What Happened with Robinhood?

 If you have not heard by now, there was been a couple names on the stock market that have undergone exponential growth within a short period of time relative to their stock price. Some of these names include NOK, GME, and AMC (each up 152%, 2,700%, and 913%, respectively, from January 4th to their respective recent all time highs of January 27, not a coincidence. GameStop also went from a market cap of $1.203 billion to $18.24 billion (daily closing values)). These parabolic runups in these three names were principally organized by the likes of those on WallStreetBets, and I think we all know who they are at this point. After crazy amounts of realized volatility within these three names, Robinhood blocked order executions on GME in particular, causing hundreds of thousands of people (there are about a million people on the forum, and I am sure others outside of that were invested into these three securities) to lose money extremely quickly, with GameStop in particular falling from a high of 483 to 112 within a matter of minutes. There has been immense backlash on the Robinhood app for allowing this to happen, however, I will explain why it happened, the various financial implications Robinhood Financial Services has with the stock market, and the various legal consequences of such an action taken by Robinhood. 

Quite honestly, I was pretty pissed off with the amount of hate that Robinhood received from social media, particularly through the likes of Instagram and Twitter, with various high-following people spurring negative remarks about the investing platform, with the likes of Portnoy, Alexandria Ocasio Cortez, and many other 'influential' people around the country. In this post, I will try and clear the air in what actually happened, and show how Robinhood is not at fault. 

Legal Stance

First off, allow me to describe two critical statements and disclosures agreements hosted by Robinhood. One titled "Options Agreement", section 23, states the following: 

"DISCLAIMER OF LIABILITY: NEITHER VENDOR, OPRA, OPRA’S PROCESSOR NOR ANY OPRA PARTICIPANT GUARANTEES THE TIMELINESS, SEQUENCE, ACCURACY OR COMPLETENESS OF ANY OF THE OPRA DATA SUPPLIED HEREUNDER AND NEITHER VENDOR, OPRA, OPRA’S PROCESSOR NOR ANY OPRA PARTICIPANT SHALL BE LIABLE IN ANY WAY, TO YOU OR TO ANY OTHER PERSON, FOR ANY LOSS, DAMAGES, COST OR EXPENSE WHICH MAY ARISE FROM ANY FAILURE OF PERFORMANCE BY VENDOR...". 

When you open up your Robinhood account, you select to agree to these terms, thereby placing the large class-action lawsuit formulated by retail investors void (essentially). Another key excerpt regarding Robinhood's liability towards the closing of accounts and restricting trading on only A COUPLE securities today is the following (from "Robinhood Customer Agreement", section 3):

"I understand that neither Robinhood Financial nor any Disseminating Party guarantees the timeliness, sequence, accuracy, completeness, reliability or content of market information, or messages disseminated to or by any party. I understand that neither Robinhood Financial nor any Disseminating Party warrants that the service provided by any such entity will be uninterrupted or error-free. I further understand that Market Data by Xignite provides market data to Robinhood Financial customers. NEITHER ROBINHOOD FINANCIAL, ANY OF ITS AFFILIATES, THEIR RESPECTIVE OFFICERS OR EMPLOYEES, NOR ANY DISSEMINATING PARTY SHALL BE LIABLE IN ANY WAY FOR (A) ANY INACCURACY, ERROR OR DELAY IN, OR OMISSION OF, (I) ANY MARKET DATA, INFORMATION OR MESSAGE, OR (II) THE TRANSMISSION OR DELIVERY OF ANY SUCH DATA, INFORMATION OR MESSAGE; OR (B) ANY LOSS (AS DEFINED IN THIS AGREEMENT) OR DAMAGE ARISING FROM OR OCCASIONED BY (I) ANY SUCH INACCURACY, ERROR, DELAY OR OMISSION, (II) NON-PERFORMANCE OR III) INTERRUPTION IN ANY SUCH MARKET DATA, INFORMATION, OR MESSAGE, WHETHER DUE TO ANY ACT OR OMISSION BY ROBINHOOD FINANCIAL, ANY OF ITS AFFILIATES...".

As one can clearly see, even though what happened to day with Robinhood restricting trading on one or two names was unfortunate, they were perfectly within their rights to do so, and are not liable for any damage following the error in data slippage or order execution.  

"Robinhood may choose to make certain market data available to Me pursuant to the terms and conditions set forth in this Agreement. By executing this Agreement, I agree to comply with those terms and conditions. 1 2020.12 A. Definitions. "Market Data" means (a) last sale information and quotation information relating to securities that are admitted to dealings on the New York Stock Exchange ("NYSE"), (b) such bond and other equity last sale and quotation information, and such index and other market information, as United States-registered national securities exchanges and national securities associations (each, an "Authorizing SRO") may make available and as the NYSE may from time to time designate as "Market Data"". 

