Game On, Robinhood
A look at the recent plumbing issue that Robinhood (and other brokers faced)
Hi All,
I hope you all are doing well and welcome (if you aren’t new then again) to Dozen Worthy Reads. A newsletter where I talk about the most interesting things about tech that I read the past couple of weeks or write about tech happenings. You can sign up here or just read on …
I completely messed up (or met??) my prediction for BTC? In Dozen Worthy Reads 📰 (No. 160), I predicted that “Bitcoin prices go up to $35k by the end of the year (I did not own bitcoin today to be clear when I write that)” . Subsequently, via Robinhood, I invested an insignificant % of my total portfolio into BTC, saw it swing up over 40k and fall back to ~$33k as of this writing. Oh well, I was hoping to get rich but it looks like I’ll still need a job :)
Bitcoin (XBT) Prices Reaches $40,000
Having swallowed humble bitcoin price pie (gulp) and thinking OK, it’s all going to be normal now, I think I pretty much lost it when Dogecoin, a freaking meme coin, primarily to make fun of bitcoin soared 800%
I’m afraid, but another week without a regular edition of Dozen Worth Reads and you have to listen to me babble about GME so lets get into it. This edition started off as a DWR, morphed into 3 topics (Clubhouse and WhatsApp privacy policy along with GME/Robinhood) and things got too long. Expect WhatsApp privacy policy and Clubhouse to land soon in your inboxes :)
The Gamestop — Robinhood saga
(NOTE : I do have a Robinhood account but do not hold a significant portion of assets in the account. I have not traded on any of the stocks listed below, so sadly I’m still poor-ish)
What a crazy week last week for GME, AMC, and Blackberry! I think this read from Ranjan Roy was great on the topic (more offbeat) as well as this read from Matt Stoller. I struggled a lot with writing this since 1) I’m not an expert and 2) Everything has already been written, however as I read so many takes, complex, simplified, on the legal repercussions, on how margins trading works (which literally blew my head open, I can’t claim to say I am smarter than I was before about options trading, only that I know, never ever ever get involved with options trading and margin calls!!)
You know the basics, a reddit board with a lot of folks wanting to stick it to WallStreet, Discord, raging hormones (or boredom??) and you have a perfect storm. A large volume of these traders banded in places such as Robinhood,Public etc resulting in short squeeze (gamma squeeze) on various “left for dead stocks” (who says you cant bring back the dead? Or were they almost dying??) Billions of dollars of money floating around from stimulus payments created a short term voting machine (In the long term the market is a weighing machine, but in the short term it's a voting machine, and the vote can be gamed.)
Then, what was seemingly a sudden move, brokers stopped letting retail trader buy more stock even with rising prices and didn’t give a decent explanation of what was happening. This resulted in a huge brouhaha about conspiracy theories, aliens (lol), and plain dumb ideas! While every take has been written, I didn’t find a take that explained it well (simple enough) for me to understand so here is my attempt at simplifying the backstory. The normal flow that Robinhood has is something like the below:
Buyer (Robinhood “customer”) → Robinhood → Clearing house → Exchange → Seller
I do not know if the conspiracy theories are true but I think not, as the linked article above indicates the finance plumbing stopped because of a financial risk to the clearing house. Robinhood had to restrict trading stocks primarily because it did not have enough collateral with the DTCC ( Depository Trust & Clearing Corporation) and this does hold water.
The way it works is that when an investor orders a buy/sell transaction that transaction has to get routed to stock exchange like NYSE of Nasdaq which matches buyers/sellers and “completes” the transaction. This transaction is however not complete since since the funds are not immediately available to withdraw from their accounts after a trade is completed. This takes an additional two days. When a stock exchange completes a trade, it sends the information to the DTCC, which essentially keeps track of all the brokers “books”. The DTCC is a clearing house. It “settles” the transaction, similar to the cash counter at a Casino (hell if only it were that simple!). Clearing houses not only process and complete trades in an efficient manner, they help limit systemic risk. The clearing house promises to make good on all trades that happen regardless of what happens to an individual broker. The DTCC, in other words is “on the hook”. However the DTCC which is responsible for transferring ownership of the stock from the seller’s broker to the buyer’s broker—and vice versa for the cash involved does not do this for every single transaction. It waits until it can “group settle” several trades into “one position per security, per client, per settlement date. On the “settlement” date cash and securities exchange hands. The selling broker delivers the stock and the buying broker provides cash. The DTCC charges a fee per trade and requires collateral from the brokers in the event that a broker (eg Robinhood, goes belly up). In this case Robinhood has to provide DTCC collateral, which pretty much gets calculated frequently depending on positions and a host of other factors. The DTCC’s collateral requirements for brokers are calculated by a much more complex formula, based on the specific shares’ notional value, volatility, and other variables.
