The Silicon Valley start-up that caused chaos on Wall Street

The online trading app Robinhood has become a cultural phenomenon and a darling of Silicon Valley with the promise to tear the stock market out of traditional Wall Street guardians and “let people trade” – making it so easy to put millions of dollars at risk how much is to summon an Uber.

Last week, in the midst of a market frenzy that opposed amateur brokers to hedge fund bigwigs, this varnish began to chip. In the end, Robinhood was at the mercy of the same industry that he vowed to bring down.

The frenzy turned into a crisis when legions of investors with arms crossed at Robinhood, who had been buying options and shares in GameStop, a video game retailer, increased those bets and also started doing big business with other stocks, including AMC Entertainment.

As the trading craze grew, the financial system’s risk-reduction mechanisms – run by obscure entities at the center of the stock market, called clearing houses – came into action on Thursday, forcing Robinhood to find emergency cash to continue to negotiate. He had to prevent customers from buying a series of heavily traded shares and obtaining a bank credit line of more than $ 500 million. On Thursday night, the company also received an emergency injection of more than $ 1 billion from its existing investors.

A high-performance start-up suddenly looked very much like an oppressed and brittle company.

“From a marketing standpoint, they position themselves as new, innovative and cool,” said Peter Weiler, executive co-president of broker and trading Abel Noser. “What I think everyone is missing is, when you peel the onion, they are just a highly regulated business.

Robinhood’s anguish follows a familiar narrative: a Silicon Valley company that promised to destabilize a sector ends up being overcome by the forces that it triggered and has to be controlled by regulators, or, in this case, by the sector that promised to change. Its arc is not much different from Facebook and Google, which has changed the way billions of people socialize and search for information, but are now stuck in the crosshairs of lawmakers and an angry public.

“They were trying to change the rules of the road without understanding how the road was paved and without any respect for the existing protective rails,” said Chris Nagy, a former commercial executive at TD Ameritrade and co-founder of the Healthy Markets Association, a non-profit organization. which aims to educate market participants. “This ended up creating risk for its customers and systemic risk for the market more broadly.”

The fiasco will almost certainly have consequences for the company. The Securities and Exchange Commission said on Friday that it would look closely at any shares that could “put investors at a disadvantage or unduly inhibit their ability to trade certain securities”. Lawmakers on both sides of the aisle have called hearings on complaints from customers who have been excluded from the market.

After Robinhood limited some deals on Thursday and the stock price plummeted, angry users flooded online app stores with scathing criticism, with some accusing Robinhood of bidding on Wall Street. Others sued the company for the losses suffered. Robinhood’s continued vulnerability, even after raising $ 1 billion, became clear on Friday, when he restricted trading of more than 50 shares.

“It wasn’t because we wanted to stop people from buying these shares,” said Robinhood in a blog on Friday night. Instead, the start-up said it had restricted the purchase of volatile stocks so that it could “comfortably” meet the deposit requirements imposed by its clearing houses, which it noted has increased tenfold during the week.

None of this seems to be slowing its growth. Even though Robinhood’s actions irritated existing customers, he was gaining new ones. The app was downloaded more than 177,000 times on Thursday, twice the previous week’s daily download rate, according to Apptopia, a data provider, and had 2.7 million daily active users on its mobile app at that time. day, the greatest of all time. This is more than its rivals – Schwab, TD Ameritrade, E * Trade, Fidelity and Webull – combined.

All growth, few railings

The controversy is not new to Robinhood.

The two Stanford classmates who created the company in 2013 said from the beginning that their focus was on “democratizing finance”, making trade available to everyone. To do this, the company in Menlo Park, California, has repeatedly employed a classic Silicon Valley formula of user-friendly software, passionate marketing and disregard for existing rules and institutions.

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

When building its business, the company disregarded academic research that shows how frequent and frictionless negotiations generally do not lead to good financial results for investors. The risks for customers became clear last summer, when a 20-year-old college student’s suicide note blamed a six-figure commercial loss on his death.

