Homework answers / question archive / Case Study The case study comprises the testimony and supporting documentation from the US House of Representatives Committee on Financial Services dated Thursday, February 18, 2021

Case Study The case study comprises the testimony and supporting documentation from the US House of Representatives Committee on Financial Services dated Thursday, February 18, 2021

Economics

Share With

Case Study The case study comprises the testimony and supporting documentation from the US House of Representatives Committee on Financial Services dated Thursday, February 18, 2021. House of Representatives (2021) House Financial Services Committee. Game Stopped? Who Wins and Loses When Short Sellers, Social Media, and Retail Investors Collide. Hearing, 18th February. Washington: Government Printing Office. Online. Available at: https://www.congress.gov/event/117th-congress/house-event/111207 Using the above case study, along with what you find out from your further reading and research on the topic, and focusing on the literature discussed in the module, answer BOTH questions below Within the first US congressional hearing relating to the Gamestop controversy, Robinhood’s business model was critiqued, while Warren Davidson, the Representative for Ohio, referenced the DTCC’s Project Ion, which explores the use of blockchain technology to improve the efficiency of payment and settlement functions within financial markets. Discuss whether the widespread adoption by retail brokerages such as Robinhood of a payment-for-order-flow model, along with the proliferation of dark pools, represents a fundamental restructuring of financial markets relative to the commission-based brokering model involving execution of orders through public exchanges. With reference to the Gamestop controversy, discuss whether a blockchainbased payment and settlement system (such as Project Ion or Project Whitney) might affect current market practices? Payment-for-order-flow model Research by Aite Group shows that close to a quarter of U.S. adults with access to the Internet are online retail traders. An additional 6% are professional traders, together with equivalent to a self-directed U.S. trading population of more than 54 million adults. ("Online trading penetration in the United States and retail traders' trading device preferences are rapidly changing," 2014). Payment for the order is a form of compensation whereby a stockbroker receives from a maker market for directing orders for trade execution, and this can be informed of a percentage. 2 This model has played a part in the increased uptake of retail investing in recent times. Robinhood started by offering free trades and getting paid by directing its volume of trades. It was a way of making the start-up pick up back then. With its growth, the model of payment for order gain traction as being attractive. It also made traditional stockbrokers switching up and adopting the model. An issue and point of discussion were that the model was not in the customers' best interest. One of the Robinhood competitors even dropped the model, stating that it was not a good model for serving the customers' best interests, that are in Public.com. Even during the congregational hearing, the model was criticized as pioneering the current problems in the current market Debate on whether payment for order flow is acting in the best interest of customers or trading fees okay continues as brokerage firms are still using the model. On the issue of conflict of interest, a broker might promise high returns but instead deliver less price. Still, if the broker and market maker offers the retail investor National Best Bid and Offer (NBBO) pricing, it is within the limit of regulations. PFOF creates conflicts of interest between (1) a retail broker-dealer's duty to seek the "best execution" available for customer orders and (2) its duty to maximize its profits for shareholders and/or owners through PFOF revenues generated by preferentially routing transactions to select HFTs (Better Market, 2021, p. 1). On the other hand, Robinhood argues that market makers provide better prices than exchanges. It only earns a fixed percentage of the bid-ask price, so it has no motive to direct orders to specific market makers, thus conflict. Recently SEC found Robinhood liable, and Robinhood had to pay a $65 million penalty for not disclosing the adverse effect of PFOF to customers. PFOF has been analyzed to better market and is harmful and poses risks to the market. One such harm is that it redirects the retail customer order away from transparent securities exchanges to a small 3 number of high-frequency trading firms that execute a great percentage of overall trading. This results in loss of liquidity which has a direct negative impact on investors using the security exchanges. It also has systemic risk implications, lack of transparency and investor protections and, interferes with price discovery. As per brokers, one benefit of PFOF is price improvement. Investors saved $3.7 billion from price improvement in 2020 (Bloomberg Intelligence, 2021). The contention issue is whether retail saves more money because of non-existing trading fees or the amount they risk losing in price improvement. The concern of transparency in PFOF has been increasing. With the lack of disclosure of PFOF, transparency concern has grown. There is speculation that the market makers could be having other businesses and benefit