It was an epic tale of everyday individuals using the online forum Reddit to outsmart Wall Street short sellers
by buying GameStop or GME shares inflating its stock price and driving hedge funds into billions of dollars of losses
most notably Melvin Capital
However no one expected that it would be Robinhood, the no cost brokerage trading app
that has essentially enabled all these Redditors to buy into Gamestop in the first place
that would try to put an end to the rising stock price by literally blocking traders from buying more stock and only allowing them to sell the stock
causing the stock to plummet.
So why would it screw its own customers like that?
In this video we’re going to dive into Robinhood's business model and how it manages to offer commission free trading.
We’ll see that because of its unique business model it turns out that traders on Robinhoods platform
aren’t actually its customers, but rather its real customers are in Wall Street.
We’ll explore whether this provided incentive for Robinhood to do what it did or whether Robinhood is being unfairly blamed
and whether it’s really also just a victim of Wall Street?
Robinhood is a brokerage firm that offers commission-free trading through its website and mobile app.
Founded in 2013, its original mission was to democratize finance allowing everyday individuals to trade stocks, options
and cryptocurrency at low cost no matter the size of their investment instead of paying hefty brokerage fees that ate into their profits.
You’ve all probably heard the saying that there’s no such thing as a free lunch.
So how does Robinhood make money when it doesn’t charge fees for trading?
Robinhood has historically been quite shady about how it makes money and it wasn’t until
the US Securities and Exchange Commission or SEC launched an investigation into it that it published details of its revenue streams
On its website it now states that one of the key ways it makes money is from selling order flow.
Now to understand how this works you need to understand the players involved when you buy a stock.
Robinhood's role in the financial system is as a broker. This means that it can buy stock and sell stock on a client's behalf.
In order to be a broker you need to have certain registrations and licences in place.
For example Robinhood is registered with FINRA.
Therefore a broker helps their clients get into the market and they may also often provide other services like stock research to help their clients invest.
In the financial system you also have what are called market makers.
These are usually large investment banks and their purpose is to provide liquidity into the market.
What this means is that they can allow the execution of trades to appear seamless by buying and selling shares whenever an order comes through.
Without market makers a person who wants to sell 100 shares would have to wait for a buyer who also wants to buy that exact number of shares in order to execute the deal.
Market makers end up making their money from the bid-ask spread.
Basically this means that they will quote a different price for buying the stock and for selling the stock so they earn a small fee from the bid-ask margin.
What this means is that market makers make more money from more volume.
The more buying and selling that occurs, the more bid-ask margin that they earn.
So this is how Robinhood makes most of its money - it sells traders' buy and sell orders or its order flow to market makers.
Robinhood gets a rebate for directing order flows to certain market makers and market makers profit from order flow margins.
Everyone wins.
The more traders that use Robinhood, the more money it gets from market makers. As I said before it is a volume business.
During the pandemic, Robinhood’s user base has grown exponentially, and accordingly its profits from selling order flows has followed.
Instead of traders being Robinhood's customers which has traditionally been the case for brokers
Robinhood's customers are actually the market makers
who are some of the largest financial organisations such as Citadel Securities which executes about 30% of all US trades.
What this means is that traders on the Robinhood platform are actually its inventory.
This is the same as the way other tech companies provide their products to you for free but essentially use you to make money
like Google and Facebook which use your information to allow advertisers to better target you.
You are essentially a commodity not a customer.
But as a licensed broker, Robinhood is still legally required to act in the best interests of its clients the traders.
So how could it then go and block its users from buying more GameStop at a time that was critical?
The prevailing theory is that Robinhood did this to appease one of its key market maker clients Citadel Securities,
which is linked to Citadel the hedge fund. Citadel actually bailed out Melvin Capital, the firm that lost all of its money shorting GameStop.
However Robinhood CEO Vlad Tenev has come out and said that the real reason they had to restrict buying GameStop
and other viral stocks like AMC and Blackberry is because of capital requirements.
Now to explain this, another player that I didn’t mention before in the financial system is the clearing house.
A clearing house is responsible for physically checking that a buyer has enough stock and the seller has enough money
so that both parties can honour the transaction and then executes the transfer.
In this way the clearing house manages default risk.
Whenever investors buy stock, there is a two-day settlement period.
Clearing brokers like Robinhood need to fund that trade with the clearing central house called depositary trust company or DTC for two whole days.
However when shares are bought at a margin, buyers aren’t paying the full amount for their shares upfront.
Therefore there’s a risk the broker won’t have the money to pay for shares its clients bought by the time of settlement 2 days later.
The risk is higher for volatile stock which can often lose value rapidly meaning the broker is more likely not to have enough money.
This could leave the clearing house on the hook.
DTC manages this risk by requiring clearing brokers like Robinhood to post collateral. And DTC made that collateral very expensive for Robinhood as well as others on 28 January.
And that was the day Robinhood pulled the stock.
So it was really DTC that caused brokers like Robinhood to stop allowing traders to buy Gamestop shares.
And it also makes sense then why Robinhood then went out and raised $1bn the next day so that it could continue to post collateral and allow people to buy Gamestop.
But it begs the question why did DTC choose such an important day when open positions on GameStop were about to close?
The market had already been volatile for quite some time so what made it increase its collateral on that particular day?
Now who owns DTC?
You guessed it - Wall Street.
DTC is a user owned cooperative. This means that the majority of the large banks and brokers in the US
who are participants in the DTC are also its owners.
So really Robinhood may actually be a victim of Wall Street.
It seems like the more layers of the onion you peel the murkier it gets.
So will we ever know the truth?
Perhaps more will come out before the courts as so far two class action lawsuits have been filed against Robinhood accusing it of market manipulation.
It also wouldn’t be surprising if FINRA or the SEC launch yet another investigation into Robinhood to work out whether its explanation is true or not.
However what is clear is that regardless of whether Robinhood intended to manipulate the market or not
its conflicted fee structure ought to be giving rise to these questions.
The appearance of bias as well as mismatched incentives is often enough to cast doubt on companies' true intentions.
For a company like Robinhood that is meant to be for the little guy, these issues could be disastrous as people lose trust in it, in the same way people are losing trust in big tech.
This would be incredibly unfortunate for a company that has made trading accessible to everyone.
The entire financial system needs to do better to remove conflicts of interest when dealing with people's money.
It is only then that trust will start to be rebuilt with Wall Street and all of its behind the scenes characters.
I hope you enjoyed this video.
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