Robinhood also popularized options trading among newbies. An option is usually cheaper than buying a stock right away, but it has the potential to lead to much bigger and faster gains and losses, which is why regulators and brokers have traditionally restricted trading of these financial contracts to more sophisticated traders.

Robinhood’s marketing, however, masked the fact that its business model, and free trade, was paid for by selling customer orders to Wall Street companies in a system known as the “pay-per-order flow” Large companies trading companies like Citadel Securities and Virtu Financial pay Robinhood a small fee each time they buy or sell to their customers, usually a fraction of a cent per share. These commercial firms make money, in turn, pocket the difference, known as the “spread”, between the buy and sell price in any stock trade, and the more trades they make, the greater their potential revenue. Many other online brokers have a similar system, but Robinhood has negotiated to collect 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 cheated customers about how he was paid by Wall Street companies to pass on customer negotiations.

Robinhood also clashed with regulators as he rushed to launch new products. In December 2018, the company said it would offer a checking and savings account that would be insured by the Securities Investor Protection Corporation, or SIPC, which protects investors when a broker goes broke.

But the then chief executive of SIPC said he had not heard of Robinhood’s plan and pointed out that SIPC does not protect simple savings accounts – that would be the job of the Federal Deposit Insurance Corporation. It took Robinhood almost a year to reintroduce the product, saying in a blog that he “made mistakes” with his previous ad.

“They came in trying to make a noise and often needed to be pulled back,” said Scott Smith, a brokerage analyst at financial firm Cerulli Associates.

The shock with Wall Street

Robinhood’s ambitions and amateurism have collided in recent weeks, when small investors, many of them on a mission to defy the dominance of Wall Street, used their free trades to increase the shares of GameStop and other companies. Rampant speculation about options contracts helped propel GameStop’s stock up from about $ 20 on Jan. 12 to nearly $ 500 on Thursday – a rise that forced Robinhood to brake on his own. customers.

One institution that stumbled upon Robinhood last week was a clearinghouse called Depository Trust & Clearing Corporation. Owned by its member financial institutions, including Robinhood, DTCC clears and settles most share trades, essentially ensuring that money and shares end up in the right hands. (Option trades are cleared by another entity.)

But the role of the DTCC is more than just administrative. Clearing houses are supposed to help protect a specific market from extreme risks, ensuring that if a single financial agent breaks down, it does not create contagion. To do its job, the DTCC requires its members to maintain a cash reserve that can be used to stabilize the system, if necessary. And when stocks are fluctuating violently or there is a flurry of negotiations, the size of the cushion it requires from each member – known as a margin call – can grow in the short term.

It happened on Thursday morning. The DTCC notified its member firms that the total reserve, which was then $ 26 billion, needed to grow to $ 33.5 billion – within hours. As Robinhood’s customers were responsible for many negotiations, they were responsible for paying a significant portion of the bill.

DTCC demand is non-negotiable. A company that fails to meet its margin call is effectively out of the stock trading business because the DTCC will no longer compensate for its trades. “If you can’t clear a deal, you can’t negotiate a deal,” said Robert Greifeld, former Nasdaq chief executive and current president of Virtu Financial. “You are off the island. You are banned. “

For veteran players like Citadel Securities and JPMorgan Chase, generating hundreds of millions of additional dollars in the short term was not a problem. But for a start-up like Robinhood, it was a crazy fight.

While collecting the necessary money from its credit line and investors, Robinhood prevented customers from buying GameStop, AMC and other shares. Allowing your investors to sell these volatile stocks – but not buy them – has reduced your risk level and helped meet your additional cash needs, Robinhood said on his blog.

Ultimately, the company managed to bring together some $ 1 billion from some of its existing investors, including venture capitalists Sequoia Capital and Ribbit Capital. As a sweetener, Robinhood issued special shares to investors that will give them a better deal when the company goes public later this year.

But the quick deal left more than one observer scratching his head.

“How does an online broker need a billion dollar overnight brew?” asked Roger McNamee, a longtime investor who co-founded private equity firm Elevation Partners. “There is something about it that says someone is really afraid of what is going on.”