from PFOF. Looking at the model, the discussion of whether PFOF is the only better option for commission-free trading is still ongoing. Although without it, market makers will still receive trades from brokers, investors will still be charged. Blockchain-based payment and settlement system impact on current market practices Depository Trust & Clearing Corporation recently released a project, Whitney. It is a platform that uses etherium as its technology. It is blockchain-based and seeks to address the digitization of assets. Distributed ledger technology (DLT) has generated tremendous interest and discussion concerning the securities market. It has since been adopted by financial institutions and researched in the best possible way it can be utilized. Areas such as financial reporting, transfers, and payments, and portfolio management have been identified to be helpful. In as much as it may be quickly adopted, there are several legal frameworks and regulatory issues that have to be considered. Moreso on the topic of central management as blockchain technology relies on the peer-to-peer connection with no central authority. Central 4 securities depository (CSD) refers to the infrastructure that enables easy processing of securities transactions. I hold recording systems where records of securities are stored in digital form. The use of DLT will enhance the entire process by reducing settlement risk and the time needed to store information. All parties will need to act together and maintain identical records. Blockchain technology will enhance efficiency in regards to cross border settlement. Traditionally banks will need to compare and reconcile data for such to happen since different banks have different databases; as DLT is a single distributed ledger, information will be shared easily and efficiently with no need to compare and reconcile data. Transparency of will also is a distinct advantage with DLT's usage. Since investors have access to an account held and managed by a central authority, DLT will combine all this information into one database that can be easily be monitored and managed by investors themselves with no intermediaries. Custody risks refer to the risk of loss incurred on securities in custody due to negligence or misuse of assets by the custodian. DLT will significantly reduce custodial risks by eliminating the need to do reconciliations of accounts through the custody chain as data is secure and cannot be modified. A smart contract is another term commonly found with DLT. These are agreement records that are stored in an inedible blockchain. When agreed, it will self execute. There is a difference between smart contracts and the automation of processes with traditional systems. Smart contracts are made by mutual agreement for the sake of meeting specific outcomes and objectives, and once made, they cannot be modified without both parties agreeing. A combination of blockchain technology and smart contracts will have a significant impact on traditional systems. It will improve on data securities and enhance the settlement process. Conclusion 5 The payment-for-order-flow model has brought a lot of debate on the transparency of the model, and the banning of the model in the U.K. indicates it still has some contention issues. One such problem is if brokers act in customers' best interest and if there is a conflict of interest. The commission-based brokering model remains a robust model with transparency. It may be concluded that payment-for-order flow may not represent a fundamental restructuring of financial markets based on the above discussion. Regarding the Gamestop controversy, Blockchain-based payment and settlement system may play an important role in the transparency of transaction of trades, if the GameStop stocks were to be traded on blockchain technology, then there would have not been and central management that block what investors can trade on, besides, if smart contracts are integrated then the trades would have continued if all the condition sets were fulfilled. No central management would stop it. 6 References Better Market. (2021). Payment for Order Flow. Chiu, J., & Koeppl, T. V. (2018). Blockchain-based settlement for asset trading. SSRN Electronic Journal. https://doi.org/10.2139/ssrn.3203917 Blockchain-based settlement for asset trading. (2018). Loader, D. (2019). Clearing, settlement and custody. Butterworth-Heinemann. Slaughter and May and Euroclear. (2016). Blockchain settlement. 7 ADDITIONAL READINGS Suggested readings The following are readings that could be of help in preparing your assignment: Battalio, R. and Loughran, T. (2008) Does Payment For Order Flow To Your Broker Help Or Hurt You? Journal of Business Ethics, 80, pp.37-44. Ben-Abdallah, R. and Breton, M. (2015) To Squeeze or Not to Squeeze? That Is No Longer the Question. Journal of Futures Markets, 36(7), pp.647-670. Chiu, J. and Koeppl, T. (2019) Blockchain-Based Settlement for Asset Trading. The Review of Financial Studies, 32(5), pp.1716-1753. Culp, C. and Heaton, J. (2008) The Economics of Naked Shorting, Regulation 31, 46- 51. DTCC (2020a) Project Ion Case Study. 25760-PS052020. New York: The Depository Trust and Clearing Corporation. Online. Available at: https://www.dtcc.com/~/media/Files/Downloads/settlement-assetservices/userdocumentation/Project-ION-Paper-2020.pdf DTCC (2020b) Project Whitney Case Study. 