After a day of being raked over the coals by lawmakers and users, the stock trading app Robinhood put out a vague statement Thursday attempting to explain why it stopped allowing its users to buy GameStop, AMC, Nokia, and other “meme stocks” that were skyrocketing in price.
A dominant theory among some investors was that Robinhood stopped allowing people to buy GameStop stock in order to benefit firms such as Citadel, a company that pays Robinhood for information about its users’ trades and recently helped bail out a company called Melvin Capital from the short-sale positions it had taken on GameStop. Regulatory experts, however, say that this doesn’t seem to be the reason. As they see it, the likeliest explanations for Robinhood defenestrating itself by breaking trust with its user base are less nefarious but perhaps more embarrassing, and suggest that the stock trading platform may not have had enough cash on hand to stay within regulatory rules for brokerage firms.
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In other words, experts tell Motherboard that a mass influx of people buying tons of GameStop stock likely created a cash flow issue—or the threat of a cash flow issue—that could have put Robinhood out of compliance with very basic regulatory rules that every brokerage is required to follow.
Soon after Robinhood released its statement earlier today, Bloomberg reported that Robinhood has “tapped at least several hundred million dollars” in lines of credit from lenders such as JPMorgan Chase and Goldman Sachs.
Key to Robinhood’s statement is this section, which likely doesn’t make sense to the average user but which several securities regulation experts say suggests that the buzzy app may have overextended itself: “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.”
While this reads as gibberish, according to Joshua Mitts, a securities law professor at Columbia Law School, it appears to point to a cash flow issue of some sort.
“It’s at least a cash flow risk of some kind that led them as a matter of prudence, as a matter of risk management to say—I wouldn’t say the cash ran out, but they were concerned about that possibility,” he said. “Sometimes you take certain actions to avoid a disaster.”
“We have to remember they’ve just been sued. It’s a big lawsuit by their customers who were trying to buy stock and were unable to,” Mitts said. “Probably one of the reasons why [the statement] is so confusing and kind of unclear is they’re deliberately leaving it ambiguous so they can then argue in their lawsuit without having boxed themselves into a particular story in the blog post.”
Both Mitts and Jill Fisch, who teaches corporate securities regulatory law at the University of Pennsylvania’s law school, said that what Robinhood did Thursday is highly unusual and that Robinhood’s statement isn’t specific enough to definitively say what’s happening behind the scenes or what caused it.
“They’re framing it in terms of risk management, but it’s not entirely clear what risk it is they’re trying to manage. I think framing it in risk management terms is an effort to respond to investors saying this is unequal treatment and they can’t and shouldn’t be doing this,” Fisch said. “I was surprised [when Robinhood stopped allowing people to buy GameStop stock.] I view it as unusual for a brokerage firm to respond on an individual [stock] basis. Typically if there’s a concern about excessive trading or volatility or price manipulation, it’s handled at the level of the exchange so everyone is treated the same way.”
Two other securities regulatory experts who are professors at major business schools also told Motherboard that they believe Robinhood’s invocation of the net capital obligation rules points to some sort of cash flow issue, but asked to be anonymous because they could not be certain of why this would be the case and did not want to comment on the record.
When swipe up on Robinhood to buy a stock, you are not buying that stock instantaneously. You are entering an agreement in which Robinhood agrees to go execute a trade for you, but Robinhood then uses a third party to execute the transaction. When you send money to Robinhood to fund your account, it isn’t instantaneous, either—your bank has to send the money to Robinhood, normally through a process called an ACH transfer.
“They have to facilitate trades and securities before they’re fully paid for, before all the money has changed hands,” Mills said. “This happens with any transaction, when we wire money or buy something with a credit card. There’s a number of delays that can occur between when we have an official commitment to sell or purchase and when that money is in their bank account.”
The SEC’s net capital obligations are rules (here is the actual, 318-page regulation) about how much money brokerages have to have on hand to ensure that they are, essentially, good for the transactions their consumers want to make. They say, broadly, that in order to be in compliance, a brokerage must have “sufficient net capital at all times prior to, during, and after purchasing or selling property securities” to protect their customers and fulfill their obligations. In other words, a brokerage must have cash flow.
“What Robinhood seems to be saying is ‘We have regulatory obligations that forced us to suspend trading,’” Mitts said. “This raises the question of if they were negligent in their management of their net capital and other regulatory obligations. It shouldn’t ordinarily be the case that basic regulatory obligations cause a problem unless the broker is doing something that in fact puts the customers at risk in some way. I’m not saying I know that to be true in that case, but it’s a reasonable inference. you ask yourself what were they doing that made their exposure so risky that they had to shut down trading to comply with basic rules.”
Robinhood declined to comment for this article. When we followed up with theories raised by experts in this article, it did not respond.
Mitts said there are a few potential reasons why Robinhood could have been caught off guard by a sudden gold rush from its users. Robinhood uses a company called Plaid to connect users’ bank accounts with their Robinhood accounts. ACH transfers (from banks to the app) are not resolved immediately, but Robinhood allows users to access a portion of that money for trades immediately, which, in a buying rush that includes new users, would mean Robinhood is allowing users to trade money that the company itself technically doesn’t have yet. “But this money shouldn’t be of the magnitude that it would cause a trading suspension,” Mitts said. Plaid declined to comment for this article.
More likely, he theorized, is that Robinhood may have been exposed to too much risk associated with margin trading. Robinhood allows its users to trade “on margin,” which means if you put $100 into Robinhood, you are allowed to spend more than $100 worth of stock, which is essentially a loan. The thinking here is that the brokerage can force you to sell the stock or put more money into the account if it believes your account is too risky (this is a “margin call”). This works fine when stock prices are relatively stable, but is much riskier when they are on a rollercoaster as GameStop, AMC, and other meme stocks have been. If the prices of the stock that people are buying en masse plummet, Robinhood could be on the hook for that money from its creditors.
“It raises a lot of questions—it could be Robinhood was being very aggressive with their speculations—maybe aggressive capital ratios were a source of risk and that risk blew up on them when these high volatile stocks were in such high demand. Or, so much of the balance sheet was exposed to those stocks, maybe,” Mitts said.
“Normally, Robinhood could satisfy your debt by making you cash out the securities. But from Robinhood’s perspective there’s a risk in a volatile market where they’ve made loans to customers—Robinhood has to get that money [for margin stock buys] from somewhere. It has its own creditors,” Mitts said. “It could be the case that people wanted to buy stock with money Robinhood doesn’t have. I’m not saying I know what happened, but it could be a problem between Robinhood and its creditors.”
What they seem to be suggesting is that there’s no specific evidence to suggest that Robinhood did this to hurt its users and help big hedge funds, but that Robinhood may not have enough money to handle the needs of its users while still complying with SEC regulations.