"I understand Robinhood may at any time, in its sole discretion and without prior notice to Me, prohibit or restrict My ability to trade securities"

Another key implication is the various capital requirements Robinhood is required to have. Because this platform allows for people to trade with margin, as well as provide varying degrees of (very generous levels, I might add) buying power, they have to monitor their own resulting order flow from their application. If you all go broke, then Robinhood goes broke. Here is a direct quote from their email to customers today:

"As a brokerage firm, we have many financial requirements, including SEC net capital obligations and clearinghouse deposits. Some of these requirements fluctuate based on volatility in the markets and can be substantial in the current environment. These requirements exist to protect investors and the markets and we take our responsibilities to comply with them seriously, including through the measures we have taken today."

All of these terms and conditions you agree to when you sign up to use the Robinhood investing platform. 

The "Market Maker" Stance

For those who are unclear what a market maker is, it is essentially a liquidity provider, assigned to a given security, that's main purpose is to ensure fair liquidity for the buyer and seller of their assigned security during trade hours (unless through an extended-hours broker). There have been numerous accusations towards Robinhood that go like the following: "The reason why you shut down our accounts was because you wanted the market makers to trade against us and steal our money!". Obviously, this is untrue. The first thing one should know about market making, or, more importantly in this case, derivatives market making, is that a market maker gets paid in accordance to the amount of volume that there is on their assigned security. For example, a market maker primarily achieves their revenues by people "crossing the spread", essentially people who buy by "hitting the offer", or sell by "hitting the bid", both of which are clearly not "limit orders" (I will get into this important distinction in a minute), or by something called the "Maker-Taker Rule". If you do not know what this is, this might blow your mind. A while ago, exchanges (like the NYSE, NASDAQ, BATS, ARCH, CME and several others) went from non-profit entities (they did not make money in providing and facilitating trading), to for-profit entities (now they can make money by performing their very function). This changed everything. Then, the "Maker-Taker" rule was introduced. This basically pays people to provide liquidity to the order book ("make" liquidity by using a limit order), and making pay those who "take" liquidity (just using a market order, or "hitting the bid/ask") through something called "rebates". A rebate is basically a very small payment for you providing liquidity (usually fractions of pennies). If you take liquidity, that magnitude of rebate goes from your account, to the person or entity that provided said liquidity. So, this is obviously very important, as now you understand two very important stances for a market maker- they get paid to provide liquidity, and they get paid when you "cross the spread" (by the amount of the bid-ask spread). So, coming back full circle, the fact that Robinhood stopped trading so the market makers in those certain names could make money is completely false, as they WANT your order flow, they WANT you to trade, they are incentivized to support you! Also, when volatility begins to ramp up (as we all know it did), market-makers will usually "widen the spread", or create a larger bid-ask spread in order to accommodate wild movements on the underlying security, or if there is a massive influx of orders coming through rapidly. So, if they are paid by people panicking to quickly get out of their positions (by crossing the spread), if it is already widened, then they obtain more revenue! In essence, they like volatility! As evidence, just look at the stock price of Flow Traders, a company that specializes in derivatives market making activities. Notice how their stock price jumps during the most recent stock market crash. 

I hope I disproved the false narrative of how Robinhood shut down your order execution on GME for the market makers. 

The "Gamma Squeeze"

Options are a derivative instrument, which basically means that they get their price (mainly) from the underlying security, their price is derived from it. In option pricing, there are numerous inputs that go into it, but one of the factors that is taken into consideration is the underlying volatility of the asset. In general, the more volatility the asset, ceterus paribus, the more the option is worth (this is an oversimplification, obviously). The key thing here is that options are now priced in what is known as "implied volatility", which basically means the volatility that people expect for the security, relative to the individual option contract, will have in the future. It is implied. Now, a key word to know is "gamma". Gamma is one of the pricing inputs to use in option pricing techniques, it is essentially the same as implied volatility. So, just remember, implied volatility = gamma. Here is where it gets interesting. Every time you buy an option, the person you buy it from (most likely the market maker) has to hedge the option he just sold to you so he/she does not lose money on the other side of your trade. So, when he/she sells you that option, he/she can do a couple things, more often than not they buy the equivalent number of shares they just sold you in your option's worth. For example, let's say that you buy a call option on Apple. Since a standard American/European option contract represents the ownership of 100 shares, the options dealer must then buy 100 shares of the stock (it is not a direct 1 for 1 hedge, as it can get extremely complicated, this is just a simplified example). So, as people are buying loads of these calls on names like AMC and GME, they are also encouraging some proportionality of buying pressure from the person you just bought from. This is called a "gamma squeeze", which is when there is such a demand for buying bullish, directional volatility, that the market makers and other options dealers must also buy volatility or stock on the underlying security. It is very similar to a short squeeze, except change the concept of squeezing an investor, to squeezing a market maker. This was an important reason why these stocks ran the way they did, as people were essentially forcing these market makers to also buy the stock extremely fast in order to hedge their gamma risk. 