25733-TC042920. New York: The Depository Trust and Clearing Corporation. Online. Available at: https://www.dtcc.com/~/media/Files/Downloads/settlement-assetservices/userdocumentation/Project-Whitney-Paper.pdf FCA (2019) Payment for Order Flow (PFOF). Pub ref: 005980. London: Financial Conduct Authority. Online. Available at: https://www.fca.org.uk/publication/multi-firmreviews/payment-fororder-flow-pfof.pdf Pagano, M., Sedunov, J. and Velthuis, R. (2021) How did retail investors respond to the COVID-19 pandemic? The effect of Robinhood brokerage customers on market quality. Finance Research Letters, In Press. 8 Bennett, W. (2014) Organization in the crowd: peer production in large-scale networked protests. Information, Communication & Society, 17(2), pp.232- 260. 4 Chohan, U. (2021) Counter-Hegemonic Finance: The Gamestop Short Squeeze. SSRN Working Paper 3775127. Available at: https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3775127 Dent, A. and Dison, W. (2012) The Bank of England’s Real-Time Gross Settlement infrastructure, Bank of England Quarterly Bulletin (Q3), https://www.bankofengland.co.uk//media/boe/files/quarterlybulletin/2012/the-boes-real-time-gross-settlement-infrastructure.pdf Farrell, M., Green, T., Jame, R., and Markov, S. (2020) The Democratization of Investment Research and the Informativeness of Retail Investor Trading. SSRN Working paper 3222841. Available at: https://ssrn.com/abstract=3222841 Ferrell, A. (2001) A Proposal for Solving the “Payment for Order Flow” Problem. Southern California Law Review, 74(4), pp. 1027-1088. Godfrey, K. (2016) Detecting the great short squeeze on Volkswagen. Pacific-Basin Finance Journal, 40(B), pp.323-334. Irrera, A. (2017) DTCC completes blockchain repo test. Online. Available at: https://www.reuters.com/article/us-dtcc-blockchain-repos-idUSKBN1661L9 Kelly, J. (2020) PwC: blockchain potentially has LOADS of potential. Online. Available at: https://www.ft.com/content/a2a43f84-1b9c-4aae-b5c5- 6786aff81654. Lyócsa, S., Baumöhl, E., and V?rost, T. (2021) YOLO trading: Riding with the herd during the GameStop episode. Econstor Working Paper. Available at: https://www.econstor.eu/bitstream/10419/230679/1/YOLO-Trading-Ridingwith-the-herdduring-the-Gamestop-episode.pdf Taketoshi, M. (2016) Financial technology: Blockchain and securities settlement. Journal of Securities Operations & Custody, 8(3), pp. 208-227. Parlour, C. and Rajan, U. (2003) Payment for order flow. Journal of Financial Economics, 68(3), pp. 379-411. Nissenbaum, A. and Shifman, L. (2015) Internet memes as contested cultural capital: The case of 4chan’s /b/ board. New Media & Society. Staer, A. and Jacquot, M. (2018) Social Media and Investor Returns: The Case of Reddit. SSRN Workin Paper 3282828. Available at: https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3282828 Tsai, W., Luo, Y., Deng, E., Zhao, J., Ding, X., Li, J. and Yuan, B. (2020) Blockchain systems for trade clearing. Journal of Risk Finance, 21(5), pp. 469-492. 9 Werner, R. (2014a) Can banks individually create money out of nothing? — The theories and the empirical evidence. International Review of Financial Analysis, 36, pp.1-19. Werner, R. (2014b) How do banks create money, and why can other firms not do the same? An explanation for the coexistence of lending and deposit-taking. International Review of Financial Analysis, 36, pp.71-77. Zhang, X., Fuehres, H. and Gloor, P. (2011) Predicting Stock Market Indicators Through Twitter “I hope it is not as bad as I fear”. Procedia - Social and Behavioral Sciences, 26, pp.55-62. 1 Case Study The case study comprises the testimony and supporting documentation from the US House of Representatives Committee on Financial Services dated Thursday, February 18, 2021. House of Representatives (2021) House Financial Services Committee. Game Stopped? Who Wins and Loses When Short Sellers, Social Media, and Retail Investors Collide. Hearing, 18th February. Washington: Government Printing Office. Online. Available at: https://www.congress.gov/event/117th-congress/house-event/111207 Using the above case study, along with what you find out from your further reading and research on the topic, and focusing on the literature discussed in the module, answer BOTH questions below Within the first US congressional hearing relating to the Gamestop controversy, Robinhood’s business model was critiqued, while Warren Davidson, the Representative for Ohio, referenced the DTCC’s Project Ion, which explores the use of blockchain technology to improve the efficiency of payment and settlement functions within financial markets. Discuss whether the widespread adoption by retail brokerages such as Robinhood of a payment-for-order-flow model, along with the proliferation of dark pools, represents a fundamental restructuring of financial markets relative to the commission-based brokering model involving execution of orders through public exchanges. With reference to the Gamestop controversy, discuss whether a blockchainbased payment and settlement system (such as Project Ion or Project Whitney) might affect current market practices? Payment-for-order-flow model Research by Aite Group shows that close to a quarter of U.S. adults with access to the Internet are online retail traders. An additional 6% are professional traders, together with equivalent to a self-directed U.S. trading population of more than 54 million adults. ("Online trading penetration in the United States and retail traders' trading device preferences are rapidly changing," 2014). Payment for the order is a form of compensation whereby a stockbroker receives from a maker market for directing orders for trade execution, and this can be informed of a percentage. 