Robinhood Is The Target Of Misguided Anger

The Reddit horde led a passionate, and, misguided outcry when Robinhood imposed trading curbs on GameStop last week.

Reddit exploded with posts on “evil hedge funds”, David and Goliath comparisons were all over the media, and Congressman Gosar demanded a DoJ investigation into Robinhood.

If Robinhood was indeed a pawn, why did Interactive Brokers, TD Ameritrade, Webull and other large brokers also impose similar trading restrictions, and at the same time? Are all brokers slaves to "evil hedge funds"?

Also, why were the restrictions eased by Robinhood the very next day?

The answer: It's not some conspiracy theory in action, but a simple case of how the stock market plumbing actually works. A boring but critical thing called market microstructure.

Here is what happens when you buy a stock on Robinhood or any other broker:

1. The broker posts your order (price, volume, buy/sell, other details) on an exchange like Nasdaq or NYSE.
2. The exchange matches a buyer and seller and a trade is executed.
3. The brokerage client will start seeing profit and loss in his account instantly, but unknown to many, the actual stock ownership and money changes hands only 2 days later in case of US stocks - known as T+2 settlement.
4. The settlement is done by a clearinghouse (DTCC for US stocks). DTCC demands cash collateral from both brokers on day T until the settlement on T+2 to ensure that neither party defaults on T+2.
5. DTCC decides how much the collateral for each stock should be, based on the magnitude of the stock's recent price fluctuations (also called volatility). Higher volatility leads to higher collateral requirements.
6. With recent 100% one-day moves in GameStop and other Reddit-powered stocks, DTCC increased collateral required on these stocks by a large magnitude. This led to billions in new collateral immediately required from Robinhood. Either it had to put up the cash immediately or Robinhood clients' holdings at DTCC could be forcibly liquidated to prevent a disorderly collapse in the markets.

Robinhood simply did not have the cash to put up as new collateral. So they stopped trading in these stocks by their clients, as a response, to minimize the cash requirement. So did the other brokers, and also for the same reason. 

Robinhood then raised billions in cash from their banks and investors later that day and then eased the trading restriction the next day, as they now had cash available to post collateral with DTCC.

Without DTCC and the collateral, there is nothing that prevents a losing trader from walking away from his obligations two days later, and that would easily trigger a chain reaction and collapse modern capital markets as we know it. 

It is because of DTCC and the collateral that the Reddit winners actually had cash in their pockets, otherwise the trades would have been defaulted upon weeks ago by the losing traders.

DTCC did the right thing. Robinhood did the right thing. The uninformed horde got it wrong, even as the whole thing was for their benefit too. 

Disclosure: I have no ownership in or any business relationship with Robinhood. I am also not receiving any compensation from anyone for this article.