Robinhood Shut down GameStop, and the markets are NOT rigged

The Robinhood GameStop saga has once again brought out the cries that the financial markets are rigged, and the Wall Street "fat cats" are sticking it to the "little guys." Specifically in this case it is because yesterday Robinhood shut down the ability for traders to buy shares of GameStop after it had already climbed over 1,700% in a couple of weeks. Brilliant political luminaries such as Elizabeth Warren, Ted Cruz, Rashida Tlaib, and AOC all came out in outrage about how Robinhood was squashing the "little guy" and Wall Street is evil.

Rep. Rashida Tlaib, D-Mich., a member of the Financial Services Committee, called Robinhood’s move “beyond absurd” and demanded a hearing on “Robinhood’s market manipulation.”

“They’re blocking the ability to trade to protect Wall St. hedge funds, stealing millions of dollars from their users to protect people who’ve used the stock market as a casino for decades,” Tlaib said.

Rep. Alexandria Ocasio-Cortez, D-N.Y., who also sits on that committee, said she would support a hearing if necessary, condemning Robinhood’s move as “unacceptable.”

Side note: How are these two on the Financial Services Committee?

Even the Winklevoss twins got into the act and accused Robinhood's actions of being some kind of problem related to centralized finance (a backhanded plug for bitcoin and their crypto exchange). If you want a chuckle, watch this little battle between the "Facebook Creators" and a CNBC anchor. These guys should really know better - they run an exchange after all.

Is Robinhood really the evil Sheriff of Nottingham? Not so fast.

The answer to why Robinhood shut down buying of GME and other volatile stocks is less nefarious. When a brokerage like Robinhood takes on positions from trades made by its customers, it has to eventually put money into a clearinghouse to manage the risk of those positions. That basically means that they have to have enough money (known as margin) in the clearinghouse to cover the possibility of the market moving if GameStop's stock comes crashing down. It's basically a risk management requirement imposed by the clearinghouse and the SEC. The issue is further complicated by the fact that many of the Robinhood traders were trading options which would allow those traders to control many more shares with less initial money creating even more risk in a downward movement of the stock.

Of course, what could go wrong when millions of day traders decide to band together to pump up the equivalent of blockbuster for gaming?

So Robinhood made the sound decision that they could not allow further buying without increasing their risk and still cover their potential losses, so they shut down buying. They likely had no choice as the clearinghouse would shut them down because their account funds exceeded the potential downside risk. So Robinhood temporarily stopped buying in GME and other volatile stocks. In the meantime, they went out and raised money from several banks including Goldman Sachs and JP Morgan in order to increase their clearinghouse deposits. Once they did that, and had enough cash to cover their risk, they resumed buying in GME and the others.

You can watch Vlad Tenev, Robinhood CEO, explain the reasoning - albeit not very effectively - here on Cuomo Prime Time.

Robinhood should have done a better job in managing their risk pool before it got to this point, and they could have communicated the situation better to their customers. They also probably shoud not have let inexperienced traders trade options on margins. There are plenty of reasons to be unhappy with Robinhood. This isn’t a case of the markets being rigged however, or Wall Street squashing the little guy. It's just basic risk management and everyday market management mechanics. The financial markets are not rigged. They have never been fairer.

I spent 18 years building exchanges and clearing houses. I don’t expect these politicians to have all the same "inside baseball" knowledge on how the financial markets work. We should all however, expect them to get some basic facts straight before they stir up a witch hunt with a tweet.

Photo by Lloyd Blunk on Unsplash

Update 1/29: Several people have asked: Why did they shut down straight buys that were not options or relying on margin? My guess here is their platform did not have the capability to shut down buys at this granular level, and they had to respond quickly so they just used a more blunt shutdown at the symbol level.

Update 1/30: Many have said that institutions were allowed to transact on Robinhood while the retails buyers were frozen out. I'm not sure if this is really the case, as there is a lot of conjecture out there. Its unclear if institutions were allowed to do anything on Robinhood, or if they had limited access while the retail buyers were frozen. It's very possible and likely these institutions made adjustments in their positions through other venues. If institutions were allowed to transact on Robinhood, then that could be sketchy, but we need more information here to know what was allowed, if anything.

The relationship with Citadel has been brought into scrutiny. Citadel is the biggest market maker on Robinhood, and some have suggested that it was pressure from Citadel that forced the retail buying freeze. Citadel has flat out denied this is the case, and I think it is very unlikely as it would bring severe penalty from the SEC. By the way, before people get upset with the market maker arrangements like Citadel, understand that it is because of those relationships that Robinhood can provide free trading. Just like Facebook, nothing is ever truly free.

There is no question that Robinhood screwed up royally in their operations. They got caught unprepared with their pants down, and as a result many retail traders got burned. I just don't think Robinhood did it intentionally to hurt the retail traders. It was their only way out of a bad situation without potentially bankrupting themselves. That said, I do think that changing the rules in the middle of the game is terrible and hurt many. All activity on these stocks probably should have been stopped to limit the overall damage and provide complete fairness, but that would have had to happen at the exchange level.

2/1/21 Update: Here is an excellent writeup on the limitations of the current clearing systems work.