2 This model has played a part in the increased uptake of retail investing in recent times. Robinhood started by offering free trades and getting paid by directing its volume of trades. It was a way of making the start-up pick up back then. With its growth, the model of payment for order gain traction as being attractive. It also made traditional stockbrokers switching up and adopting the model. An issue and point of discussion were that the model was not in the customers' best interest. One of the Robinhood competitors even dropped the model, stating that it was not a good model for serving the customers' best interests, that are in Public.com. Even during the congregational hearing, the model was criticized as pioneering the current problems in the current market Debate on whether payment for order flow is acting in the best interest of customers or trading fees okay continues as brokerage firms are still using the model. On the issue of conflict of interest, a broker might promise high returns but instead deliver less price. Still, if the broker and market maker offers the retail investor National Best Bid and Offer (NBBO) pricing, it is within the limit of regulations. PFOF creates conflicts of interest between (1) a retail broker-dealer's duty to seek the "best execution" available for customer orders and (2) its duty to maximize its profits for shareholders and/or owners through PFOF revenues generated by preferentially routing transactions to select HFTs (Better Market, 2021, p. 1). On the other hand, Robinhood argues that market makers provide better prices than exchanges. It only earns a fixed percentage of the bid-ask price, so it has no motive to direct orders to specific market makers, thus conflict. Recently SEC found Robinhood liable, and Robinhood had to pay a $65 million penalty for not disclosing the adverse effect of PFOF to customers. PFOF has been analyzed to better market and is harmful and poses risks to the market. One such harm is that it redirects the retail customer order away from transparent securities exchanges to a small 3 number of high-frequency trading firms that execute a great percentage of overall trading. This results in loss of liquidity which has a direct negative impact on investors using the security exchanges. It also has systemic risk implications, lack of transparency and investor protections and, interferes with price discovery. As per brokers, one benefit of PFOF is price improvement. Investors saved $3.7 billion from price improvement in 2020 (Bloomberg Intelligence, 2021). The contention issue is whether retail saves more money because of non-existing trading fees or the amount they risk losing in price improvement. The concern of transparency in PFOF has been increasing. With the lack of disclosure of PFOF, transparency concern has grown. There is speculation that the market makers could be having other businesses and benefit from PFOF. Looking at the model, the discussion of whether PFOF is the only better option for commission-free trading is still ongoing. Although without it, market makers will still receive trades from brokers, investors will still be charged. Blockchain-based payment and settlement system impact on current market practices Depository Trust & Clearing Corporation recently released a project, Whitney. It is a platform that uses etherium as its technology. It is blockchain-based and seeks to address the digitization of assets. Distributed ledger technology (DLT) has generated tremendous interest and discussion concerning the securities market. It has since been adopted by financial institutions and researched in the best possible way it can be utilized. Areas such as financial reporting, transfers, and payments, and portfolio management have been identified to be helpful. In as much as it may be quickly adopted, there are several legal frameworks and regulatory issues that have to be considered. Moreso on the topic of central management as blockchain technology relies on the peer-to-peer connection with no central authority. Central 4 securities depository (CSD) refers to the infrastructure that enables easy processing of securities transactions. I hold recording systems where records of securities are stored in digital form. The use of DLT will enhance the entire process by reducing settlement risk and the time needed to store information. All parties will need to act together and maintain identical records. Blockchain technology will enhance efficiency in regards to cross border settlement. Traditionally banks will need to compare and reconcile data for such to happen since different banks have different databases; as DLT is a single distributed ledger, information will be shared easily and efficiently with no need to compare and reconcile data. Transparency of will also is a distinct advantage with DLT's usage. Since investors have access to an account held and managed by a central authority, DLT will combine all this information into one database that can be easily be monitored and managed by investors themselves with no intermediaries. Custody risks refer to the risk of loss incurred on securities in custody due to negligence or misuse of assets by the custodian. DLT will significantly reduce custodial risks by eliminating the need to do reconciliations of accounts through the custody chain as data