Stanford economists weigh in on Robinhood controversy

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Stanford economists say that Robinhood, the trading app founded by Vlad Tenev ’08 and Baiju Bhatt ’07 M.S. ’08, was justified in limiting user trading of GameStop stock amid soaring prices late last month.

Two weeks ago, individual traders sent video game retailer GameStop’s stock ballooning to a closing price of $347 — a 2,000% increase from that of the previous month — to the chagrin of institutionalized investors who have been betting on the stock price falling in a tactic known as “shorting” the stock.

Historically, individual traders have not been able to affect institutions like hedge funds or investment banks. But with more people staying at home with stimulus checks in hand, day trading has become an increasingly popular pandemic activity.

Last month, a group of Reddit users succeeded in inflating the stock price of GameStop, a video game retailer that is not likely to be profitable until 2023. Then, Robinhood shuttered trading, sending prices plummeting and criticism raging.

Since then, Robinhood has published messages of clarification on its blog, saying that they shut down trading because they didn’t have enough cash on hand to pay clearinghouses their deposits, not to stifle the day traders.

“This is a dynamic, volatile market, and we have and may continue to take action to make sure we meet our requirements as a broker so we can continue to serve our customers for the long term,” Robinhood wrote on its blog. On Feb. 2, the company announced that it had raised $3.4 billion to “continue to invest in record customer growth.”

“In the case of Robinhood, limiting that trading was actually necessary to protect their customers’ money,” said Darrell Duffie Ph.D. ’84, professor of finance in the Graduate School of Business (GSB).

Duffie studies financial markets from the viewpoint of making them more efficient and safe. He explained that companies in the financial services industry, such as Robinhood, are expected to comply with several government regulations, including a number of fiduciary responsibilities laid out in Section 15(c)(3) of the Securities Exchange Act of 1934.

The National Securities Clearing Corporation (NSCC) requires Robinhood to guarantee that its customers’ will be able to pay for their trades, which take two days to be settled. Thus, the reasons that the trade of securities was limited were “mundane,” according to Duffie.

And the theory that Robinhood was somehow conspiring with other investors in an attempt to stop retail traders from going after other investors?

“That’s just not the case,” Duffie said. “All the indications are that Robinhood was just meeting its regulatory requirements to make sure their customers’ cash was safe.”

Graduate School of Business finance professor Anat Admati concurred, saying that “there’s no something out of nothing.” Admati’s work takes a cross-disciplinary approach to advocacy for accountability in the private sector and government.

In other words: “no free lunch.” The company makes money through a process known as payment for order flow. To better understand the system, customers should think critically about how money is being made, she said.

Robinhood does not have the stocks on its “shelf” per se. Instead, when a user makes a purchase, it puts the shares to the user’s name and then submits orders to intermediaries. The NSCC clearinghouse helps transfer the shares within the following two days, usually without taking on much risk itself. During the height of the controversy, however, the NSCC began to demand larger deposits from Robinhood as collateral because of the larger volume of orders.

Robinhood made “optimistic assumptions,” Admati said, and on Jan. 28, Tenev woke up at 3:30 a.m. and faced a public crisis. With a demand from a clearinghouse to deposit money as a safety measure hedging against risky trades, he had to get $1 billion from investors. Normally, Robinhood only has to put up $2 for every $100 to vouch for their clients, but now, the whole $100 was required. Thus, trading had to be slowed down until the money could be collected.

“It’s like you have a store and your product is popular and then you know there’s a line out the street and they all assume they could get it,” Admati said.

On the horizon

While market forces may stabilize the situation without intervention, Duffie said, regulators such as the Securities and Exchange Commission and Congress “should keep a careful lookout to see if these situations might persist and whether there’s a new form of financial instability that needs to be controlled.”

Stanford Blyth Fund president Taylor Kendall ’21 said that although nothing new may be discovered in terms of “bad actors,” an investigation would still be “warranted.”

“It’s been illegal to force these short squeezes intentionally with a group of people, and this is called market manipulation,” Kendall said. At the same time, given the dispersed nature of the act among many smaller investors, he said that “the SEC is not going to have the resources to chase everyone down for a $3,000 fine.”

Kendall said that market manipulations lead to a misallocation of resources, the antithesis to a society under this financial system. He said that giving cash to certain companies that keep losing money is not a “positive benefit to society.”

Additionally, in a YouTube video from Jan. 29, Admati said that capital is supposed to fund productive companies and not “gyrations and the crowd going after other investors.”

As the share price of GameStop has dipped in recent days to below $60, some still believe the price will go back up. With regulators now looking into how the rally of this stock and other “meme stocks” such as AMC first began, the possibility of writing new fiduciary rules to avoid future short squeezes is growing.

“We should upgrade our systems so we can have near-instantaneous settlement,” Kendall said. In cases like these, markets shut down to avoid counterparty risk, the probability that the other participant in a transaction will not hold up their end of the deal. “I think that’s the main solution here. The back ends to everything from technology companies to financial systems are not sexy things, but they’re really important.”

A previous version of this article said that 56% of Robinhood clients at one point had GameStop stock. This percentage was falsely reported by Motherboard and was corrected in a later tweet. The Daily regrets this error.

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Matthew Turk is a writer for The Stanford Daily. Contact Matthew at news ‘at’ stanford.daily.com.