Over the past week, we’ve received inquiries from many friends, family and connections asking what Robinhood is all about and how it’s in the middle of the Reddit/GameStop situation, and we expect you may be getting the same. Questions have ranged from the basics of what occurred to more philosophical questions around payment for order flow, the market-maker business model and capital requirements.
In times when our industry is making so many headlines, we believe it is our collective responsibility to engage with the public, especially when there is so much misinformation out there. Forefront Communications’ own Rafi Reguer put together a great primer on the issues at play, so we’re sharing it today in hopes that it will foster greater understanding of this incredibly eventful period in the markets.
WHAT ROBINHOOD IS
Robinhood is a brokerage firm. Specifically, it falls into the category of “discount brokerage.” The lines have been blurred in recent years, but here is the basic difference among firms: Many traditional brokerage firms (think Bank of America Merrill Lynch, Morgan Stanley, etc.) package investment advice with trade executions. Clients may pay hundreds of dollars per trade, a percentage of assets or something else, but they pay a lot and receive financial guidance. Discount brokerages (think Charles Schwab) came along to serve self-directed investors. Their clients pay far less in trade commissions because they are simply paying for the execution of trades, not tailored investment advice.
THE DEMOCRATIZATION OF TRADING
The revolution didn’t happen in 2020. It started in 1975. That’s when the SEC did away with the standard schedule that every brokerage firm was required to use. Jack Bogle (Vanguard) pioneered low-cost mutual funds. Charles Schwab (Schwab), Larry Waterhouse (TD Ameritrade) and others decoupled trading cost from investment advice and began charging much lower fees. The industry got another jolt in the 1990s when many of these firms adopted online trading, which dropped brokerage fees even more.
Robinhood furthered the revolution when it launched in the early 2010s. A Silicon Valley-based company, it created a mobile app that was a lot more user-friendly and geared toward younger investors, a demographic that some more established firms hadn’t bothered with. Importantly, Robinhood also mainstreamed the concept of commission-free trading, and when it got enough traction, firms like Schwab, TD Ameritrade and Fidelity (best known as a mutual fund company, but also a discount brokerage) followed suit. Robinhood also began offering “stock slices,” partial shares of stocks enabling people to buy several stocks with only a few hundred dollars. Again, other firms followed suit.
WHAT ROBINHOOD ISN’T
Notwithstanding the aforementioned items, Robinhood isn’t really different from any other discount brokerage firm. “We’re on a mission to democratize finance for all” is a slogan. The whole David versus Goliath thing is branding. The firm is trying to communicate a modern attitude with an ethos of changing the industry’s longstanding power structures – the name “Robinhood” isn’t an accident – but it’s important to remember that under the hood, the mechanics of operating a brokerage firm are the same for everyone. Don’t confuse the actual company with its brand.
COMMISSION-FREE TRADING ISN’T FREE
You might think that when you buy or sell a stock that your brokerage firm is sending your order to a stock exchange. In truth, there are many places to route an order. Robinhood, like many discount brokerage firms, sells its order flow to a market maker, a practice called “Payment for Order Flow” (PFOF). Market-making firms buy and sell the same stocks over and over again throughout the day, making money on the spread (e.g. buy stock for $42 and sell it a minute later for $42.01 – that’s a one-cent spread).
Market makers prize – and thus, are willing to pay for the privilege of interacting with — retail order flow because they like to trade against people who aren’t trying to get in and out of positions in microseconds, the way they are. In addition, retail traders typically don’t have a much larger portion of their order still set to come the way a large pension fund, endowment or Mutual Fund manager might. These “institutional-sized” orders invariably drive the price in the direction they are trading it, hence a market maker’s desire to be cautious when interacting with it, if not attempting to avoid it altogether
SO PAYMENT FOR ORDER FLOW IS EVIL, RIGHT?
It’s quite easy to demonize payment for order flow. In fact, it becomes a big topic in our industry every 15 years or so, as a new class of investors open brokerage accounts and become aware of the practice. It certainly seems like a conflict of interest for a firm like Robinhood. After all, Robinhood is required to get the best execution for its customers. There are dozens of places to route order flow, so how can a brokerage route it all to one place, a place that conveniently pays them quite a bit of money?
The debate about payment for order flow can get quite involved, but the major case for it is this: Without payment for order flow, brokerage firms would have to charge high commissions or make the money up somewhere else. Brokerage firms are huge, expensive operations and none are non-profit entities – you’re paying one way or another. Could you get a slightly inferior execution compared to what you might have gotten? Sure. But in most heavily traded stocks, the spreads are only pennies. If you’re a long-term investor, does the fact that you bought 300 shares of a stock at $105.11 instead of $105.09 really make a difference? Remember, the ultra-low commissions that were commonplace before Robinhood were in the neighborhood of $8.00, and not long before that were much higher. Your commission-free trade’s slightly inferior execution price only costs you $6.00 on an investment of over $30,000.