is secure and cannot be modified. A smart contract is another term commonly found with DLT. These are agreement records that are stored in an inedible blockchain. When agreed, it will self execute. There is a difference between smart contracts and the automation of processes with traditional systems. Smart contracts are made by mutual agreement for the sake of meeting specific outcomes and objectives, and once made, they cannot be modified without both parties agreeing. A combination of blockchain technology and smart contracts will have a significant impact on traditional systems. It will improve on data securities and enhance the settlement process. Conclusion 5 The payment-for-order-flow model has brought a lot of debate on the transparency of the model, and the banning of the model in the U.K. indicates it still has some contention issues. One such problem is if brokers act in customers' best interest and if there is a conflict of interest. The commission-based brokering model remains a robust model with transparency. It may be concluded that payment-for-order flow may not represent a fundamental restructuring of financial markets based on the above discussion. Regarding the Gamestop controversy, Blockchain-based payment and settlement system may play an important role in the transparency of transaction of trades, if the GameStop stocks were to be traded on blockchain technology, then there would have not been and central management that block what investors can trade on, besides, if smart contracts are integrated then the trades would have continued if all the condition sets were fulfilled. No central management would stop it. 6 References Better Market. (2021). Payment for Order Flow. Chiu, J., & Koeppl, T. V. (2018). Blockchain-based settlement for asset trading. SSRN Electronic Journal. https://doi.org/10.2139/ssrn.3203917 Blockchain-based settlement for asset trading. (2018). Loader, D. (2019). Clearing, settlement and custody. Butterworth-Heinemann. Slaughter and May and Euroclear. (2016). Blockchain settlement. 7 ADDITIONAL READINGS TO BE ADDED Suggested readings The following are readings that could be of help in preparing your assignment: Battalio, R. and Loughran, T. (2008) Does Payment For Order Flow To Your Broker Help Or Hurt You? Journal of Business Ethics, 80, pp.37-44. Ben-Abdallah, R. and Breton, M. (2015) To Squeeze or Not to Squeeze? That Is No Longer the Question. Journal of Futures Markets, 36(7), pp.647-670. Chiu, J. and Koeppl, T. (2019) Blockchain-Based Settlement for Asset Trading. The Review of Financial Studies, 32(5), pp.1716-1753. Culp, C. and Heaton, J. (2008) The Economics of Naked Shorting, Regulation 31, 46- 51. DTCC (2020a) Project Ion Case Study. 25760-PS052020. New York: The Depository Trust and Clearing Corporation. Online. Available at: https://www.dtcc.com/~/media/Files/Downloads/settlement-assetservices/userdocumentation/Project-ION-Paper-2020.pdf DTCC (2020b) Project Whitney Case Study. 25733-TC042920. New York: The Depository Trust and Clearing Corporation. Online. Available at: https://www.dtcc.com/~/media/Files/Downloads/settlement-assetservices/userdocumentation/Project-Whitney-Paper.pdf FCA (2019) Payment for Order Flow (PFOF). Pub ref: 005980. London: Financial Conduct Authority. Online. Available at: https://www.fca.org.uk/publication/multi-firmreviews/payment-fororder-flow-pfof.pdf Pagano, M., Sedunov, J. and Velthuis, R. (2021) How did retail investors respond to the COVID-19 pandemic? The effect of Robinhood brokerage customers on market quality. Finance Research Letters, In Press. 8 Bennett, W. (2014) Organization in the crowd: peer production in large-scale networked protests. Information, Communication & Society, 17(2), pp.232- 260. 4 Chohan, U. (2021) Counter-Hegemonic Finance: The Gamestop Short Squeeze. SSRN Working Paper 3775127. Available at: https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3775127 Dent, A. and Dison, W. (2012) The Bank of England’s Real-Time Gross Settlement infrastructure, Bank of England Quarterly Bulletin (Q3), https://www.bankofengland.co.uk//media/boe/files/quarterlybulletin/2012/the-boes-real-time-gross-settlement-infrastructure.pdf Farrell, M., Green, T., Jame, R., and Markov, S. (2020) The Democratization of Investment Research and the Informativeness of Retail Investor Trading. SSRN Working paper 3222841. Available at: https://ssrn.com/abstract=3222841 Ferrell, A. (2001) A Proposal for Solving the “Payment for Order Flow” Problem. Southern California Law Review, 74(4), pp. 1027-1088. Godfrey, K. (2016) Detecting the great short squeeze on Volkswagen. Pacific-Basin Finance Journal, 40(B), pp.323-334. Irrera, A. (2017) DTCC completes blockchain repo test. Online. Available at: https://www.reuters.com/article/us-dtcc-blockchain-repos-idUSKBN1661L9 Kelly, J. (2020) PwC: blockchain potentially has LOADS of potential. Online. Available at: https://www.ft.com/content/a2a43f84-1b9c-4aae-b5c5- 6786aff81654. Lyócsa, S., Baumöhl, E., and V?rost, T. (2021) YOLO trading: Riding with the herd during the GameStop episode. Econstor Working Paper. Available at: https://www.econstor.eu/bitstream/10419/230679/1/YOLO-Trading-Ridingwith-the-herdduring-the-Gamestop-episode.pdf Taketoshi, M. (2016) Financial technology: Blockchain and securities settlement. Journal of Securities Operations & Custody, 8(3), pp. 208-227. Parlour, C. and Rajan, U. (2003) Payment for order flow. Journal of Financial Economics, 68(3), pp. 379-411. Nissenbaum, A. and Shifman, L. (2015) Internet memes as contested cultural capital: The case of 4chan’s /b/ board. New Media & Society. Staer, A. and Jacquot, M. (2018) Social Media and Investor Returns: The Case of Reddit. SSRN Workin Paper 3282828. Available at: https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3282828 Tsai, W., Luo, Y., Deng, E., Zhao, J., Ding, X., Li, J. and Yuan, B. (2020) Blockchain systems for trade clearing. Journal of Risk Finance, 21(5), pp. 469-492. 