Business: Robinhood’s explosive but risky growth

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Here is how Robinhood makes money.

Robinhood Markets Inc. is in the business of getting people to trade stock (and options, and cryptocurrencies) on their phones. The more people who sign up for accounts, and the more they trade, the happier Robinhood is. The way it makes money is that each time its customers trade stocks (or options, or cryptocurrencies), Robinhood sends their order to a market maker, and the market maker pays Robinhood a tiny fee for the right to execute the order. Unlike many other retail brokers, Robinhood charges these market makers a variable fee that is, roughly speaking, higher for very volatile stocks. So the more people who sign up for Robinhood’s service, and the more they trade, and the more volatile the stocks that they trade are, the more money Robinhood makes.

By this standard, the last week of January 2021 was incredibly, incredibly good for Robinhood, an amazingly perfect week. That was the height of the GameStop Corp. meme-stock mania: The whole world’s attention was focused on the soaring price of GameStop stock, which was leading a lot of people to sign up for Robinhood and trade GameStop, and GameStop was very volatile and so Robinhood got paid a lot for trading it. Robinhood both increased its future value by signing up a lot of customers, and increased its present profits by extracting a lot of money from them each day.

There was, however, a problem. When Robinhood’s customers buy a stock, the trade does not settle right away: The customer agrees to buy the stock, and the market maker agrees to sell it to them, but they don’t actually exchange money for stock until two business days later. There is a credit component to the trade: The buyer has to deliver the money in two days, and the seller has to deliver the stock. If the stock shoots up over those two days, you might worry that the seller will back out of the deal; if the stock crashes, you might worry that the buyer will back out of the deal. In practice, the stock market deals with this risk through clearinghouses: One giant entity (for US stocks, it’s the National Securities Clearing Corp., a subsidiary of the Depository Trust & Clearing Corp.) guarantees all the trades, and clearinghouse members, like Robinhood, post cash with the clearinghouse to guarantee their customers’ trades.

Broadly speaking, Robinhood has to post more cash with the clearinghouse as its customers trade more stocks. And it has to post more cash as those stocks are more volatile: The more likely it is that a stock will crash or moon, the bigger the credit risk is, so the more money is required. 

By this standard, the last week of January 2021 was incredibly bad for Robinhood. The GameStop meme-stock mania caused a lot of its customers to buy GameStop, and caused the price of GameStop to be very volatile, which caused Robinhood to have to post enormous amounts of cash with the clearinghouse, and it happened not to have that cash lying around. 

And so Robinhood’s otherwise great week came shockingly close to killing it.

Last week the US House Financial Services Committee released a report about that week at the end of January 2021, and it is fascinating reading. It is mostly about Robinhood, and specifically it is about the tension inside Robinhood between the fact that it was a great week and the fact that it almost blew up Robinhood.

So on the one hand, the meme-stock week was great for Robinhood’s growth, and the people whose job it was to make Robinhood grow were excited. On Tuesday, Jan. 26, Elon Musk tweeted “Gamestonk!!,” which of course pushed up interest in trading GameStop on Robinhood. A Robinhood product manager emailed about this: “FYI massive spike [in Robinhood account openings] in last 30m likely caused by Elon Musk tweet” and “we could probably interact with this movement to promote RH growth.” 

But as the week went on, Robinhood got more nervous, both about its cash needs and about whether its technology was up to all the activity. So here is a discussion — at about 11:24 p.m. on Wednesday, Jan. 27 — between a brokerage product manager at Robinhood and the firm’s head of data science:

Product manager: conflict brewing

Product manager: we have to keep the growth flywheel running

Product manager: webull is right on our tail

Head of data science: haah dont worry, we need to survive first

They wanted to grow to pull ahead of the competition, but growth that week was becoming a problem. Here is how close Robinhood came to blowing up the next day:

On the morning of January 28, 2021, Robinhood had approximately $696 million in collateral already on deposit with the NSCC, leaving it with a collateral deficit of approximately $3 billion, which it was required to post to satisfy the NSCC’s clearing fund requirement or risk being in violation of the NSCC’s rules and potentially losing the ability to clear trades for their customers altogether. [President of Robinhood’s clearing operation Jim] Swartwout confirmed that this amount came as a surprise to Robinhood and explained to Committee staff that they had anticipated and prepared for the $1.4 billion of collateral deposit requirements that represent “core” charges, but because they did not model for Excess Capital Premium charges, Robinhood therefore did not expect and had not arranged adequate funding for the additional $2.2 billion Excess Capital Premium charge. On the morning of January 28, 2021, Jim Swartwout texted [Robinhood Chief Operating Officer] Gretchen Howard at 6:29 a.m. EST, writing “Huge liquidity issue.” 

