The Silicon Valley launch that wreaked havoc on Wall Street

The online trading app Robinhood has become a cultural phenomenon and a darling in Silicon Valley with a promise to pull the stock market away from Wall Street’s traditional gatekeepers and ‘let the people trade’, making it so easy to risk millions of dollars as it is to summon an Uber.

This past week, amid a frenzy in the market, which puts amateur traders against bigwigs of the hedge fund, the veneer began to shatter. As it turns out, Robinhood was at the mercy of the industry he promised to uplift.

The frenzy turned into a crisis when legions of armchair investors bought Robinhood, which bought options and shares of GameStop, a video game retailer, increased its stake and also began trading large shares in other stocks, including AMC Entertainment.

As the trading mania grew, the risk mitigation mechanisms of the financial system – managed by obscure institutions in the middle of the stock market called clearinghouses – began on Thursday, forcing Robinhood to find emergency cash to continue trading. It had to stop customers from buying a number of heavily traded stocks and pulling on more than $ 500 million in bank credit. On Thursday night, the company also took an emergency supply of more than $ 1 billion from its existing investors.

A high-flying start-up suddenly looks a lot like an overwhelming, crackling company.

“From a marketing standpoint, they position themselves as new, innovative, cool,” said Peter Weiler, co-CEO of brokerage and trading firm Abel Noser. “What I think everyone is missing is that if you peel back the onion, it’s a strongly regulated business.”

The plight of Robinhood follows a well-known story: a company in Silicon Valley that promised to disrupt an industry is eventually overcome by the forces it unleashed and must be controlled by regulators, or in this case, the industry that he promised to change, be overtaken. Its arc is not entirely different from Facebook and Google, which changed the way billions of people socialize and seek information, but is now trapped in the crosshairs of lawmakers and an angry public.

“They tried to change the rules of the road without understanding how the road was paved and without respecting the existing safety rails,” said Chris Nagy, a former CEO of TD Ameritrade and co-founder of Healthy Markets Association, said. , a non-profit organization that seeks to educate market participants. “This has ultimately created a greater risk for their customers and a wider systemic risk for the market.”

The fiasco will almost certainly have consequences for the company. The Securities and Exchange Commission said on Friday that it would investigate any actions that ‘undermine investors or otherwise impair their ability to trade certain securities’. Lawmakers on both sides of the aisle have called for hearings on complaints that customers have been shut down outside the industry.

After Robinhood had a bit of trading on Thursday and the price of the stock dropped, angry users flooded online app stores with poisonous reviews, and some accused Robinhood of making the bid for Wall Street. Others sued the company for the losses they suffered. Robinhood’s continued vulnerability, even after raising $ 1 billion, became clear on Friday when it restricted trading in more than 50 shares.

“It was not because we wanted to stop people from buying these shares,” Robinhood said in a blog post Friday night. The company rather said that it limited the purchase of volatile shares so that it could ‘comfortably’ meet the deposit requirements set by its clearing houses, which he said were tenfold during the week.

None of this seems to be slowing down growth. Although the actions of Robinhood angered existing customers, it gained new customers. According to Apptopia, a data provider, the app was downloaded more than 177,000 times on Thursday, twice the previous week’s daily download rate, and it had 2.7 million active users on its mobile app that day, the highest ever. It’s more than its competitors – Schwab, TD Ameritrade, E * Trade, Fidelity and Webull – combined.

All growth, little handrail

Controversy is not new to Robinhood.

The two Stanford classmates who founded the company in 2013 have said from the beginning that they focus on ‘democratizing finances’ by making trade available to anyone. To do this, Menlo Park, California, has repeatedly used a classic Silicon Valley formula of user-friendly software, unlimited marketing and disregard for existing rules and settings.

Online brokers traditionally charge about $ 10 for each trade, but Robinhood said customers can trade for free from his phone. The move attracted hordes of young investors.

In building its business, the company ignored academic research that shows how regular, frictionless trading generally does not lead to good financial results for investors. The risks to customers became clear last summer when a 20-year-old university student’s suicide note accused him of losing six figures for his death.