9 Werner, R. (2014a) Can banks individually create money out of nothing? — The theories and the empirical evidence. International Review of Financial Analysis, 36, pp.1-19. Werner, R. (2014b) How do banks create money, and why can other firms not do the same? An explanation for the coexistence of lending and deposit-taking. International Review of Financial Analysis, 36, pp.71-77. Zhang, X., Fuehres, H. and Gloor, P. (2011) Predicting Stock Market Indicators Through Twitter “I hope it is not as bad as I fear”. Procedia - Social and Behavioral Sciences, 26, pp.55-62. 1 Case Study The case study comprises the testimony and supporting documentation from the US House of Representatives Committee on Financial Services dated Thursday, February 18, 2021. House of Representatives (2021) House Financial Services Committee. Game Stopped? Who Wins and Loses When Short Sellers, Social Media, and Retail Investors Collide. Hearing, 18th February. Washington: Government Printing Office. Online. Available at: https://www.congress.gov/event/117th-congress/house-event/111207 Using the above case study, along with what you find out from your further reading and research on the topic, and focusing on the literature discussed in the module, answer BOTH questions below Within the first US congressional hearing relating to the Gamestop controversy, Robinhood’s business model was critiqued, while Warren Davidson, the Representative for Ohio, referenced the DTCC’s Project Ion, which explores the use of blockchain technology to improve the efficiency of payment and settlement functions within financial markets. Discuss whether the widespread adoption by retail brokerages such as Robinhood of a payment-for-order-flow model, along with the proliferation of dark pools, represents a fundamental restructuring of financial markets relative to the commission-based brokering model involving execution of orders through public exchanges. With reference to the Gamestop controversy, discuss whether a blockchainbased payment and settlement system (such as Project Ion or Project Whitney) might affect current market practices? Payment-for-order-flow model Research by Aite Group shows that close to a quarter of U.S. adults with access to the Internet are online retail traders. An additional 6% are professional traders, together with equivalent to a self-directed U.S. trading population of more than 54 million adults. ("Online trading penetration in the United States and retail traders' trading device preferences are rapidly changing," 2014). Payment for the order is a form of compensation whereby a stockbroker receives from a maker market for directing orders for trade execution, and this can be informed of a percentage. 2 This model has played a part in the increased uptake of retail investing in recent times. Robinhood started by offering free trades and getting paid by directing its volume of trades. It was a way of making the start-up pick up back then. With its growth, the model of payment for order gain traction as being attractive. It also made traditional stockbrokers switching up and adopting the model. An issue and point of discussion were that the model was not in the customers' best interest. One of the Robinhood competitors even dropped the model, stating that it was not a good model for serving the customers' best interests, that are in Public.com. Even during the congregational hearing, the model was criticized as pioneering the current problems in the current market Debate on whether payment for order flow is acting in the best interest of customers or trading fees okay continues as brokerage firms are still using the model. On the issue of conflict of interest, a broker might promise high returns but instead deliver less price. Still, if the broker and market maker offers the retail investor National Best Bid and Offer (NBBO) pricing, it is within the limit of regulations. PFOF creates conflicts of interest between (1) a retail broker-dealer's duty to seek the "best execution" available for customer orders and (2) its duty to maximize its profits for shareholders and/or owners through PFOF revenues generated by preferentially routing transactions to select HFTs (Better Market, 2021, p. 1). On the other hand, Robinhood argues that market makers provide better prices than exchanges. It only earns a fixed percentage of the bid-ask price, so it has no motive to direct orders to specific market makers, thus conflict. Recently SEC found Robinhood liable, and Robinhood had to pay a $65 million penalty for not disclosing the adverse effect of PFOF to customers. PFOF has been analyzed to better market and is harmful and poses risks to the market. One such harm is that it redirects the retail customer order away from transparent securities exchanges to a small 3 number of high-frequency trading firms that execute a great percentage of overall trading. This results in loss of liquidity which has a direct negative impact on investors using the security exchanges. It