That is, the clearinghouse called Robinhood and said it needed to post about $3 billion to cover its obligations, and Robinhood didn’t have the money. Ultimately the clearinghouse waived most of the collateral requirement that day, for Robinhood and some other firms in similar predicaments. If it hadn’t (emphasis added):

Without the NSCC’s waiver of Robinhood’s Excess Capital Premium charge, Robinhood’s nonpayment would have constituted a “serious rule violation” according to the NSCC’s rules. When a clearing-broker cannot deposit the required collateral, the member is in default to the clearinghouse and NSCC may “cease to act” for that member under its rules, as the NSCC did for Lehman Brothers on September 24, 2008 and MF Global on October 31, 2011. When NSCC ceases to act, the clearinghouse assumes control of the defaulted member’s portfolio and liquidates it. This is done to limit the risk that the defaulted member poses to NSCC and to other nondefaulting NSCC members, who can be subject to mutualized losses if the collateral already held by NSCC is insufficient to cover losses on the defaulter’s portfolio. Robinhood leadership remained aware during the morning of January 28, 2021 that the NSCC could effectively eliminate the company’s ability to clear their client’s trades and liquidate the firm’s holdings.

That would have been bad! “Hypothetically what happens if a firm can’t meet their morning NSCC margin settlement,” an operations manager asked their former boss that morning in a text message. Nothing good! 

Robinhood responded to the problem — of not having enough money to support its explosive growth — by raising capital, but also by limiting customer trading in meme stocks, imposing PCO, “position closing only,” restrictions to prevent customers from buying more GameStop:

As Robinhood employees worked through Wednesday, January 27, 2021, to code position limits for meme stocks, they struggled with how to frame the trading restrictions to the public and seemed to want to avoid giving their own clients the real reasons for imposing restrictions. A product manager at Robinhood Financial asked, “Do we have a customer facing rational we can provide? In response, a manager in Robinhood’s brokerage responded, “The real reason is firm risk and us needing to control the velocity of trading. …But we shouldn’t expose that.”

It also slowed down new account approvals:

According to Robinhood operations staff, turning off auto approval meant that Robinhood was still “accepting applications, but approval is turned off. This means a large number of customers (were) still applying but (wouldn’t) be approved immediately,” delaying their ability to transact on the platform. The decision to throttle new account creation arose spontaneously on the morning of January 28, 2021. During the afternoon of January 28, 2021, Robinhood Director of Account Operations estimated that approximately 300,000 customer applications were waiting in the queue to be approved. Robinhood employees discussed when to turn auto approval back on throughout the day on January 28, 2021 but decided to keep the auto approvals turned off for the remainder of the day due to risk concerns associated with increased load on their platform. As a Robinhood employee said in a chat discussing when to resume approving accounts, “any additional load takes us to the bottom faster.”

Ultimately Robinhood’s decision to turn off auto approval had a significant impact on the number of new accounts on its platform. On the morning of January 29, 2021, the next day, Robinhood Financial’s Director of Brokerage Risk estimated that the number of customers waiting in the queue for their accounts to be approved had increased to approximately 730,000.

The meme-stock craze was so good for Robinhood that 430,000 people tried to sign up for its service overnight! And so bad for Robinhood that it had to ignore all of them. 

I don’t know. It all worked out, I guess. On Jan. 28, Robinhood Financial President David Dusseault told the Robinhood team “ah we will navigate through this nscc issue,” and “we are to big for them to actually shut us down.” Never something you want to put in writing, but not exactly wrong. The meme-stock craze made Robinhood arguably the most important company in finance for a week. It would have been better if Robinhood’s explosive success had made it rich and safe, but making it too big to fail also worked.