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🗡 Dangerous Trades

Abby Hadidian
Abby Hadidian

As we continue to unpack the events on the market last week, I would be remiss if we didn't take this opportunity to talk about Robinhood. To be honest, before last week, I had never thought too deeply about using the well designed, free platform to do my trading. But as last week reminded us “Nothing in the world is more dangerous than sincere ignorance..”- Dr. Martin Luther King Jr. So today we’ll  take a deeper look at this trading platform, and the possible motivations behind their actions last week.

📰 Headline Translator

Breaking down this weeks biggest stories

🍎 Apple Puts $3.6 Billion Into Kia

The iCar is coming

From the company that has revolutionized everything from the way we buy music to how much we stand event day (is anyone else neurotic about closing their rings?), the newest disruption is upon us: cars. After years of speculation, chatter, and startup acquisitions, Apple has made a major investment in making the car of the future a reality. An official statement on the deal will be made on Feb. 17, but what we know is that the facility is expected to begin production in 2024 and make around 100,000 cars per year, so you better get on that waiting list soon.

🍷 Vivino raises $155 million

We’ve all been buying more wine

This incredible wine identifying rating and recommendation app has been experiencing rapid growth during our lockdowns, seeing its user base grow from 29 million in 2018 to 50 million currently. This investment is likely a part of the growing trend of millennials paying closer attention to what they put in their body, and the value of food and beverage companies that prioritize transparency over affordability. Also, I partially chose this story because I think Vivino is amazing and is a great way to help you pretend you can tell the difference between a $12 and $60 bottle of wine. If you have checked it out, I highly recommend you do

👨🏼‍💻 Zoom Launches Tools Focused on Post-Lockdown Health, Safety

Remote-work tech is preparing for a return to the office

Now that multiple COVID vaccines have been approved are slowly being administered, many tech companies that have thrived in the WFH economy are starting to look ahead. Its easy to say Zoom was one of the biggest winners of the pandemic, with figures that suggest the platform has over 300 million daily meeting participants, compared to just 10 million in December 2019. Now that lockdowns are social distancing restrictions are being lifted, the company will have to pivot and innovate to keep their users happy. It is still not clear how the company will fare as the world shifts back to more IRL.


🏹 “Are We Good Guys Or Bad Guys?"

If you are just getting into investing, there is a good chance that Robinhood is the platform you use to execute trades. Its name is a nod to the idea of helping the “poor” access the wealth available to top traders, playing off the momentum of the Occupy Wall Street movement. In the words of its official rubric, Robinhood is “democratizing finance for all”. Now, over 16 million people use the platform to participate on the US financial system.

This mission was significantly compromised last Thursday when Robinhood suspended the ability to buy shares of GameStop. After a historical rally caused a short squeeze that drove up the stock more than 400% in one day, the app restricted trading in $AMC and $GME and only allowed users to close out positions, causing the value of Gamestop to dip and costing thousands to those who brought in to ride the wave.

This decision has sparked a lot of speculation about Robinhood’s motives. A group of users have filed lawsuits against Robinhood for restricting trading, and lawmakers from both sides are calling for the SEC to look into the trading platforms actions. Before we dive into what may have really happened, let's take a look at how this platform can offer a free service and remain profitable in the first place.

💸 PayDay

Robin hood was founded to be zero-commission trading, “now and forever”, and they only pass along regulator fees for securities sales over $500. So if they're not charging  their customers, how do they stay in business?

Since Robinhood advertises itself as a “free” app, it generates income through a mechanism called payment for order flow. Essentially, when a person trades on the app, Robinhood sends that information to a larger entity, which is able to use the information about thousands of orders at once for a slight advantage. The larger entity then compensates Robinhood for the information.

Robinhood often receives less than a penny for a single trade. However, now that Robinhood has up to 16 million users making multiple trades a day, it can generate significant amounts from the practice. A recent SEC filing reveals that Citadel Securities and a handful of other firms paid Robinhood nearly $100 million in the first quarter of 2020 alone.

The old guard brokerages have also come to rely on payment for order flow as a revenue stream too. Annual reports show that Charles Schwab, eTrade and TD Ameritrade all pulled in record PFOF revenues in 2019—$135 million, $188 million and $492 million respectively.

Payment for order flow is rather controversial, especially as Robinhood has marketed itself as an “anti-Wall Street” stockbroker. Consumer advocates and regulators believe it creates a conflict of interest, as the stockbroker is looking to route orders to the market maker which pays the most.

The company also generates income from account interest and Robinhood Gold, which lets users trade on margin, make larger deposits and access professional reports from Morningstar. However, according to Fortune, payment for order flow is the primary form of revenue generation.

