How Robinhood’s Game Stopped

Unless you were hiding under a rock last week, you must have noticed the Gamestop story. In case it left you bemused, Simon Taylor of 11FS gives a great breakdown of what happened. Over to you Simon ...

How Robinhood weaponized the Occupy Wall Street movement

What happened with Gamestop is the beginning of economic populism. Robinhood weaponized the Occupy Wall Street movement, social drove viral interest, and nearly everyone hates Wall Street and Robinhood. There's a lot to unpack here, political, economic, social, and technological, but understanding how all these themes come together is crucial to understand the future of fintech.

What happened to Gamestop 

At the start of January 2021, Gamestop traded at $18; by 28th January, it closed at $364. The story goes that users of the subreddit r/wallstreetbets drove the price rise.

The Redditors had four primary weapons.

1. Deep analysis of Gamestop strategy (and its potential value):  A point missed in the mainstream media is r/wallstreetbets analysis is deep and has sense. The argument went that Gamestop would revamp its stores around e-sports and switch to become the premier online video game retailer in the booming video game industry. It might not work, but it is playing towards trends.
2. Robinhood and the Call Option:  A Call Option allows investors to bet that a stock price will increase. The option gives you the right to buy stock in the future at a set price. If you purchased a $1 stock for $10k and it doubled, well done, you doubled your money.  But if you bought $10k of call options at 10x leverage, you just 20x your investment.
3. Anti-Wall Street sentiment: Since the Global Financial Crisis in 2008, wealth inequality has increased, and a generation of young adults saw their parents lose out as Wall Street got bailed out. The middle class has hollowed, opportunity has decreased, and the anger from Occupy Wall Street hasn't gone away. It got stronger.
4. Memes:  A meme is an incredibly efficient way to communicate an idea. Gen Z is especially effective at communicating in Memes. It may baffle most boomers, but don't confuse the humor with not having a point.  Memes are this generation's punk or hip-hop.

With these weapons, r/wallstreetbets began meme'ing and identified Gamestop as a target stock for growth.

Redditors spotted Gamestop was:

• Potentially undervalued
• Being "shorted" by a large "Wall Street" hedge fund called Melvin capital
• If they could push the price up, they'd trigger a "short squeeze" that would both rocket the price up further and cause significant damage to Melvin capital in the process

Melvin Capital is a hedge fund with $12.5 billion assets under management. Melvin had placed a bet many months ago that Gamestop would decrease in price.  The size of the short position adopted by Melvin capital (and others) resulted in more than 139% of existing Gamestop shares being shorted, making Gamestop the most shorted stock in the world.

The Redditors believed this did not represent value for the stock and was unfairly punishing a company amid a potentially positive turnaround. The Redditors posted analysis, bought call options, and memed anti-Wall-Street sentiment. Then, the price began to rise steadily until a massive jump on 25th January.

The Redditors had done it. They'd triggered a short squeeze.

Like the Redditors who had bought options, Melvin had gone short (betting the price would go down). Like call options, put options operate on leverage and borrowing. If the price had gone down, Melvin would earn the difference between what they borrowed and the current price. When the price didn't go down, Melvin had an obligation to buy a significant amount of shares at a much higher price. This massive stock purchase at a higher price would trigger a further run-up in the Gamestop stock. That's what happened.

The Gamestop price's huge run-up caught the attention of mainstream media, and culturally aware meme-lords like Chamath and Elon Musk amplifying the buying frenzy. The attention drew more investors to the Robinhood app, buying Gamestop and further pushing up the price.

Then Robinhood suspended trading Gamestop stock.

Cue outrage, disbelief, and thousands of 1-star reviews for the Robinhood app. Robinhood put out a vaguely worded press release about how they could no longer offer Gamestop stock purchases because of S.E.C. rules. Redditors were having none of it, and this is when the story caught fire. We had seen parabolic runs in stock prices this year (e.g., Hertz), but the Robinhood move seemed to anger everyone.

Why did Robinhood stop Gamestop buys?

