and brokers do not have sufficient funds to support stock buy orders, NSCC will bear unnecessary risks. Therefore, NSCC raised the trading margin requirements for brokers. The trading margin requirements are the result of risk measurement and are mainly influenced by three factors: generally, the longer the settlement cycle, the larger the trading volume, or the higher the stock volatility (reflected in the volatility multiplier set by NSCC), the higher the trading margin requirements will be.

This issue arose during the GameStop short squeeze incident. NSCC significantly increased the trading margin requirements for Robinhood, causing Robinhood to restrict trading on several stocks, including GameStop, before January 28, 2021, and subsequently seek two rounds of emergency external financing from January 29 to February 1. On February 2, Robinhood CEO Vlad Tenev called for a shift from "T+2" settlement to real-time settlement.

On February 24, 2021, DTCC announced that it would shorten the stock settlement cycle from "T+2" to "T+1" in 2023. The "T+1" settlement cycle helps reduce counterparty risk and trading margin requirements. According to DTCC's estimates, under the "T+2" settlement cycle, an average of $13.4 billion in trading margin is required daily; if it changes to a "T+1" settlement cycle, trading margin requirements will decrease by 41%. However, DTCC currently holds reservations about the "T+0" settlement cycle, believing that "T+0" settlement requires higher liquidity and cannot achieve the liquidity-saving benefits of netting, and that a full transition to "T+0" settlement poses significant challenges for stock market participants and existing infrastructure.

Mechanism and Significance of Paxos Blockchain Settlement

In 2019, Paxos' blockchain settlement project received a no-action letter from the U.S. Securities and Exchange Commission (SEC). In 2020, Paxos collaborated with Credit Suisse and Instinet to conduct tests. Paxos uses a private permissioned blockchain, and the settlement process is as follows:

Digitalization of securities. Users issue instructions to their brokers to transfer eligible stocks from the broker's DTCC account to Paxos' DTCC account, thereby completing the deposit operation into Paxos' settlement service account. Paxos generates a digital representation of the stocks (i.e., tokenization) on the blockchain and transfers it to the user's address on the blockchain.

Digitalization of funds. Users transfer funds to a bank account designated by Paxos, and Paxos generates a digital representation of the funds on the blockchain and transfers it to the user's address on the blockchain. Clearly, this is also the construction mechanism of stablecoins.

Trade submission for settlement. After a trade is completed over-the-counter or on a Paxos-authorized trading platform, it is submitted to Paxos settlement services.

Settlement. If both parties to the trade have sufficient digitalized securities and funds in the Paxos settlement service account, Paxos will automatically transfer securities and funds between the two parties.

Paxos blockchain settlement can support "T+1" and "T+0" settlement cycles while supporting the "T+2" settlement cycle, and provides accuracy and visibility through timestamped records of securities and funds ownership on the blockchain. Paxos believes that blockchain settlement helps address the damage assessment issues in class action lawsuits under the indirect holding model, especially in cases of short selling. Under the indirect holding model, DTCC does not penetrate to the ultimate investors, and both parties involved in short selling may raise claims, leading to double counting issues. However, for tokenized securities, all transactions (including buying, selling, borrowing, lending, and related funds transfers) are timestamped and recorded on the blockchain, effectively avoiding double counting issues.

Next, Paxos will apply for a clearing company license from the SEC. If successful, Paxos settlement services will provide settlement cycle services from "T+0" to "T+2," as well as real-time multilateral net settlement.

In fact, DTCC has also been paying attention to the application of blockchain technology in the stock market, having published its first white paper in 2016. In 2019, DTCC proposed principles for post-trade processing of tokenized securities. The ION project, which is a collaboration between DTCC's clearing and settlement product group and business innovation group, aims to assess the benefits of accelerating settlement through blockchain applications in the U.S. stock market.