also has systemic risk implications, lack of transparency and investor protections and, interferes with price discovery. As per brokers, one benefit of PFOF is price improvement. Investors saved $3.7 billion from price improvement in 2020 (Bloomberg Intelligence, 2021). The contention issue is whether retail saves more money because of non-existing trading fees or the amount they risk losing in price improvement. The concern of transparency in PFOF has been increasing. With the lack of disclosure of PFOF, transparency concern has grown. There is speculation that the market makers could be having other businesses and benefit from PFOF. Looking at the model, the discussion of whether PFOF is the only better option for commission-free trading is still ongoing. Although without it, market makers will still receive trades from brokers, investors will still be charged. Blockchain-based payment and settlement system impact on current market practices Depository Trust & Clearing Corporation recently released a project, Whitney. It is a platform that uses etherium as its technology. It is blockchain-based and seeks to address the digitization of assets. Distributed ledger technology (DLT) has generated tremendous interest and discussion concerning the securities market. It has since been adopted by financial institutions and researched in the best possible way it can be utilized. Areas such as financial reporting, transfers, and payments, and portfolio management have been identified to be helpful. In as much as it may be quickly adopted, there are several legal frameworks and regulatory issues that have to be considered. Moreso on the topic of central management as blockchain technology relies on the peer-to-peer connection with no central authority. Central 4 securities depository (CSD) refers to the infrastructure that enables easy processing of securities transactions. I hold recording systems where records of securities are stored in digital form. The use of DLT will enhance the entire process by reducing settlement risk and the time needed to store information. All parties will need to act together and maintain identical records. Blockchain technology will enhance efficiency in regards to cross border settlement. Traditionally banks will need to compare and reconcile data for such to happen since different banks have different databases; as DLT is a single distributed ledger, information will be shared easily and efficiently with no need to compare and reconcile data. Transparency of will also is a distinct advantage with DLT's usage. Since investors have access to an account held and managed by a central authority, DLT will combine all this information into one database that can be easily be monitored and managed by investors themselves with no intermediaries. Custody risks refer to the risk of loss incurred on securities in custody due to negligence or misuse of assets by the custodian. DLT will significantly reduce custodial risks by eliminating the need to do reconciliations of accounts through the custody chain as data is secure and cannot be modified. A smart contract is another term commonly found with DLT. These are agreement records that are stored in an inedible blockchain. When agreed, it will self execute. There is a difference between smart contracts and the automation of processes with traditional systems. Smart contracts are made by mutual agreement for the sake of meeting specific outcomes and objectives, and once made, they cannot be modified without both parties agreeing. A combination of blockchain technology and smart contracts will have a significant impact on traditional systems. It will improve on data securities and enhance the settlement process. Conclusion 5 The payment-for-order-flow model has brought a lot of debate on the transparency of the model, and the banning of the model in the U.K. indicates it still has some contention issues. One such problem is if brokers act in customers' best interest and if there is a conflict of interest. The commission-based brokering model remains a robust model with transparency. It may be concluded that payment-for-order flow may not represent a fundamental restructuring of financial markets based on the above discussion. Regarding the Gamestop controversy, Blockchain-based payment and settlement system may play an important role in the transparency of transaction of trades, if the GameStop stocks were to be traded on blockchain technology, then there would have not been and central management that block what investors can trade on, besides, if smart contracts are integrated then the trades would have continued if all the condition sets were fulfilled. No central management would stop it. 6 References Better Market. (2021). Payment for Order Flow. Chiu, J., & Koeppl, T. V. (2018). Blockchain-based settlement for asset trading. SSRN Electronic Journal. https://doi.org/10.2139/ssrn.3203917 Blockchain-based settlement for asset trading. (2018). Loader, D. (2019). Clearing, settlement and custody. Butterworth-Heinemann. Slaughter and May and Euroclear. (2016). Blockchain settlement. 7 ADDITIONAL READINGS TO BE ADDED Suggested readings The following are readings that could be of help in preparing your assignment: Battalio, R. and Loughran, T. (2008) Does Payment For Order Flow To Your Broker Help Or Hurt You? Journal of Business Ethics, 80, pp.37-44. Ben-Abdallah, R. and Breton, M. (2015) To Squeeze or Not to Squeeze? That Is No Longer the Question. Journal of Futures Markets, 36(7), pp.647-670. Chiu, J. and Koeppl, T. (2019) Blockchain-Based Settlement for Asset Trading. The Review of Financial Studies, 32(5), pp.1716-1753. Culp, C. and Heaton, J. (2008) The Economics of Naked Shorting, Regulation 31, 46- 51. DTCC (2020a) Project Ion Case Study. 