From Vlad Tenev’s appearance on Clubhouse
“Thursday morning I’m sleeping. At 3:30am Pacific, our operations team receives a file from the NSCC, which is the National Securities Clearing Corporation. So, basically as a broker as a clearing broker. And this is where RobinHood Securities comes in. We have to put up money to the NSCC based on some factors including things like the volatility of the trading activity into certain securities. And this is is the equities business so it’s based on, stock trading and not options trading or anything else.
So, they give us a file with the deposit and the request was around $3 billion, which is, you know, about an order of magnitude more than what it typically is.”
Musk: This is not an unprecedented increase in demand for capital. What formula that they use to calculate that”
Vlad: Just to give context, Robinhood up until that point has raised around $2 billion in total venture capital. Up until now, so it’s a big number, like $3 billion is a large number, right. So, basically, the details are, we don’t have the full details, it’s a little bit of an opaque formula, but there’s a component called the VAR of it, which is value at risk. And that’s based on kind of some fairly quantitative things although it’s not fully transparent. So, there are ways to reverse engineer it, but it’s not kind of publicly shared.
And then there’s a special component, which is discretionary. So that kind of acts as a multiplier, and basically
Musk: Discretionary meaning like it’s just their opinion”
Vlad: There’s definitely more, more than just their opinion.
Musk: Everyone wants to know, did something shady go down here? It seems weird that you get a sudden $3 billion demand, you know, at 3.30am in the morning. Just suddenly out of nowhere.
Vlad: I wouldn’t impute shadiness to it or anything like that and actually you know the NSCC was reasonable.
They worked with us to actually lower it. So, it wasn’t unprecedented activity. I don’t have the full context about, you know, what was going on in the NSCC make these calculations.
What the hell is NSCC???
NSCC is a subsidiary of DTCC. Along with NSCC, DTCC manages an additional four clearing corporations and one depository. DTCC is the world's largest financial services corporation dealing in post-trade transactions
For risk free transactions such as Apple or MSFT where the volatility is not going to be that high (I mean can Apple stock go up 800% in a week??) the collateral is 10% of the transaction. However GME is way more risky and because of that the collateral requirement is higher because it takes on greater risk. That’s because the DTCC could be on the hook to deliver an asset that’s worth a materially different amount on the settlement date than the trade date if one of the brokers involved can’t complete the transaction.
When traders are using margin to buy, the broker needs to come up with the cash on its own. And when there’s a large imbalance between a broker’s buy and sell orders for a given security, it doesn’t net out as cleanly at the end of the day, meaning more collateral is required. This is why the DTCC asked the brokers (Robinhood) for additional collateral as opposed to a conspiracy theory
I think the more accurate name for this saga is the “Bored Trader Saga” since this is about individuals like you and me -- becoming cowboy day traders. You might recall that something similar happened quite recently with Hertz which was a bankrupt company. When that happened the risk and exposure wasn’t that much so the clearing houses (DTCC) didnt care … This time they did and this resulted in Robinhood raising an additional $2.4B (plus the $1B) in collateral to satisfy the clearing house
There is also a non clearing house risk. For all practical purposes Robinhood “lends” money to its clients. So they, in turn have a line of credit from large banks such as Goldman Sachs in order to offer loans to the customers (margin trades) who in turn bought risky stock. These banks probably got nervous that so much lending was collateralized by GameStop, and wouldn’t let Robinhood continue on its business model of encouraging margin-heavy speculation by its clients unless the brokerage brought in more capital to absorb possible losses.
In other words, Robinhood’s clients and their penchant for borrowing and speculating were putting Robinhood at risk. It’s the old adage, if you borrow a thousand dollars from the bank and you can’t pay it back, you have a problem. If you borrow a billion dollars from the bank and you can’t pay it back, the bank has a problem. In this case, Robinhood’s customers in aggregate had taken on too much risk, which means Robinhood had to raise more money to let them continue trading. Once it had raised that money, it could reopen the casino.