Some Thoughts on the Application of Blockchain in the Stock Market

The GameStop short squeeze incident highlighted the necessity of shortening the stock settlement cycle, and DTCC quickly responded to the calls from market institutions by proposing a plan to change to a "T+1" settlement cycle in 2023. The Paxos trial demonstrated the feasibility of shortening the settlement cycle using blockchain. Although previous projects such as the Jasper project by the Bank of Canada, the Stella project by the European Central Bank and the Bank of Japan, the Ubin project by the Monetary Authority of Singapore, and the Shanghai Clearing House in China have all experimented with using blockchain to improve the post-trade processing of government bonds and bills, these were conducted in testing environments. The Paxos trial, however, was conducted in a real trading environment, effectively demonstrating the feasibility and benefits of blockchain applications in financial post-trade processing. The fact that Paxos conducted trials under the SEC's no-action letter and plans to apply for a clearing company license also illustrates the significance of reasonable regulation in promoting market innovation.

The Paxos trial has also deepened our understanding of the application of blockchain in the stock market from the following perspectives. First, to achieve delivery versus payment (DvP), blockchain should not only transform the delivery side through tokenized securities but also incorporate a mechanism similar to stablecoins to transform the payment side. If there are only tokenized securities but payments still go through the banking account system, the settlement efficiency will be compromised, and the benefits of blockchain applications in post-trade processing cannot be fully realized. Early tests by the Shanghai Clearing House also reached similar conclusions. This indicates that in financial post-trade processing, digital financial assets must be paired with digital currencies.

Second, Paxos blockchain settlement relies on the support of DTCC as the central securities depository and does not attempt to change the indirect holding model, representing a form of integrative marginal innovation rather than a disruptive innovation that starts from scratch. This reflects both the feasibility of blockchain compatibility with existing financial infrastructure and Paxos' pragmatic choices, which help alleviate the resistance faced by blockchain settlement in implementation. Paxos could even apply for a clearing company license that competes with DTCC.

Third, all transactions of tokenized securities are timestamped and recorded on the blockchain, which indeed compensates for several shortcomings of the indirect holding model. This is a very good application scenario for timestamps. However, the improvement of blockchain settlement for the direct holding model remains to be observed and tested. The direct holding model helps maintain a complete record of securities ownership, facilitating penetrating regulation, but it somewhat limits the innovation space for market institutions.

Fourth, although blockchain settlement can achieve a "T+0" settlement cycle, the benefits of this should not be overstated. While the "T+0" settlement cycle is efficient and helps reduce counterparty risk and trading margin requirements, it cannot achieve the liquidity-saving benefits of netting. There is a trade-off involved. Additionally, for stock trading involving retail investors, not adopting real-time settlement also considers suppressing market speculation. From the practical situation of financial infrastructure, real-time settlement requires higher liquidity and is mainly used in wholesale payment systems managed by central banks, and it requires cooperation with central banks to provide intraday credit lines to financial institutions.

Finally, it should be noted that although this article discusses the stock market infrastructure, the bond market infrastructure has also recently received attention, including the application of blockchain. For example, the U.S. Treasury market is theoretically the safest and most liquid market in the world, known as a "safe haven." U.S. Treasuries are primarily traded over-the-counter. However, in March 2020, due to the impact of the COVID-19 pandemic, a large amount of U.S. Treasuries were sold off, and the limited balance sheet capacity of dealers significantly worsened market liquidity. The Federal Reserve was forced to intervene, including purchasing large amounts of Treasuries, providing essentially unlimited repo financing for dealers' Treasury positions, and excluding Treasuries from the calculation of the Supplementary Leverage Ratio (SLR) regulation. In response to these issues, Stanford University's Darrell Duffie suggested introducing central counterparties (CCPs) and central clearing mechanisms in the U.S. Treasury market.

Additionally, the Director of the Technology Supervision Bureau of the China Securities Regulatory Commission, Yao Qian, proposed a blockchain-based connectivity solution in "Building Bond Market Infrastructure Based on Blockchain" (China Finance, July 2021) to promote the interconnection of relevant infrastructures between the interbank bond market and the exchange bond market. This solution can reuse existing financial infrastructure and achieve overall business and regulatory unity without merging institutions, thereby promoting incremental reform in a win-win manner without touching the existing stock, accommodating the interests of all parties, and facilitating the formation of a unified consensus.