Silicon Valley Start-up Robinhood- Wall Street Chaos

Why in news?

The online trading app Robinhood became a cultural phenomenon in Silicon Valley with being one of the hottest venues in the past week’s retail-trading frenzy.

But it abruptly blocked clients from purchasing shares of some companies whose stock prices had spiked dramatically and shaken up Wall Street.

How did Robinhood evolve?

Robinhood is a trading platform operated by American financial services company Robinhood Markets Inc.

It is a broker-dealer registered with the United States Securities and Exchange Commission.

The company is headquartered in Menlo Park, California.

It was founded in April 2013 by Vladimir Tenev and Indian American Baiju Bhatt.

Both of them are now co-chief executive officers of the company. Robinhood’s revenue comes from interest earned on customers’ cash balances, margin lending and selling order information to high-frequency traders.

The platform is believed to have had 13 million users in 2020.

It came with a promise to wrest the stock market away from Wall Street’s traditional gatekeepers and “let the people trade.”

What happened now?

Many of the small investors were on a mission to challenge the dominance of Wall Street.

They thus used Robinhood’s free trades.

Investors on Robinhood, who had been buying up options and shares of GameStop, a video game retailer, enlarged those bets.

Rampant speculation on options contracts helped drive the rise of GameStop’s shares from about $20 on January 12, 2021 to nearly $500 in less than 20 days.

Investors also began making big trades in other stocks, including AMC Entertainment.

The trade frenzy thus morphed into a crisis.

What did the firm do?

As the trading mania grew, the financial system’s risk reduction mechanisms kicked in.

The mechanism is managed by obscure entities at the center of the stock market called clearinghouses.

This forced Robinhood to find emergency cash to continue to be able to trade.

It had to stop customers from buying a number of heavily traded stocks and draw on a more than $500 million bank line of credit.

The company also took an emergency infusion of more than $1 billion from its existing investors.

What was the clearinghouse’s role?

One institution that tripped up Robinhood in the recent episode is a clearinghouse called the Depository Trust & Clearing Corp (DTCC).

It is owned by its member financial institutions including Robinhood.

The DTCC clears and settles most stock trading, essentially making sure that the money and the shares end up in the right hands.

Options trades are cleared by another entity.

But the DTCC’s role is more than just clerical.

Clearinghouses are supposed to help insulate a particular market from extreme risks.

It does this by making sure that if a single financial player goes broke, it doesn’t create a contagion.

To do its job, the DTCC requires its members to keep a cushion of cash that can be put toward stabilizing the system if needed.

When stocks are swinging wildly or there’s a flurry of trading, the size of the cushion it demands from each member, known as a margin call, can grow on short notice.

In the recent event, the DTCC notified its member firms that the total cushion, which was then $26 billion, needed to grow to $33.5 billion, within hours.

As Robinhood customers were responsible for so much trading, it was responsible for footing a significant portion of the bill.

The DTCC’s demand is not negotiable.

A firm that cannot meet its margin call is effectively out of the stock trading business because DTCC will not clear its trades any more.

For a start-up like Robinhood, generating additional hundreds of millions of dollars on short notice is a big deal.

What was the response?

The company ended up creating risk for their customers and systemic risk for the market more broadly.

Users flooded online app stores with hurtful reviews, with some accusing Robinhood of doing the bidding of Wall Street.

Others sued the company for the losses they sustained.

On the other hand, even as Robinhood’s actions angered existing customers, it was winning new ones.

The Securities and Exchange Commission said that it would closely review any actions that may “disadvantage investors or otherwise unduly inhibit their ability to trade certain securities.”

While Robinhood arranged for the needed cash from its credit line and investors, it limited its customers from buying GameStop, AMC and other shares.

Allowing its investors to sell the volatile stocks, but not buy them, reduced Robinhood’s risk level and helped it meet requirements for additional cash.

Notably, the deposit requirements had increased tenfold during the week.

What was unique with Robinhood and what impact did this create?

The two who created the company in 2013 said from the beginning that their focus was on “democratizing finance” by making trading available to anyone. To do so, the company has repeatedly employed a classic Silicon Valley formula of user-friendly software, brash marketing and a disregard for existing rules and institutions.

E.g. online brokers had traditionally charged around $10 for every trade But Robinhood said that customers of its phone app could trade for free. The move drew in hordes of young investors.

Robinhood also popularized options trading among new investors. An option is generally cheaper than buying a stock outright.

But options trading has the potential to lead to much bigger and faster gains and losses.

This was why regulators and brokers have traditionally restricted trading in these financial contracts to more sophisticated traders.

In building its business this way, the company disregarded academic research.

It thus ignored propositions showing how frequent, frictionless trading generally does not lead to good financial outcomes for investors.

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