FROM THE kerb it does not look like much. The low-slung terracotta building is a far cry from the futuristic spaceship-style campuses favoured by tech firms down the road in Palo Alto, or the gleaming skyscrapers that house most powerful financial institutions in New York. The insides of the headquarters in Menlo Park, California, of Robinhood, an online stockbroker, are understated and elegant, as befits the mid-century former home of the books section of Sunset, a glossy west-coast lifestyle magazine.
It was outside this unassuming façade that a knot of protesters gathered on January 28th, after Robinhood suspended trading in shares of GameStop, a struggling brick-and-mortar seller of video games, and a host of other firms for the day. The price of GameStop’s shares had soared from around $20 on January 12th to a peak of $469 during that day, a rally seemingly driven by users of r/wallstreetbets, a forum on Reddit where retail investors discuss risky short-term stock bets. (The subreddit had just 2m followers at the start of January; it has now amassed more than 6m.) GameStop stock was unloved by institutional investors who had sold short (borrowed and sold shares, hoping that the price would fall and they could buy them back more cheaply, pocketing the difference) on an enormous scale: short positions were worth 130% of the company’s market capitalisation on January 15th.
Vladimir Tenev, one of Robinhood’s founders, explained on CNBC that the firm had suspended trading because the broker needed to comply with regulatory net capital requirements and deposit demands from clearing-houses, the institutions that match and settle share transactions. There is a two-day lag between an equity trade and its settlement, when the buyer receives their share and the seller gets their cash. In the interim, brokers can be required to post capital to back trades made through their platforms. “These requirements fluctuate quite a bit based on volatility in the markets, and they can be substantial in the current environment where there is a lot of volatility and a lot of concentrated activity in these names that have been going viral on social media,” said Mr Tenev. The pressures this put on the firm to post capital were immense: Robinhood said that the deposits related to equities required of it by clearing-houses increased ten-fold in the week of January 25th. The firm raised $1bn of capital from its investors on January 28th and drew down several hundred million dollars more of its credit lines with banks, ostensibly to meet these demands.
A David-and-Goliath narrative has been whipped up around the frenzied rise of GameStop: it puts wealthy hedge-fund managers against little guys who have rallied around a beleaguered retailer. Viewed through this lens the step to suspend trading of GameStop shares is nothing short of a betrayal. The GameStop drama presents Robinhood, once a beneficiary of the wave of retail investing, with existential threats.
From this point of view, the purported perfidy may have been exacerbated by the role of Citadel, a hedge fund, and Citadel Securities, a marketmaker, which are both owned by Ken Griffin, a Chicago-based billionaire. To understand this role, first consider how Robinhood makes money. It does not charge its users for each share trade they make. Instead, marketmakers pay it for “order flow”—ie, directing its retail users’ trades through them. Robinhood earned $271m in this way in the first half of last year. Marketmakers can take a small profit on the “spread,” or difference in price between what a Robinhood user pays and the price at which the security is being sold in the market. Citadel Securities was the marketmaker through which most of Robinhood’s orders were routed in 2020.
This is not necessarily nefarious: marketmakers are keen to receive retail order flow because it can improve their trading algorithms. It is also “friendly” compared with institutional flow. Institutions might place big orders in several places simultaneously or one after another, which can make it hard for a marketmaker to execute a trade at a profit. Retail investors’ orders do not present this risk.
But Robinhood has got into trouble for this practice before. On December 17th 2020 the Securities and Exchange Commission charged the firm with making “repeated misstatements that failed to disclose the firm’s receipt of payments from trading firms for routing customer orders to them.” The SEC also found that this had resulted in customers’ trades being executed at worse prices than needed to satisfy their “best-execution” requirements. Robinhood paid $65m to settle the charges.
Now consider the role that Citadel, the hedge fund, has played in the GameStop saga. One of the hedge funds that was heavily short GameStop shares is Melvin Capital. As GameStop shares spiked on January 25th Melvin Capital took a capital injection from two hedge funds, including $2bn from Citadel. Mr Tenev staunchly denies that these dynamics played any part in their decision to halt trading: “We absolutely did not do this at the direction of any marketmaker or hedge fund.” But a cursory scroll through Reddit suggests that plenty of Robinhood’s users do not believe him. Citadel told Bloomberg news: “Citadel is not involved in, or responsible for, any retail brokers’ decision to stop trading in any way.”
This poses two, potentially existential, threats to Robinhood. The first is that it might lose many of its users. It is impossible to untangle the growth of Robinhood from the growth of the suddenly famous subreddit. Founded a decade ago by Mr Tenev and Baiju Bhatt on a mission to “democratise finance for all”, the startup was the first to offer retail investors unfettered access to the stockmarket. Their method of doing this was to make share trading free at the point of the transaction, and also to grant retail investors easy access to leveraged derivatives, once the preserve of rich and sophisticated investors.
This was precisely the kind of access demanded by those looking to have fun in the stockmarket. A year or two ago, before they gained notoriety, users of r/wallstreetbets would post screenshots of wild bets (which they call “yolos”) that had struck gold or not paid off (shared with the hashtag #lossporn); the neon-green colours of the Robinhood platform were always featured. Mr Tenev and Mr Bhatt were often talked about as heroes among the subreddit’s denizens. It would be hyperbolic to claim that the frenzy in GameStop could not have happened without Robinhood’s success, but the platform certainly hastened its arrival.
Robinhood’s monopoly over this group of users has waned since the end of 2019, when several other discount brokers, such as Charles Schwab, TD Ameritrade and E*Trade, succumbed to the inevitable by cutting their fees to zero too. But it is clear, given that Robinhood seemed the most exposed to the rise in GameStop shares (most others managed to keep two-way trading open all day), that it was still by far their favourite. It is unlikely to remain so.
The second threat to Robinhood is that the practice of payment for order flow has attracted attention from regulators, and from lawmakers on both sides of the aisle. The Democratic leaders of the House Financial Services Committee and the Senate Banking Committee both said they would hold hearings about the decision to halt trading. It seems inevitable that the practice will come under closer scrutiny, if not be restricted in some way. This too could cause problems for Robinhood. It is unclear how much of its revenues come from payment for order flow, because the firm is privately held. But it is possible that they make up a substantial share. The GameStop rally is already creating pain for a handful of financial institutions. Robinhood may be one more to suffer.