Robinhood has also made option trading popular with beginners. An option is generally cheaper than buying a stock, but it can lead to much larger and faster gains and losses, which is why regulators and brokers have traditionally restricted trading in these financial contracts to more sophisticated traders.

However, Robinhood’s marketing underscored that the business model and free trade were paid for by selling customers’ orders to Wall Street businesses in a system known as’ order flow payment ‘. Large trading companies such as Citadel Securities and Virtu Financial give Robinhood a small fee each time they buy or sell to their clients, usually a fraction of a cent per share. These trading firms in turn earn the difference, known as the ‘spread’, between the buying and selling price on a given stock trade, and the more transactions it handles, the greater their potential income. Many other online brokers rely on a similar system, but Robinhood negotiated to raise significantly more for each trade than other online brokers, The Times found.

The mismatch between Robinhood’s marketing and the underlying mechanics led to a $ 65 million fine from the SEC last month. The agency said Robinhood deceived customers about how it was paid by Wall Street businesses because they were driving customers’ trade.

Robinhood also made a waste of regulators when he rushed to release new products. In December 2018, the company announced that it would offer a checking and savings account secured by the Securities Investor Protection Corporation, or SIPC, which protects investors when a brokerage business fails.

But the then CEO of SIPC said he had not yet heard of Robinhood’s plan, pointing out that the SIPC did not protect savings accounts with ordinary vanilla – that would be the job of the Federal Deposit Insurance Corporation. It took almost a year before Robinhood re-launched the product and said in a blog post that he had ‘made mistakes’ with his earlier announcement.

“They were trying to make big splashes, and they often had to be caught up again,” said Scott Smith, a broker at financial firm Cerulli Associates.

The collision with Wall Street

Robinhood’s ambitions and amateurism have clashed over the past few weeks as small investors, many of them on a mission to challenge Wall Street dominance, have used its free trade to push up the stock of GameStop and other companies. Rapid speculation over option contracts led the rise of GameStop’s shares on January 12 to about $ 500 on Thursday – a rally that forced Robinhood to brake on its own customers.

One institution that Robinhood drowned in the past week is a clearance center called the Depository Trust & Clearing Corporation. The DTCC is owned by its financial institutions, including Robinhood, and cleans up most of the stock trading, essentially getting the money and the shares into the right hands. (Options are cleared by another entity.)

But the role of the DTCC is more than just spiritual. Trading houses are supposed to help isolate a particular market from extreme risks, by making sure that if a single financial player fails, it does not create contamination. To do its job, the DTCC requires its members to keep a cushion of cash needed to stabilize the system if necessary. And if stocks fluctuate wildly or there is a wave of trading, the size of each member’s cushion – known as a margin call – can grow at short notice.

This is what happened Thursday morning. The DTCC informed its members that the total cushion, which was then $ 26 billion, had to grow to $ 33.5 billion within hours. Since Robinhood customers were responsible for so much trading, Robinhood was responsible for paying a significant portion of the bill.

The claim of the DTCC is non-negotiable. A business that cannot meet its margin call is effectively out of stock trading because DTCC no longer trades. “If you can not trade a trade, you can not trade,” said Robert Greifeld, the former CEO of Nasdaq and current chairman of Virtu Financial. ‘You’re off the island. You are banned. ‘

For veteran players like Citadel Securities and JPMorgan Chase, it was not a problem to earn hundreds of millions of dollars on short notice. But for a startup like Robinhood, it was a crazy scramble.

While it collects the necessary cash from its credit line and investors, Robinhood restricts customers from buying GameStop, AMC and other stocks. Allowing its investors to sell these volatile shares but not buy them has reduced the risk level and helped it meet the requirements for additional cash, Robinhood said in his blog post.

Eventually, the company manages to raise about $ 1 billion from some of its existing investors, including the companies Sequoia Capital and Ribbit Capital. As a sweetener, Robinhood has already issued special shares to investors this year that will give them a better deal when the company goes public.

But the quick fix has left more than one observer wondering.

“How does an online broker need a billion-dollar overnight deduction?” asks Roger McNamee, a longtime investor who founded the private equity firm Elevation Partners. “There’s something about this that says someone is really scared about what’s going on.”