On Tuesday, GameStop was the most traded stock on the planet. Of the $32.5 trillion in equities that change hands every day — between multitrillion-dollar asset managers, insurance companies, hedge funds, and banks — the company that commanded the largest volume of trading activity is a brick-and-mortar video-game retailer that lost $275 million last year.
Fueled by the army of day traders that populates Reddit’s “Wall Street Bets” forum, GameStop saw its market capitalization go from $3 billion to $25 billion in a week. In a kind of stock-market flash mob, retail investors put enough money into risky call options to push up share prices and force short sellers out of their positions.
With everyone wanting a piece of the action, some 50 million shares of the company changed hands in the span of an hour on Monday. That hourly volume plummeted today to only 3 million shares. In the intervening period, the adults in the room said enough is enough: Brokerage platforms Robinhood and Interactive Brokers halted trading in GameStop, while other brokerages limited trading of the company’s options.
A wide array of critics chided the move as an attempt to protect institutional investors at the expense of hobbyists. Representative Alexandria Ocasio-Cortez called for a House hearing on the matter, a proposal endorsed by none other than Ted Cruz. Elon Musk, Mark Cuban, Dave Portnoy, and the Winklevoss twins all condemned Robinhood for allegedly fleecing its customers to protect Wall Street.
From Robinhood, a company that claims to be “democratizing finance,” the decision smacks of hypocrisy. But by most indications, Robinhood and its peers halted trading in GameStop out of caution rather than corruption.
Robinhood makes money by routing trades from its platform to large brokers, who compensate the company for its order flow. The larger the trading volume, the better for Robinhood. But Robinhood also makes money through various forms of lending, primarily margin lending to customers.
Robinhood customers can borrow up to two times the value of the cash they’ve deposited. A $2,000 deposit gets you $4,000 in stock-buying power. Because of the risk posed to Robinhood by margin lending, the company has “margin maintenance requirements” — a minimum amount of equity that customers must hold in each investment (usually 25 percent). If you use your $2,000 to buy $4,000 of stock, and the stock falls by 50 percent, you’ve lost your entire $2,000, but you still hold the shares in your account. In this event, Robinhood would issue a “margin call” requiring you either to sell the stock or deposit enough cash to ensure you don’t end up in the red.
Back to GameStop. Basically everyone, even the Reddit bulls, agrees that the recent rally is based on nothing more than sentiment. GameStop is the same company on January 28 as it was on January 20 — just many billions of dollars more valuable. From Robinhood’s perspective, the GameStop rally is beneficial insofar as it generates revenue from increased trading activity, but it is also extremely risky, because the brokerage platform is lending millions of dollars to retail investors buying a world-historically volatile stock. As more and more buyers have flocked to GameStop, Robinhood has lent out more and more money.
Separately, Robinhood also lends to short sellers. When a hedge fund wants to bet against GameStop, it borrows shares in the company from a broker such as Robinhood and then sells them. If the stock falls, the hedge fund buys back the shares at a lower price, pays the broker back, and pockets the difference. Considering GameStop has long been a Robinhood favorite, it’s reasonable to assume a sizeable chunk of the $5 billion in GameStop short interest was borrowed from Robinhood Securities, which reported $674 million in securities loaned in 2019. It’s unclear how much GameStop stock Robinhood has lent to hedge funds, but whatever the amount, they’ve been lucrative, commanding as much as 80 percent in interest due to the massive amount of money betting against the stock.
Not only did the short squeeze cut off Robinhood’s revenue from lending to short sellers, it may even have wiped out some of the principal. And if it had continued, it would have hit harder.
In the face of all these risks, a broker would typically increase margin requirements — reducing the amount of leverage allowed to its customers. Robinhood had already done so repeatedly, raising the margin requirement on GameStop first to 80 percent, then to 100 percent. Customers who did not meet those required amounts had their accounts locked. But GameStop is so volatile and so obviously overvalued that Robinhood presumably saw the risk of waiting for customers to deposit as unacceptable. And a meaningful increase in margin requirements would likely trigger a fire sale and effect the outcome Robinhood was trying to avoid.
So the decision to halt trading in GameStop is like a margin call on steroids. Robinhood and Interactive Brokers are attempting a controlled demolition of the meme-stock bubble.
This feels wrong, but in a certain sense, it’s the market working. In efficient markets, counterparties are supposed to correct bubbles. In the curious case of GameStop, technical dynamics prevented normal pricing. Robinhood and other brokers, themselves effectively owners of large amounts of GameStop stock, pulled the plug. That doesn’t mean they don’t bear responsibility: Those customers who invested with cash alone were left holding the bag for risks that brokerages let build up. One class-action suit has already been brought against Robinhood, and I’d expect more to come. That Robinhood made a reasonable decision once the bubble became excessively risky does not mean that it upheld its obligations to its customers, but it does put paid to the belief that it’s in the business of protecting “the system.”
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