Robinhood’s Lesson in Risk Management — The Capital Note

Vlad Tenev, co-founder and co-CEO of investing app Robinhood, speaks throughout the TechCrunch Disrupt occasion in Brooklyn, N.Y., in 2016. (Brendan McDermid/Reuters)

Welcome to the Capital Note, a newsletter about organization, financing, and economics. On the menu today: Robinhood’s arbitrage store, its possible IPO, completion of Bezos’s period as Amazon CEO, and a 1920 brief capture. To register for the Capital Note, follow this link.

Robinhood’s Arbitrage Store
Robinhood’s organization design is based upon concealing expenses. In the pre-Robinhood world, retail traders paid a repaired commission in between $5 and $7 per trade. Now that almost all retail brokerages have actually gotten rid of commission, retail traders compensate brokerages not with commissions however by paying too much for securities, generally a cent or less per share greater than the very best rate readily available. The noticeable, in advance commission expense is now concealed from consumers, the majority of whom presume they are trading totally free.

This procedure is helped with by market makers such as Castle Securities, whose high-frequency-trading desks make money from the spreads in between quote and ask costs in stocks and choices. When Robinhood sends out an order to Castle, the marketplace maker’s traders offer stocks to Robinhood’s consumers at a somewhat greater expense than they buy them for (if they’re doing their job properly). Castle makes a couple of cents per trade, however at scale this can be an incredibly rewarding organization, particularly in less-liquid choices markets where spreads are bigger.

On balance, the rate per trade for small-money financiers is lower in the Robinhood world, due to the fact that a repaired commission per trade enforces excessive expenses on little trades. Robinhood offsets its lower costs by taking advantage of a bigger swimming pool of consumers that trades frequently, due to the fact that it pays no in advance deal expenses. The Wall Street Journal computed that a $1,000 trade yields Robinhood approximately 26 cents, almost 60 times the earnings of standard brokerages such as Charles Schwab and TD Ameritrade.

This organization design indicates there is almost no integrated limitation to Robinhood’s success. Like a social-networking platform, it simply requires to increase its variety of daily-active users, due to the fact that the minimal expense of an extra client — a little bit more server area and a little bit more financing — is nearly no. And the sign-up procedure for a brokerage account — in which a brand-new client needs to input his bank details, social security number, motorist’s license, etc. — develops a sticky user base with a high life time worth.

So Robinhood is a lot more like a social media network than a banks. Simply as Facebook leverages its huge user base to offer advertisements, Robinhood leverages its user base to offer order circulation. This is basically safe arbitrage, due to the fact that the threat embedded in those trades is right away unloaded to market makers. If Robinhood performed the orders itself, it would need to hold stocks and choices on its balance sheet to negotiate with its consumers. Rather, Robinhood lets the army of PhDs at Castle Securities manage the pipes. Castle’s high-frequency traders reduce threat by performing orders as rapidly as possible and hedging their market direct exposure.

Omitting margin financing and other line of work, Robinhood’s trading earnings totals up to the distinction in between what it spends for consumers’ orders in server area, marketing, labor expenses, and upkeep, and what it offers those orders for. This design indicates that scale needs to supply almost costless advantages to Robinhood, due to the fact that the problems of increased trading volume are borne by market makers. All Robinhood needs to do is keep its app up and running (which isn’t precisely simple, however is definitely simpler than keeping the app while likewise running a market-making operation).

That’s the concept, however what recently exposed is that, similar to its consumers, Robinhood faces its own concealed expenses. Although market makers perform Robinhood’s order circulation, the brokerage is still a counterparty to its consumers’ deals. When Robinhood users buy stocks, market makers find someone to sell it to them. Those transactions end up going to the National Securities Clearing Corporation, a clearinghouse where member brokerages settle trades between their consumers. If Robinhood customers were net buyers from Fidelity customers, Robinhood transfers funds to and receives stocks from Fidelity two days after the trades were executed.