Order Flow

This next topic is extremely important, as it is essentially the core driver of Robinhood's revenues, and most people do not even know it is happening. There is something called "payment for order flow". This is essentially various firms, most often HFT firms (High Frequency Trading) that incentivize Robinhood to send your order execution details to them, and in return, they will provide volume on the select number of names that Robinhood usually sends orders towards (securities and their respective exchanges) to ensure a "better" trading environment with respect to liquidity for the average investor. Essentially, these people (whether they may be hedge funds or HFT firms) see your order coming in from "miles away", and can easily see what you, your friends, and others are into, what are the conditions of your trade, where did you get in price-wise, etc. . This is extremely important for any user of Robinhood, TD Ameritrade, E Trade, really any retail-oriented broker and trading provider to know. You are getting scalped and you do not even know it. There are a plethora of other various HFT strategies that are employed to trade against you the instant you hit the "send" button, but that if for another discussion. 

Hedge Funds/ HF's are Bad

I would also like to talk about this discussion topic, how "Robinhood is just siding with the billionaires to destroy us because we were investing too good" or something along those lines. I would first like to say that these accusations are ridiculous. If everyone believes that businesses care the most about revenues, their bottom line (which, if you do not, I feel sorry for you), then why would Robinhood suspend trading on two names only because a hedge fund called them up and said "stop their trading, we are getting absolutely crushed", when the main source of revenue results from volume of order flow from those who use the app? Besides, the amount of volume that was being done today was insanely high, which means that Robinhood actually SHOULD have made it EASIER for you to trade. Obviously, due to superseding circumstances, this could not happen (Robinhood could have possibly gone bankrupt if they encouraged such activity). 

The notion that hedge funds are bad is ridiculous. When prices get out of line from their fundamental "fair value", hedge funds have the sophistication, amount of capital, and proprietary leverage to "realign" prices using arbitrage strategies, as well as traditional directional strategies. An example I would like to use would be Walmart. Imagine your parents retire, and their entire income from there on out would be through dividends on Walmart stock. Now, assume hedge funds no longer exist, and it is the WallStreetBets community that essentially is the only player here. Not only can they control what happens to that stock, but they can drive the stock down to irrational levels, simply because someone said they should do it. This obvious drive from the "fair value" of Walmart would cause dividend yields to collapse, and the value of your parents' retirement fund just diminished almost entirely, all because there was nobody to perform deep analysis to see the fundamental price level of Walmart. You see, this is essential to everyone. HF's are a net benefit. 

In addition, with exception to Long Term Capital Management, they are not bailed out of bad trades. They fail, so their best interest is to preserve and grow the wealth of their clients through legal trades and investments, not to "hurt the little guy". Also, a vast majority of hedge fund managers often commit a large percentage, if not all, of their wealth towards their fund. This means that, if they don't trade well, they also go broke in the process. So, why on earth would HF's main goal to be to hurt the little guy? They are trying to outperform some given benchmark/index, that is it. The only way the "little guy" would get hurt would be if, through sheer stupidity by the "little guy" they blow up prices in such a way that, fundamentally speaking, prices cannot be sustained at that level. It is their own doing and irrational investing sense that perpetuates their losses in the end. I hate to say it, but it is true. If anything, this irrational exuberance provided a once-in-a-lifetime short opportunity, fueled by a lack of intelligence in the basics of investing knowledge. 

Why did you take on this Risk?

Lastly, I would like to talk about the level of risk that people on WallStreetBets accumulates. It is to mind-blowing proportions, as some risk their entire life savings on a couple derivative instruments (calls and puts) that leverage the hell out of your initial investment, purely for speculative reasons. If you are trying to day-trade a multi-million dollar position, where the future of your life lies on the line, why would you continue to use a phone app? Why not a better suited platform, such as something of more sophistication at least on your laptop. You expect to assume risk of massive proportions with no VaR calculations, no hedging, nothing, simply profits. I mean, derivatives instruments were meant for HEDGING, NOT SPECULATION for crying out loud. 

Conclusion

I hope I changed or at least provided another way of thinking about what happened with all of these crazy events. If you have any questions, I would love to receive any input from this post in which you think something is wrong. factually inaccurate, or if you have another viewpoint I did not consider.