25760-PS052020. New York: The Depository Trust and Clearing Corporation. Online. Available at: https://www.dtcc.com/~/media/Files/Downloads/settlement-assetservices/userdocumentation/Project-ION-Paper-2020.pdf DTCC (2020b) Project Whitney Case Study. 25733-TC042920. New York: The Depository Trust and Clearing Corporation. Online. Available at: https://www.dtcc.com/~/media/Files/Downloads/settlement-assetservices/userdocumentation/Project-Whitney-Paper.pdf FCA (2019) Payment for Order Flow (PFOF). Pub ref: 005980. London: Financial Conduct Authority. Online. Available at: https://www.fca.org.uk/publication/multi-firmreviews/payment-fororder-flow-pfof.pdf Pagano, M., Sedunov, J. and Velthuis, R. (2021) How did retail investors respond to the COVID-19 pandemic? The effect of Robinhood brokerage customers on market quality. Finance Research Letters, In Press. 8 Bennett, W. (2014) Organization in the crowd: peer production in large-scale networked protests. Information, Communication & Society, 17(2), pp.232- 260. 4 Chohan, U. (2021) Counter-Hegemonic Finance: The Gamestop Short Squeeze. SSRN Working Paper 3775127. Available at: https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3775127 Dent, A. and Dison, W. (2012) The Bank of England’s Real-Time Gross Settlement infrastructure, Bank of England Quarterly Bulletin (Q3), https://www.bankofengland.co.uk//media/boe/files/quarterlybulletin/2012/the-boes-real-time-gross-settlement-infrastructure.pdf Farrell, M., Green, T., Jame, R., and Markov, S. (2020) The Democratization of Investment Research and the Informativeness of Retail Investor Trading. SSRN Working paper 3222841. Available at: https://ssrn.com/abstract=3222841 Ferrell, A. (2001) A Proposal for Solving the “Payment for Order Flow” Problem. Southern California Law Review, 74(4), pp. 1027-1088. Godfrey, K. (2016) Detecting the great short squeeze on Volkswagen. Pacific-Basin Finance Journal, 40(B), pp.323-334. Irrera, A. (2017) DTCC completes blockchain repo test. Online. Available at: https://www.reuters.com/article/us-dtcc-blockchain-repos-idUSKBN1661L9 Kelly, J. (2020) PwC: blockchain potentially has LOADS of potential. Online. Available at: https://www.ft.com/content/a2a43f84-1b9c-4aae-b5c5- 6786aff81654. Lyócsa, S., Baumöhl, E., and V?rost, T. (2021) YOLO trading: Riding with the herd during the GameStop episode. Econstor Working Paper. Available at: https://www.econstor.eu/bitstream/10419/230679/1/YOLO-Trading-Ridingwith-the-herdduring-the-Gamestop-episode.pdf Taketoshi, M. (2016) Financial technology: Blockchain and securities settlement. Journal of Securities Operations & Custody, 8(3), pp. 208-227. Parlour, C. and Rajan, U. (2003) Payment for order flow. Journal of Financial Economics, 68(3), pp. 379-411. Nissenbaum, A. and Shifman, L. (2015) Internet memes as contested cultural capital: The case of 4chan’s /b/ board. New Media & Society. Staer, A. and Jacquot, M. (2018) Social Media and Investor Returns: The Case of Reddit. SSRN Workin Paper 3282828. Available at: https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3282828 Tsai, W., Luo, Y., Deng, E., Zhao, J., Ding, X., Li, J. and Yuan, B. (2020) Blockchain systems for trade clearing. Journal of Risk Finance, 21(5), pp. 469-492. 9 Werner, R. (2014a) Can banks individually create money out of nothing? — The theories and the empirical evidence. International Review of Financial Analysis, 36, pp.1-19. Werner, R. (2014b) How do banks create money, and why can other firms not do the same? An explanation for the coexistence of lending and deposit-taking. International Review of Financial Analysis, 36, pp.71-77. Zhang, X., Fuehres, H. and Gloor, P. (2011) Predicting Stock Market Indicators Through Twitter “I hope it is not as bad as I fear”. Procedia - Social and Behavioral Sciences, 26, pp.55-62. 2. Within the first US congressional hearing relating to the Gamestop controversy, Robinhood's business model was critiqued, while Warren Davidson, the Representative for Ohio, referenced the DTCC's Project lon, which explores the use of blockchain technology to improve the efficiency of payment and settlement functions within financial markets. Discuss whether the widespread adoption by retail brokerages such as Robinhood of a payment-for-order-flow model, along with the proliferation of dark pools, represents a fundamental restructuring of financial markets relative to the commission-based brokering model involving execution of orders through public exchanges. With reference to the Gamestop controversy, discuss whether a blockchain- based payment and settlement system (such as Project lon or Project Whitney) might affect current market practices. [50 marks] 2 Case Study The case study comprises the testimony and supporting documentation from the US House of Representatives Committee on Financial Services dated Thursday, February 18, 2021. House of Representatives (2021) House Financial Services Committee. Game Stopped? Who Wins and Loses When Short Sellers, Social Media, and Retail Investors Collide. Hearing, 18th February. Washington: Government Printing Office. Online. Available at: https://www.congress.gov/event/117th-congress/house-event/111207