Clearinghouses are useful because, among other things, they reduce transaction costs and counterparty risk. Rather than having to exchange cash and securities for every single transaction, brokerage firms only transfer the difference between their customers’ purchases and sales, a process called “netting.” If Robinhood users purchase $1 billion in stocks on a given day, the brokerage will typically only have to send a small fraction of that amount in cash to other institutions. And thanks to deposit requirements, clearinghouse members don’t have to worry about the brokerages they do business with failing to meet their obligations. If a brokerage fails, their counterparties know that they will be entitled to its clearinghouse deposits.

Naturally, when a brokerage is at greater risk (e.g., when a critical mass of its customers pile into a meme stock overvalued by approximately 700 percent), its clearinghouse-deposit requirements increase. According to Robinhood’s CEO, the NSCC asked Robinhood to put up $3 billion in cash last week, at least ten times as much as its typical deposit. Unwilling or unable to risk its own cash, Robinhood halted trading in GameStop, AMC, and other stocks favored by retail investors.

On one hand, the trading halt was the one-off result of an insane week in financial markets. Robinhood can be reasonably certain that this kind of thing won’t happen every week. On the other hand, it raises serious questions about Robinhood’s business model. Because volume is the be-all and end-all for Robinhood, its singular focus has been removing trading frictions by charging nothing in cash, letting customers trade before their deposits have gone through, and offering margin to all customers by default.

But in its push to remove trading frictions, Robinhood seems to have incurred its own hidden costs in the form of increased balance-sheet risk. Even if another GameStop–type rally does not occur, the brokerage will need to be more cognizant of the costs of scale. And there is no free lunch, because managing risks by, say, reducing margin lending or being pickier about which customers it allows onto its platform, will eat away at revenue.

Around the Web
Robinhood considering an IPO:

A swift public listing would let the company capitalize on its rapid growth of the past year — and provide a potential windfall for investors who stepped in to support the firm during its crises at hand.

Indeed, people close to Robinhood said the startup plans on moving ahead with an IPO. And alternatively, one person said, the brokerage could pursue a debut via direct listing or a deal with a publicly traded “blank-check” firm, known as a special purpose acquisition company.

I like to imagine Redditors shorting a newly public Robinhood into oblivion and taking it over.

Jeff Bezos steps down as Amazon CEO:

Mr Bezos is indeed following the Microsoft model. In the third quarter, he will switch — as Bill Gates did — from day-to-day running to a position of broader strategic leadership. With little sign of a horse race, Andy Jassy, the current head of Amazon’s cloud computing division, will step up to be the new chief executive. Amazon insisted that Mr Bezos, as executive chairman, would only be involved in what it described as “one-way door” decisions, from which there is no turning back.

Random Walk
Short squeezes are nothing new. From a 1998 issue of Financial History magazine:

Allan A. Ryan was the son of the famous financier William Fortune Ryan. The elder Ryan arrived in the United States penniless in 1886 but was worth $50 million by 1905. The younger Ryan was a bullish trader who profited immensely from the rising market of 1919. One of his largest investments was in the Stutz Motor Car Company of America, Inc., in which he held controlling interest.

Ryan became president of Stutz Motors in 1916. At the beginning of January 1920, Stutz sold for about $100 a share and had risen throughout the month. On Feb. 2, the stock rocketed from $120 to $134 when an organized group of bear raiders began selling the stock short.

Ryan decided to fight the bears by buying all of the Stutz share that came up for sale. He raised the funds needed for his plan by borrowing from banks and wealthy acquaintances, such as Charles Schwab. The price of Stutz reached a low of $113 in early March purchase began to rise thereafter, as Ryan’s purchasing strategy began to affect the stock’s price. By mid-month, excited bears were borrowing Stutz stock from their brokers and selling it into the market (to Ryan) in anticipation of its ultimate decline. Ryan began to “feed the bears” by lending shares to brokers, who in term lent them to their clients. In late March, many Stutz shareholders were eager to money in on the inflated price, and so they sold, unbeknownst to them, to Ryan. By the end of the month when the price reached $391, Ryan owned or held contracts for 110,000 shares. He had cornered the market and the shorts were squeezed.

— D.T.

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Jobber Wiki author Frank Long contributed to this report.