US Congressional Report on Meme Stocks Reveals Robinhood’s Culture of Growth Over Stability
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US Congressional Report on Meme Stocks Reveals Robinhood’s Culture of Growth Over Stability

Robinhood's unique business model strained the market's capacity to accommodate retail orders, as per US House Committee report.
Neither the author, Tim Fries, nor this website, The Tokenist, provide financial advice. Please consult our website policy prior to making financial decisions.

After two years of headlines, hearings and class-action lawsuits against Robinhood, the U.S. House Committee on Financial Services finally delivered its report last Friday. The title of the 138-page document is long and self-explanatory, dubbed “Game Stopped: How the Meme Stock Market Event Exposed Troubling Business Practices, Inadequate Risk Management, and the Need for Legislative and Regulatory Reform”. 

US House Committee’s Report Takes in-depth Look at Meme Stocks

Before delving deeper into the report, here is a brief recap of why the GameStop (GME)/ AMC Entertainment (AMC) saga has been the focus of so much attention:

Retail traders mobilized across social media to short-squeeze Wall Street hedge funds, who were shorting GME, AMC, and other stocks suffering from the lockdown fallout. Their primary tool was the Robinhood brokerage app, known for pioneering zero-commission trading. It quickly becomes one of the most popular stock-trading apps in the country. Furthermore, the company’s motto has been “democratize finance for all”.

The clash between retailers and hedge funds created unprecedented market volatility, as GME value skyrocketed by 2,700+% within the month of January 2021 alone.

As a result of these conditions, over 2 million trade orders failed to execute. This caused several brokers to restrict trading in targeted “meme” stocks. One of them was Robinhood, which held $2.6 billion in GME shares and $1.3 billion in AMC shares prior to implementing trading restrictions.

Some hedge funds engaged in shorting GME/AMC were also indirectly tied to Robinhood’s payment for order flow (PFOF). The PFOF business model allows Robinhood to offer zero-commission trading in the first place, by paying market makers, such as Citadel Securities, to route customer orders in exchange for a fee. 

Therefore, PFOF not only incentivizes zero-commission brokers to intensify retail trading activity, thus creating market volatility, but it also creates a seeming conflict of interest. In fact, it was suggested that Robinhood intentionally sabotaged trading due to its PFOF obligations.

Based on these events, the Committee on Financial Services had to figure out if the stock trading pipeline is robust enough for future use. And if not, to identify and plug the leaks. One of them was Robinhood as the fastest-growing stock trading platform handling the most trade orders.

Source: Game Stopped: How the Meme Stock Market Event Exposed Troubling Business Practices, Inadequate Risk Management, and the Need for Legislative and Regulatory Reform

Report Identifies Key Issues with Superbrokers like Robinhood

While Robinhood recently settled a class-action lawsuit related to outages in March 2020, the lawsuit pertaining to GME/AMC short-squeeze was dismissed by the federal court in Florida last November. Although Chief Judge Cecilia Altonaga noted “somewhat suspicious” electronic messages between Robinhood and Citadel Securities, this did not rise to the level of plausible conspiracy. 

Nonetheless, the House Committee’s report found faults in Robinhood’s business model:

  • Failed to incorporate best practices according to the Financial Industry Regulatory Authority (FINRA) guidelines, regarding stress-testing its platform.
  • Failed to incorporate best practices according to the Depository Trust and Clearing Corporation (DTCC), regarding sufficient collateralization. 
  • In fact, without the DTCC’s waiver for the deposit requirement – $9.7 billion in total on January 28, 2021 – Robinhood would have defaulted on its collateral obligations. Apparently, DTCC prioritized market stability over strict adherence to regulatory rules. 
  • Robinhood’s over-reliance on the PFOF business model strained the capacity of market makers to keep up. 
  • Robinhood’s public liquidity assurances prior to stock restrictions don’t add up with its executives’ actions scrambling for emergency funding. 

Overall, the Committee pointed to low barriers to market entry and gamification as primary culprits for market instability. The PFOF business model makes it happen, with further retail trading growth expected as $70 trillion in wealth transfers from Baby Boomers to younger generations in the next 25 years.

“…do I think it’s going to happen again, the answer is, yes, for sure. No doubt about it. How it’s going to manifest itself, I’m not sure, but for sure it’s going to happen again.”

CEO of Apex Clearing Corporation, Bill Capuzzi

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What About the Future of PFOF?

Throughout the report, there is a recurring theme that the PFOF business model was the progenitor of the “Meme Stock Market Event”. Specifically, how Robinhood approaches it.

“Robinhood’s disproportionately high order flow and unique formula for calculating PFOF rebates strained several market makers and introduced risk to the stock market.”

Game Stopped: How the Meme Stock Market Event Exposed Troubling Business Practices, Inadequate Risk Management, and the Need for Legislative and Regulatory Reform

Robinhood’s unique spread-based formula even led to conflict with Citadel Securities. Electronic messages revealed they had discussed that PFOF rebate rates were unsustainable given the extreme levels of trading volume.

Source: Game Stopped: How the Meme Stock Market Event Exposed Troubling Business Practices, Inadequate Risk Management, and the Need for Legislative and Regulatory Reform

Furthermore, the report separates Robinhood as distinct from other brokers using the same model. Because Robinhood generates income by volume, it is incentivized to push every customer into making as many trades as possible. This leads to gamifying trading to increase activity and even allowing entry traders to engage in exceedingly risky margin trading

Virtu Financial market maker confirmed Robinhood’s pivotal role, as they have received more orders from Robinhood than all other clients combined in that time period. For these reasons, Alexis Goldstein (Americans for Financial Reform), Sal Arnuk (Themis Trading), and Dennis Kelleher (Better Markets) advocated for PFOF to be either banned or curtailed because it distorts order routing.

Robinhood (HOOD) Reeled Ahead of PFOF Crackdown but Rallies After Rating Upgrade

It seems that current SEC Chair, Gary Gensler, agrees with that conclusion. In May’s hearing, he noted that PFOF enables “one or two wholesalers to have a dominant share in the retail market”. Based on that sentiment, the SEC had already announced a regulatory crackdown on PFOF practices this month.

In turn, Robinhood (HOOD) stock suffered a severe decline, amplified by reputational hits and a market downturn, triggered by the Fed’s interest rate hikes which could trigger a recession.

Since its ATH price last August at $70.39, HOOD dropped down by -88%. Image credit: Trading View

Nonetheless, during the last week, HOOD went up by +16.84%, suggesting there is plenty of retail interest left as many are taking advantage of discounted assets. Additionally, HOOD’s rally comes after Goldman Sachs upgraded the stock’s rating from sell to neutral.

In the end, with or without PFOF, Robinhood can look forward to a new era of stock trading as generational wealth transfer takes place and retail investors get more capital over time.

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Do you think retail traders would benefit from the return to trading fees, but with more transparent business practices? Let us know in the comments below.

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