Robinhood in the Hot Seat

February 19, 2021 by Victoria Turner
A GameStop store on 14th Street at Union Square, in New York City. (AP Photo/John Minchillo)

The decision by the online brokerage firm Robinhood to impose restrictions on customer trading at the high point of last month’s online trading frenzy was brought under scrutiny at Thursday’s hearing of the House Financial Services Committee.

While Robinhood insists that its decision did not favor hedge funds or its business partners such as market-makers like Citadel, members of the Committee put Robinhood’s business practice under the microscope for over five hours in the hearing entitled, “Game Stopped? Who Wins and Loses When Short Sellers, Social Media, and Retail Investors Collide.”

The hearing also highlighted the ongoing regulation versus deregulation debate between Democrat and Republican lawmakers. Both sides pointed to January’s GameStop “frenzy” as indicative of their regulatory stance, with one side stating better regulation would have avoided it and their cross-aisle colleagues countering that more regulation would have made the matter worse or even led to it. This week’s hearing is the first of a series on the unprecedented market volatility that took place, and the debate is far from over. 

In January, a number of hedge funds were massively short-selling in GameStop, AMC and others – borrowing what they saw as overvalued stock to sell it at the market price with the intention of buying it back at a lower price when returning it to the broker, pocketing the difference. A group of retail investors rallied through online platform Reddit and challenged this short-sale venture by buying the stock, leading instead to an exponential jump in price from one day to the next, causing losses to the hedge funds and making them sell at current market prices to avoid higher loss. 

Robinhood Co-Founder and CEO Vlad Telev testified that Robinhood had to restrict their customers from buying certain securities in order to meet the clearinghouse deposits, which had increased tenfold in three days. This stoppage was also necessary to comply with the capital regulatory requirements of the Securities and Exchange Commission, Telev said. 

Robinhood’s business model, however, was singled out as a potential conflict of interest by some critics as they pointed out that most of its revenue came from payment for order flow agreements, particularly with Citadel, despite Telev saying this model is what has allowed Robinhood to provide zero-commission offerings and no account minimums to its over 13 million customers. \

However, according to Rep. Sean Casten, D-Ill., the fact that Robinhood does not route any options trades to entities other than those they receive these payments from creates an “innate conflict” of interest. When Robinhood first began trading options, Casten said, their revenue growth went hand-in-hand with their user growth, not how much they charged the user – which was $10 per user per year in 2018 and $50 in 2020. 

“Your revenue model went from growing revenue by growing users to growing revenue earned on the back of each user consistent with taking on options … You’re ruling out anybody who is not paying you for the privilege to put the trade,” Casten said, challenging Telev on how this ensures the customer is receiving the best price. 

Telev said that these “uniform” agreements actually did the opposite by having them at the same rate across the board with all their market-makers, eliminating any “decision-making for where to route orders,” he said. Market-makers are required to meet “best execution” requirements, he added.

If Robinhood had not met the clearinghouse deposit, they ran the risk of having their entire portfolio liquidated, said Telev, “resulting in a total lack of access to the markets” for their customers – not just the 13 securities they limited that week. 

 “A vulnerability was clearly exposed in your business model and perhaps in the regime that governs your capital requirements,” said Rep. Anthony Gonzalez, R-Ohio. 

However, according to Rep. Michael San Nicolas, D-Guam, the “material benefit” halting the buying while still allowing sales to minimize the amount they needed to raise meant that Robinhood took money from its customers “to protect your position.” 

Instead, the Democratic lawmakers pointed to additional legislative proposals for financial regulation to protect everyday investors – such as a proposed 0.1% financial transaction tax and other proposals on rates paid on different financial instruments. These proposals look to protect individual pension and retirement plans, said Rep. Rashida Tlaib, D-Mich..

Their Republican counterparts, however, said more regulation will increase the barriers for everyday investors and held that regulation led Robinhood to restrict trade to meet compliance. 

“We need not rush to enact more big government legislation that could ultimately harm investors,” said Rep. Barry Loudermilk, R-Ga. “Piling on more and more regulations only increases complexity and does not help investors,” he said, and the regulations that were in place helped the market work through the January frenzy “as it was supposed to.” 

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