Issue 97
February 7, 2021
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Last week, in a historic sequence of events on Wall Street, the struggling mall-based videogame retailer GameStop (Ticker: GME) was the subject of an epic “short squeeze” ignited primarily by individual investors on the Reddit message board r/wallstreetbets (WSB). Members of WSB implored each other to purchase shares of GME; a buying frenzy ensued. The stock, heavily “shorted” by certain hedge funds and other professional investors increased to nearly $500, up from just ~$20 in early January. Additional stocks including AMC Entertainment (AMC), BlackBerry (BB), Bed Bath & Beyond (BBBY), and a few others were caught up in the buying hysteria. Hedge funds and other professional investors suffered severe losses. After the fact, certain WSB members and other retail investors were in a jovial, celebratory mood. Together, they bet against the supposed smartest people in the room…and won. It was an apparent victory for the little guy. Or was it?

What Happened

During the speculative mania’s zenith, the retail stock and options trading platform Robinhood enacted sudden changes to their platform. Without warning, account holders were banned and or severely curtailed from trading in the shares of GME and other heavily volatile stocks; only sell orders to liquidate existing positions were permitted. Immediately thereafter, a collective rage took hold.

Politicians on both sides of the aisle, Robinhood customers, market pundits, and even entertainers lashed out at Robinhood. In their view, the brokerage firm’s actions unfairly punished individual investors while professionals were left unscathed. Said David Portnoy, founder of the popular website Barstool Sports, “@RobinhoodApp entire business model is to cater to the exact people they are now trying to fck with and scare into selling. They will never recover from this.” As usual, Senator Elizabeth Warren (D-MA) blamed “hedge funds, private-equity firms and wealthy investors…for…treating the stock market like their own personal casino while everyone else pays the price.” Gavin Wax, President of the New York Young Republican Club accused Wall Street of “corporatizing the American dream and making a mockery of American freedom.” Curtis Sliwa, founder of The Guardian Angels, a “volunteer organization of unarmed crime-prevention,” apparently had a change of heart when he encouraged his followers to “get these hedge-fund monsters before they get us.” In a rare moment of unity, Alexandria Ocasio Cortez (AOC) (D-NY) & Ted Cruz (R-TX) both voiced their displeasure at Robinhood for helping hedge funds to the detriment of day traders. How ironic, for the first time in political history, AOC and Ted Cruz agreed…and they were both wrong. Let us be clear, the optics (and explanation) of what transpired were abysmal. That said, the statements above are categorically incorrect, highly irresponsible and were spit by people who share one important property in common. They have absolutely no clue what they are talking about.

In truth, the happenings of last week were complex, multi-faceted, and extremely granular. They involved the plumbing of financial markets that very few people, except dedicated experts, fully comprehend. In fact, many people who work in finance themselves do not fully grasp the magnitude of terms such as T+2 trade settlement, margin calls, margin loans, collateral, collateral calls, implied volatility, and so forth, that are closely intertwined and imperative in maintaining an orderly process of buying, selling, and shorting stocks and settling those trades. In this post, we will try our best to explain, in plain English, what transpired and dispel many of the falsehoods that are circulating on (and off) line.

Capital Punishment: Why Robinhood Restricted Trading

Did Robinhood restrict trading to “screw the little guy,” as Curtis Sliwa so eloquently espoused? How about to bail out hedge funds that were caught in a short squeeze? Or to help Citadel and Point72, two firms that injected capital into a hedge fund called Melvin, that had suffered losses in GME? Or did Robinhood throttle back because they are in the view of Mr. Portnoy, “the biggest frauds of them all” and because “too many ordinary people are getting rich”? The simple answer(s) to all these questions is unequivocally “no.”

Robinhood curbed trading because a sudden onset of activity concentrated in a few stocks, combined with the volatility of those stocks, left them desperately short of cash. If they did not take decisive action, they risked insolvency. In fact, in addition to restricting trading, Robinhood simultaneously drew down all their existing credit lines. Worth noting is that drawing on credit lines is an expensive form of financing. Firms draw on credit lines when they must, not because they want to. Finally, to further strengthen their balance sheet, Robinhood raised billions of dollars of additional capital as expeditiously as possible.

But Wait, How Could Robinhood “Run Out Of Cash”?

When an investor purchases (or sells) a stock, they see (and have come to expect) the funds credited (or debited) to their account instantaneously. Typically, they can use those funds to purchase another security, withdraw the cash, and or for collateral. What they do not see is the backend complexities that must work seamlessly for the aforementioned to be facilitated.

Unbeknownst to most investors is that almost all stock trades take 2 business days to “settle.” In Wall Street parlance, this is called T+2 settlement. Because there is a lag from the time a trade is executed to the time it settles, an investor’s broker – in this case Robinhood – must ensure they have enough cash on hand to meet customer demands until the trade settles. And since so many customers were trading GME at one time, often on the same “side” of the trade, Robinhood’s cash position dropped precipitously.

