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Looking Back at the Gamestop/Robinhood Saga - Part 2

See part 1 here.

We left off in our saga with Robinhood restricting trading on Gametop stock (GME), causing the price per share to plummet from a high of $483 to closing the day at $193.

Backing up: how Robinhood fares as a brokerage firm

Before we dive into Robinhood's claim for why they halted trading as well as what was happening behind the scenes, let's examine Robinhood's record as a brokerage firm. To do so we will benchmark them against the second largest broker, Charles Schwab, as to put their record into context.

The following are facts obtained directly from FINRA:

  • Client Assets:

  • Schwab: $7.57 Trillion

  • Robinhood: $81 Billion (or about 1% of Schwab)

  • Disclosure events & fines in the past 3 years (defined as "certain criminal matters, regulatory actions, civil judicial proceedings and financial matters"):

  • Schwab: 2 events & $50,000 in fines

  • Robinhood: 3 events & $123,250,000 in fines

In summary: Robinhood, with 1/100 of the client assets of Schwab, has 2,465x the fines.

The largest of these fines was for $65 million, described as "[Robinhood]'s high payment for order flow rates from principal trading firms could result in inferior execution prices for its customers."

How Robinhood works

Robinhood passes their customer's orders (as do most brokers) to market making firms. These market makers pay Robinhood and other brokers for this order flow (essentially like an affiliate marketing fee).

Market makers do this because they make money on the spread between transactions (more here). Robinhood was found to be taking high payment for order flow rates at the expense of their own customers. They were essentially directing customers to places that gave them the highest revenue rather than their customers the best prices. Reminds me of this. It also makes the next quote particularly curious.

During Robinhood's trading halt, their CEO explained, "in order to protect the firm and protect our customers we had to limit buying in these stocks."

He further referenced the clearing deposit with the NSCC being extraordinarily high as a reason for this halt. He went on to say, "Robinhood is a brokerage firm, we have lots of financial requirements. We have SEC net capital requirements and clearing house deposits. So that’s money that we have to deposit at various clearing houses. Some of these requirements fluctuate quite a bit based on volatility in the market and they can be substantial in the current environment where there’s a lot of volatility and a lot of concentrated activity in these names that have been going viral on social media."

Lets examine that more closely. The NSCC requires all brokers to keep a certain amount of cash on hand that represents unsettled trades. This calculation nets all buys and sells within an individual broker for that period (aka all customers who bought and sold GME stock netted together). This net number is then plugged into a formula set against a volatility figure to measure the amount required to be on deposit (for full reference, see discussion starting on page 291 here).

Margin trading versus cash trading

The most critical factor in all of this is margin trading. If all Robinhood customers were trading based on cash in their accounts, there wouldn't be a risk associated with settling trades.

To illustrate this, imagine there were $10 billion more buys than sells on that day. If all of those transactions were done by cash customers, $10 billion would be sitting in their accounts to cover those trades.

The problem emerges when customers trade on margin. They may only have 75% of that cash on hand and are borrowing the other 25%. That means Robinhood is putting that 25% up for those customers.

While this means big bucks in margin interest revenue for Robinhood, it is also extremely risky, especially on a stock as volatile as GME was at the time. Robinhood has come under scrutiny in the past for letting customers trade on margin who probably shouldn't be. This means, again, Robinhood created the source for its own problems. Rather than call into question their biggest revenue driver, their margin lending business, they used the volatility of GME as a scapegoat.

Was Robinhood a victim or policy or of their own negligence?

So in short, was it true that Robinhood's trading halt was driven by the NSCC requirement? Yes. Was there other ways they could have reacted, like halting margin lending exclusively or other reactions? Yes.

Then there poses the third and most popular question: was any of this driven by Robinhood's relationship with Citadel? This one in my opinion is probably a red herring. While everyone loves a good conspiracy theory, myself included, I think the Citadel-Robinhood relationship is being thought of incorrectly.

I used to work with another one of Robinhood's market making relationships and the short story is that market making firms need Robinhood more than Robinhood needs them. Although Robinhood makes money from Citadel, they could very easily take their business elsewhere. For that reason, I find it hard to believe that Ken Grifin called up Vlad Tenev and pressured him to shut down trading.

As previously discussed, I think this was entirely negligence on Robinhood's part. FINRA in its ongoing investigation will have their own take on all of this that will ultimately reveal just how much of this you can attribute where.

The story doesn't end here, however. There is one more chapter to this whole thing that was less covered by the media but important to understand for retail investors. Stay tuned.

To be continued.

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