Also, we need market makers because they are the ones that offer liquidity in the stock market. They facilitate the ability for investors to get in and out of positions quickly throughout the day. Market makers can survive by having either large spreads (which used to be 12.5 cents or 25 cents before the market moved to decimal-based pricing in 2000) on a smaller number of trades or very small spreads on a huge number of trades.
WHAT HAPPENED TO ROBINHOOD LAST WEEK
Of course, all of this is in the headlines because of the GameStop (GME) short squeeze. A short is when people sell a stock even though they don’t own it and must borrow it in order to sell. They hope to buy the stock at a later date, when the stock price has dropped, so they can return the stock to where it was borrowed from. This can be lucrative, if the price drops, but these short sellers can get “squeezed,” forcing them to buy the stock at a high price. This is what occurred last week, fueled at least in part by retail investors who frequent the popular WallStreetBets subreddit. By the time it peaked on January 27, GME had climbed by more than 1,500% in the previous two weeks, dealing significant damage to many hedge funds in the process. As the story grew, retail investors began to eagerly eye similar positions and a growing number of individuals decided to wade in – last week, Robinhood, Webull and Cash App all made the front page of the app store on both Google Play and iOS.
On January 28, the other shoe dropped, as Robinhood restricted trading in GameStop, AMC, BlackBerry, Nokia and other volatile stocks (as did several other discount brokerage firms). The decision was met with outcry from many in the retail trading world and beyond, who pointed to it as evidence of corruption and favoritism.
WHY ROBINHOOD AND OTHERS RESTRICTED TRADING
Let’s take a step back and take a more nuanced look at the situation. Robinhood may not have handled this situation well, but most of the conspiracy theories you may have seen have been proven false.
First, so that everyone understands, Robinhood restricted clients from opening NEW positions in the handful of stocks that had a large amount of short interest. Contrary to what people were saying on the news and even on CNBC, there were no Robinhood customers who were stuck in a position that they could not get out of. If you owned 100 shares of GameStop and wanted to sell, you could. You just weren’t allowed to buy 100 new shares.
Second, according to interviews with Robinhood CEO Vlad Tenev, the firm did NOT restrict trading because of pressure from their market maker partners (Citadel is the most substantial), the SEC or hedge funds (even the hedge fund that is a partial owner of Robinhood). The answer is far more mundane: Brokerage firms have capital requirements, mandated by the regulators.
While buying or selling a stock online seems virtually instantaneous, stocks actually settle T+2. That means the stock you bought on Thursday doesn’t arrive in your account until the following Monday. This creates systemic risk. What happens if the firm you bought the stock from blows up on Friday? To avoid this situation, brokerage firms are required to post capital every morning (Note: on Febuary 2, Robinhood CEO and Co-Founder Vlad Tenev released a blog post calling for the industry to move to real-time settlement).
Posting capital is usually not an issue for most firms, but Robinhood suddenly faced an extremely unusual situation: its customers were heavily concentrated in just a few highly volatile stocks. Some of its customers traded on margin (borrowing money from the brokerage firm), all of which added up to a huge risk.
As an analogy, pretend you own a home insurance firm that has customers all across the country. There is always risk that houses could burn down, but it’s extremely unlikely that houses all across the country are suddenly destroyed. Now pretend your business heats up and suddenly you have doubled the number of homes you insure. Then you quickly double again. But there’s a problem: every one of these new homes is located in one area of Northern California. Your risk just jumped through the roof because you have so many houses in one area and suddenly one wildfire could wipe you out.
That’s kind of what happened to Robinhood. In the middle of the week, the firm tapped its credit lines for $200 million and raised $1 billion overnight from its ownership group (and, reportedly, another $2.4 billion yesterday). It was suddenly in danger of being unable to meet its capital requirement for DTCC (the central repository for stocks), which would have shut the doors on Robinhood, at least temporarily (for more on this, Telis Demos of the Wall Street Journal wrote a nice explainer). And of course, even if it would have been able to re-open a few days later, who trusts their money to a brokerage firm that ran out of capital?
THAT’S IT, IN A NUTSHELL
The story above does oversimplify things a bit. There are also some aspects of this situation we simply don’t know about yet. And the arguments for and against things like PFOF get very nuanced around issues such as the difference some see between volume and liquidity. But hopefully, even for those who are not familiar with all the aspects of the market, this can serve to educate and reduce the spread of misinformation.
We hope you enjoyed this article. At Forefront Communications, we strive to showcase our capital markets expertise in everything we do, from written content on the topics that define our industry to our PR and digital marketing capabilities. Interested in what we can do for your firm? Don’t hesitate to reach out.