Robinhood has packaged this nicely and blamed the clearing house which isn’t untrue at all but not the full story.
The real issue here is that Robinhood doesn’t really care that much about investors - you or me! In the stock market arms race they are the arms supplier so to speak. And each of us the foot soldiers fighting a battle we’ve no experience fighting! Crazy!! This risky behavior also stopped legit traders who were willing to pay full cash for a GME stock upfront (since, remember the clearing is not done per trade but for a set of trades -- a good trade can offset a bad trade easily)
If I buy a share with my cash then there is NO COLLATERAL RISK, I own it, there is no collateral. The clearinghouse refused ANY transactions (options or outright purchase) and of course both the DTCC as well as Robinhood didn’t have a better way of separating these transactions out.
BUY OPTION → COLLATERAL NEED GOES UP
SELL OPTION → COLLATERAL NEED GOES DOWN
BUY STOCK → NO CHANGE TO COLLATERAL (ITS OWNED IN FULL BY THE PURCHASER)
BUY STOCK → NO CHANGE TO COLLATERAL (ITS OWNED IN FULL BY THE PURCHASER)
Robinhood is for all practical purposes not even legally on the hook. Not legally on the hook, but what about morally?
From Robinhood Hit With Class Action Suit—but Here's Why It's Likely to Fail
However, with Robinhood's user agreement, a class action lawsuit is unlikely to be successful, said Remington Gregg, counsel for civil justice and consumer rights at the advocacy group Public Citizen.
He Joined the GameStop Uprising to Screw the Big Guys—and Save His Dog’s Life
Under the user agreement, Robinhood investors waive their right to sue the company. Instead, claims must be litigated via arbitration—individually—in the state of California.
So unless there was a conspiracy theory which there likely wasn’t Robinhood will get past this and sail through until the next storm. There are however several key impacts which are bound to harm -- collectively or individually -- all of us in future …
Trading stock is addictive and this is only going to make it worse
Humans are mimetic and more people are going to look at Keith Gill (Reditt user u/DeepFuckingValue) who turned $54k into $48M overnight is a normal 34 year old guy, not some crazy kid with a trigger and a death wish
Everyone wants to be Keith Gill and we can be sure that many more people will try
Social Fintech products such as Public.com are going to become more valuable (or maybe not?? See below)
Robinhood will probably get a slap on their wrist and things will go back to normal (None of what they did was illegal, they may have pissed off customers, but its not like they were the only company who stopped trading (Webull, M1)
Remember they now have $3.4B of liquidity, expect this arms race to get worse. much worse.
Interestingly, Public, in a medium post said that :
To do the right thing for our customers, we have to lead the industry with first principles thinking, and proper values.
Public will stop participating in Payment for Order Flow and introduce tipping.
To align our incentives with those of our members, we will stop participating in the practice of PFOF and instead introduce a tipping feature on trades. By doing this, we can remove this conflict of interest from our business model.
To align our incentives with those of our members, we will stop participating in the practice of PFOF and instead introduce a tipping feature on trades. By doing this, we can remove this conflict of interest from our business model.
Trades will remain commission-free and tipping is entirely optional. Members of the Public.com community can freely decide if they’d like to leave a tip to help pay for the cost of executing their trades. The reality is that there is no such thing as free trades.
I hate to be the skeptic here (no wait, I actually like to be the skeptic!) but just removing PFOF and trying to run a company on “optional” tips is either crazy, stupid, or both. In order for me to tip I must make money. Granted Public has the “come for the trade, stay for the network” feel and it is very much a r/WSB meets Discord/WSB meets trading platform is amazingly cool, this step while “feel good” is misguided and they will need to introduce a subs product as they, themselves indicated on their website : How does Public make money?
Thank you for reading. Stay safe, be well! If you enjoyed reading this please consider sharing with a friend or two (or sign up here if you came across this or were forwarded this)
Great Reads on this topic :
Robinhood, Webull, M1 and these other platforms have resumed trading of GameStop and AMC shares
Why Did Robinhood Stop GameStop Trading? Everything to Know.
Analysis: Robinhood and Reddit protected from lawsuits by user agreement, Congress
Robinhood plummets back down to a one-star rating on Google Play