The dust has settled on the GameStop saga, and so has the stock price. Noise about Robinhood's questionable trading restrictions is calling into question the feasibility of current market infrastructure in our new, digitally connected world. The redditors came and saw, but they didn't conquer in their valiant mission to "beat the hedge funds." A significant blow, however, was dealt to the GameStop (GME) short seller Melvin Capital, who was blindsided by the socially-driven price rally. 

In the end, Wall Street firms will always prevail in legacy financial markets as the landscape is far too regulated, complicated, and favorable to those who have the most influence and capital. But a new force in the markets driven by social media, global unrest, and distrust of the "system" is forcing many to reconsider positions. Retail-investor misunderstanding of how markets work certainly played a role in WallStreetBets’s go against the hedge funds, and many were left "holding the bag" because of it. Regardless, the GameStop saga stands as a loud example of the free market speaking to retail investors, and the message is very clear: Markets require more efficiency, inclusiveness, and transparency. The path to get there starts with decentralized finance and distributed ledger technology, but without abandoning the existing financial system.

Understanding the GameStop-Robinhood hoopla

These days, when a story  picks up steam on social media and garners the attention of the masses, it's easy to get lost in (and echo) the popular narrative. As was reported, the popular online brokerage among young retail investors failed to put up just under $3.5 billion as collateral for clearinghouses to allow GameStop trades to continue. The result: an angry mob of Robinhood users initially charging that the brokerage was favoring hedge funds. But Robinhood's actions are nothing particularly new.

Centralized trading restrictions are not new to the public markets, but typically these circuit breakers are imposed by regulators and "free" markets are not subject to the discretion of one of its participants. As recently as mid-2020, restrictions were slapped onto oil-commodities trading to help manage the rapid drop in price, to a point at which the price even turned negative. It happens from time to time and is an unfortunate byproduct of our centralized system that relies heavily on intermediaries and regulation designed to protect investors. Ironically, however, those regulatory protections sometimes limit opportunities for retail investors.

While they missed that this is a standard market mechanism that has nothing to do with covert efforts to "keep the wealthy propped up" or favor a large stakeholder, questions do remain. Why did Robinhood allow selling to continue as buying was restricted? Why was this severe liquidity issue not communicated to its users and mitigated sooner? The negative optics are even further exacerbated by Robinhood’s business model, which offers free trading to its users in exchange for the ability to monetize their trading data. This data is sold to market makers and the stakeholders who would benefit the most from a short-term price decline (or get hurt the most from a continued price rise) of GME.

In the end, Robinhood is expected to pay a heavy price for the fiasco when the company goes public in the coming weeks, and lose a lot of its retail users to competitors like Public, which also offers free trading, but recently announced that it will no longer sell user order flow. 

Many of the existing market controls are needed due to inefficiencies of current market infrastructure. In the case of Robinhood, t+2 settlement is the key issue. But blockchain can make the difference.

The emergence of blockchain and its relationship to Wall Street

Ever since Bitcoin's creation merely a decade ago and the dawn of decentralized finance (DeFi) that followed, the blockchain industry has had somewhat of a love-hate relationship to Wall Street. When events in centralized finance take a turn for the worst or uncertainty takes hold, retail investors become enticed, to a degree, by the narrative surrounding blockchain-based finance, especially DeFi.

During the pandemic, total value locked (TVL) in DeFi skyrocketed as traditional markets faced uncertainty for months. According to DeFi Pulse, the TVL in USD rose over 1,000 percent between June and October of 2020, before plateauing and then rising sharply again amid the Robinhood saga. 

Numbers aside, "institutional adoption" has long been the real holy grail for crypto enthusiasts, mainly due to the amount of capital that can be allocated to digital assets by institutions and the symbolic representation of beating the big banks. But now that institutional adoption has finally arrived, we are witnessing the real issue of fitting a square peg into a round hole.  

Decentralization, at its core, is designed to remove much of the regulation, intermediaries and third parties we commonly call "Wall Street'' and create a trustless, distributed system. But not everything that’s decentralized is inherently better. Some elements of a decentralized system can have positive impact, and other elements not. 

Decentralization can empower those previously excluded from finance to participate, but without any sort of authority to regulate and protect investors of all kinds, the results could be disastrous. There is a middle ground to be found between the existing centralized system and the hardcore decentralized gang. One place the middle ground exists in where the angry Robinhood mob is missing: using blockchain to solve brokerage t+2 settlement issues.

Settling the differences between Wall Street and DeFi on blockchain

Blockchain, known for its transparency and automated transactability, allows instant payments to take place via trustless smart contracts between peers on a network, and therefore eliminates the need for a clearinghouse to settle trades. At the same time, traders could clearly access network data showing what trades have taken place.

In the case of the GameStop trades on Robinhood, where trade volumes skyrocketed without any transparency to end users regarding who is making those trades, blockchain would enable traders to gain access to all of that transaction data, which would level the playing field.  Here, the transparency would have protected retail investors more effectively than the regulations that caused an near-instant crash of the stock price, because traders would have been able to see if any large players were acting to manipulate the price. 

Because the current state of DeFi and t+0 settlement is in its infancy and the DeFi market is extremely immature for the amount of capital formation within it, t+0 settlement is the low hanging fruit for immediate adoption in existing real public and private securities. T+0 would not require an entire rethinking of the existing financial system to integrate, but rather an innovative mentality and initiative from regulators. 

Once the basic framework for peer-to-peer transacting in traditional markets is established, DeFi mechanisms can be applied to them. In a correctly designed and applied distributed system, Robinhood would not have been able to take unilateral action to the benefit or detriment of any user or stakeholder, even if there is a limited number of nodes hosting centralized securities. Trades would be tagged with a set of rules, and an authority to validate the trades is what becomes distributed.  A decision to stop trading would require consensus throughout a transparent set of validators, and collateral requirements would not exist as trades settle instantly and directly between buyer and seller.

As events like that of GameStop's stock run continue to take place in the coming years, so will retail investor desires to find alternative, decentralized ecosystems to invest and trade on. Be as it may that there are gross misunderstandings about how the market mechanisms function, the lessons we can draw on from the outrage is that the mechanisms of the centralized way need to change, and blockchain is where regulators can look.