3 Possible Reasons Robinhood Restricted Trading

We are still unsure about why Robinhood took such unprecedented measures in response to the increase in trading, but there are currently three schools of thought:

👄 Lip Service

Robinhood’s officials statement explaining its actions read, "We continuously monitor the markets and make changes where necessary. In light of recent volatility, we are restricting transactions for certain securities to position closing only." The statement, which was posted on Robinhood's website and sent via email to its millions of users, also went on to say, "Amid significant market volatility, it's important as ever that we help customers stay informed."

Translation? They did it to protect their customers. The spike in Gamesop was not founded on the company's value, but the massive buying volume fueled by Reddit and the short squeeze. Eventually, the momentum would end and the stock value would crash back down, exposing Robinhood’s users to thousands of potential losses. They claim that by restricting trading, they cut things off before they could get too out of control and cause users even more harm.

Given that Robinhood has been criticized for profiting off risky decision making in the past, it's possible that the company is feeling the pressure to better inform their users of the potential risks in day trading.

🔍 Follow the Money

One of the more likely explanations for the restrictions is that their investors and banks asked them to make the trading stop, because they were the ones losing a fortune. If you were following along with John on the podcast as the Gamestop saga was happening, you may remember him mentioning a company called D1 Capital. One of last year’s top-performing hedge funds, D1 gave $200 million to Robinhood in their latest round of funding. The fund was managing about $20 billion as this year began and was reported to have lost 20% of its capital due to the short squeeze. Other hedge funds that lost billions of dollars last week like Candlestick Capital Management, Citron Capital, Maplelane Capital, Melvin Capital and Point72 have also invested in Robinhood, and the CEO of Point72 sits on their Emeritus Board.

Another angle to this is Robinhood’s plans to go public. The company has openly discussed its plans to IPO sometime in 2021 and they would have a better shot of achieving the kind of valuation they would like if it cozies up to the banks. This move may be their way of showing their loyalty to financial incumbents as they make their way to Wallstreet for themselves.

⚖️ Highly Leveraged

The final reason Robinhood cut off trading boils down to one word: leverage. If you remember from tuesdays newsletter, leverage is the ratio of how much you owe to how much you have, or in Robinhood’s case, how much they might have to pay out to users to the amount they have in the bank.

There is a minimum requirement of leverage that Robinhood is required to have in their bank accounts to pay out to their users. This is necessary because the US stock market is a ‘T+2’ system, meaning that it takes 2 days for trades to clear officially, but the trading platforms are on the hook to pay their users that day. When the price of Gamestop stock hit its highest peak of $347/ share on Wednesday 1/27, Robinhood was suddenly possibly on the hook to pay out millions of dollars to their customers that they did not have.

When the volatility of a stockbrockrage (Robinhood)’s portfolio increases, their clearinghouse will raise their leverage requirements to make sure they can pay out their customers if necessary. Robinhood’s sudden fundraise of over $3 billion from previous investors is a sign that they were receiving pressure to increase their leverage. This was confirmed by Robinhoods CEO, Vlad Tenev, who mentioned to Elon Musk in a livestream on Clubhouse that they had a request that was "about an order of magnitude more than what it typically is."

While the National Securities Clearing Corporation originally requested that Robinhood put up $3 billions collateral, Tenev has said that they ultimately settled on $1.4 billion. While this suggests Robinhood had somehow whittled down the demand, the reality is likely that the NSCC agreed to lower the amount when Robinhood agreed to limit trading in GameStop and other “meme shares.”

It's also worth noting that Robinhood has had some leverage issues in the past. Back in 2019, a small group of Robinhood customers on Reddit realized that they could manipulate the trading app to obtain seemingly unlimited leverage by using options and margin. For example, One user was able to deposit $3,000 and build to a position of over $1.7 million. It was absolute insanity, and Robinhood closed this loophole quickly after it was discovered, so it seems as if Robinhood is just the victim of their own lax policies again.

Final Thoughts

If we have learned anything this past week, it's that platforms like Robinhood are really important. Providing access to trading with low account minimums unlocks a market of investors like you and me who couldn’t trade like this before.

It is also exposing a lot of the ways the financial system is set up to only benefit those in the system, and not the people like us who depend on them to make good decisions. While the events of last week led to fury at Robinhood on the part of some traders, there are likely to be few long-term repercussions.


Word of the Day

Clearinghouse

(n.) A middle man in financial markets that is responsible for validating transactions between institutions.

They are the third party that makes sure brokers follow through on trades, settle their accounts, deliver assets to their new owners, and reporting trading data.

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Abby Hadidian

Newsletter writer for Four Minute Finance | Econ Nerd & Pun Enthusiast