On 28th Jan, Robinhood put out a blog post called "Keeping customers informed through market volatility." It talked about how important it is to stay informed and provided links to its learning portal; it also said, "We continuously monitor the markets and make changes where necessary."  I've read the blog post 8 or 9 times and cannot find an actual explanation.  This poor communication was compounded by their C.E.O. appearing on T.V. and managing to spend four minutes saying absolutely nothing.

A day later, Robinhood put out a much better explanation. Robinhood is a registered broker-dealer. As a broker-dealer, it has to place deposits at a clearinghouse. A clearinghouse is a central depository for securities (where the stocks live). They keep a record of which broker holds which stock on behalf of which beneficial owner.

The short version of what happened is Robinhood's clearinghouse increased its deposit requirements by 10x.  To meet these requirements, Robinhood had to both stop trades, or it would have gone insolvent.

On the face of it, that makes sense, but there's a twist.

Robinhood is "free" because you are the product being sold.

When you buy a stock on Robinhood, Robinhood sells that order information to a Wall Street firm called Citadel. Seeing the buy order, Citadel can "front-run" the retail investor and buy the stock in front of (or before) you do. As a result, you end up with a slightly worse price than Citadel did. Robinhood had been selling its order flow for years.

This hadn’t caused much controversy.

Then Gamestop happened.

A twist you couldn’t make up.

Remember Melvin Capital? (The fund that had gone short on Gamestop)

Melvin was in significant trouble, and who stepped up to help? You guessed it. Citadel. The firm that r/wallstreetbets had been fighting was saved by the firm making money from the r/wallstreetbets traders all along. 

It may have been a rational decision by Citadel to invest in a fund that historically had done well but was a victim of circumstance, but it didn't look like that.  It looked like Wall Street was working together. 

This is where the story crossed over and captured the imagination of the entire world. Regardless of your political affiliation, nearly everyone saw this as the evils of Wall Street.

Wall Street vs Main Street.

The outrage was compounded by commentators and C.E.O.s on mainstream business news (like CNBC) calling what r/wallstreetbets did "market manipulation," and regulators should introduce further regulation.  

Wall Street never calls for regulation; in fact, it spends billions pushing for the opposite to happen.  Regulation typically benefits incumbents far more than the person on the street.  These comments play into a sense of unfairness, where Wall Street can "get away with market manipulation," but if main-street tries to fight back, they call for regulation.

Perhaps the soberest take on the risk to main-street was by the Raymond James C.E.O., who noted that while main-street can win when a price goes up significantly, they're less able to absorb shocks when the price goes down. It's with this logic that after the Great Depression, the current system of regulation was introduced. In effect, only those who can afford to lose their capital had been allowed to take risky bets.

On the one hand, you have consumer protection from significant potential losses. On the other, you have only the rich able to get richer in the financial markets. It's a hard line to balance, which was a reality until Robinhood introduced free options trading.

My take

Is it market manipulation? The obvious answer is yes. Redditors are colluding to raise the price of a security. The technical answer is no. Under section 230, both Reddit and Redditors are protected by free speech. What the Redditors did is a symptom of a bigger problem.

The world is angry because we financialized the economy and sold out the middle class.

The populism we have seen in politics comes from the anger of wealth inequality. That wealth inequality is driven by an economic policy that targets low inflation and rising asset prices. The anger also comes from Wall Street's unfairness in getting a bailout while the middle class is hollowed out.

Mainstream, neo-liberal economic policy is slowly becoming political and social vandalism. It trades short term gains (through money printing and stimulus) for long term social problems.  This is why young people prefer Bitcoin to Gold, Tesla to Ford, and Meme's to politics. When you look past how flippant "lol nothing matters is" on the surface, you have a generation of people losing trust in institutions.

Fintech alone can't fix this. Fintech abstracted the pains of the existing financial system and created a better experience. Fintech is a 1.5 technology.

Defi and Crypto are remaking financial markets with new infrastructure. It's early, and like all early infrastructure, it's messy, optimistic, and weird. Defi also offers 12% savings rates on U.S. dollars and is driven by builders' global community.

It's time for policy to catch up.

Meantime, two more useful links:

• How the DTCC stopped Gamestop Mania (calls for collateral)
• The 10-year-old who made a mint from Gamestop