Like all brokers, Robinhood allows qualified clients to trade on “margin,” or with borrowed money. Robinhood earns a fee for providing this financing. However, should one of their customers fail to meet a margin call (pay back the loan), Robinhood would be on the hook for the funds. Some customers were buying shares of GME using borrowed funds (or margin). If the shares of GME dropped by a certain percentage, a customer might face a “margin call,” meaning the balance in their account had fallen below a minimum maintenance level required by law. When this happens, an investor must deposit more funds into their account. If they fail to do so, their broker is obliged to liquidate some or all their remaining holdings to satisfy the margin call. If the cash derived from liquidating a customer’s account is not sufficient to cover the margin call, the broker (Robinhood) is responsible for the balance. A disproportionate amount of customers trading shares in one extremely volatile stock, GME, thrusted Robinhood into an extraordinarily difficult and highly unusual situation; too many customers might be unable to meet margin calls simultaneously, forcing Robinhood to draw down their cash reserves to fill the difference.

Finally, all brokers clear and settle trades through an intermediary called The Depository Trust and Clearing Corporation (DTCC). To better understand what DTCC’s function is, imagine it as a broker to all brokers, or a reinsurer to all brokers. The “buck” excuse the pun, stops with them. The DTCC demands cash collateral (think of it as an insurance premium) from all clearing brokers, including Robinhood. The amount of capital they require depends on various quantitative factors (think of how an insurance company prices a life insurance policy). When market conditions change, the DTCC can, and often does, demand more (or less) collateral from clearing brokers. Last week’s buying binge in a few highly speculative, volatile stocks prompted DTCC to raise cash collateral requirements to protect the financial system’s integrity. Because Robinhood had a disproportionate number of retail accounts trading in these securities, they had to come up with a lot of cash, and quickly. Robinhood was far from the only affected broker. Noted Thomas Peterffy, the well-respected chairman of the brokerage firm Interactive Brokers, (we were) "concerned about the ability of the market and the clearing systems, through the onslaught of orders, to continue to provide liquidity. And we are concerned about the financial viability of intermediaries and the clearing houses.”

Paying For Order Flow

Robinhood does not charge brokerage commissions for stock and options trading; customers can trade for free. Indeed, the lure of zero commissions has been a huge driver of demand for retail brokerage services throughout the financial services community. This then begs the question: How does Robinhood make money? One way is by charging interest to customers who trade on margin. Another way is through something called “payment for order flow.” Here is an oversimplification of how it works: Retail brokerage firms like Robinhood, Ameritrade, Fidelity, etc., route customer orders to sophisticated firms called market makers in exchange for cash payments. Two of the largest market makers are Citadel Securities and Virtu Financial. These firms and other market makers pay for this order flow for the simple reason that they can trade against it for a profit.

The merits of paying for order flow go well beyond the scope of this post. In short, detractors say there is an inherent conflict of interest. Advocates say it facilitates low or no cost trading for individual investors and the opportunity for “price improvement." In this post, we only mention payment for order flow to dispel some nonsensical arguments from a peanut gallery of ill-informed charlatans. Suppose Robinhood was out to “screw the little guy” and or involved in a conspiracy with other professional market participants to illegally profit at the expense of individual investors. Why would they restrict trading in their most heavily traded stocks and by doing so, have less customer order flow to sell and earn a profit from? They would not. Bottom line, the more Robinhood’s customers trade, the more order flow Robinhood can sell; the more order flow Robinhood sells, the more money Robinhood makes, not the other way around.

Legitimate Beef

The action taken by Robinhood and many other retail brokers last week was not only correct, but it was also well within their legal rights. Still, it is also worth calling out certain market professionals on their hypocrisy; for in the past, they have profited from the very thing they are now complaining about, which is a coordinated a short squeeze. This time, however, they were the ones nursing losses.

Said Nicholas Colas, co-founder of DataTrek Research, “Retail investor wolf packs are new, but if you’ve ever sat on a hedge fund trading desk you know squeezing shorts has been a Wall Street blood sport for decades.”

Most professional investors are honest, hard-working people that adhere to the rules and (try to) earn legitimate profits. They do not get involved in activities that stretch the bounds of legality. Still, we can certainly understand and appreciate why the general public has little if any sympathy for a few hedge fund managers crying foul because now, instead of them orchestrating and profiting from a short- squeeze by sharing information at an idea dinner or investment summit, it is retail investors on reddit doing something similar.

Short Sellers & Short Sightedness

True to form in acting reactively instead of proactively, the Senate Banking Committee and other regulators will hold hearings on the “current state of the stock market.” Among the topics of discussion will be restrictions or even banning the practice of short selling. This is a terrible idea.

Short sellers are good for the stock market. And despite what some ill-informed people say, short selling specialists protect individual investors in a myriad of ways. How? Traditional Wall Street analysts almost always (~90%) have “Buy” or “Hold” recommendations on stocks. One reason for this is because financial malfeasance is often extraordinarily difficult to identify. Short sellers are experts at rooting out nefarious behavior. They provide a vital service to individual investors, sniffing out corporate misdeeds such as aggressive accounting and even outright fraud. Their research helps keep companies honest and investors well-informed. Worth noting, it was not Wall Street analysts that alerted the investing public (and regulators) about the multi-billion-dollar frauds Enron, WorldCom and SinoForest. It was short sellers. Finally, during normal stock market corrections short sellers often purchase shares they have previously sold short to close out their trades. This helps stabilize the market during a downturn, when most market participants want to sell. Eliminate short selling, and you eliminate a natural buyer of stocks, at precisely the juncture when you need them most.