Robinhood’s Meteoric Rise Feels the Pull of Wall Street Physics

Robinhood Markets’ emergency ban on trading eight stocks this week ignited rage across the political spectrum, swiftly drew state and federal scrutiny and sent furious customers into the arms of competitors.

That was Thursday. By Friday afternoon, it was limiting purchases of shares in 23 companies. Soon, it wasabout 50.

A drama that began with a quirky jump inGameStop Corp.’s shares this month has grown into a full-blown rebellion of retail investors against Wall Street’s status quo and left Robinhood, long their beloved brokerage, caught between customers and the cold demands of finance’s gatekeepers. Mounting strains on the firm forced it to grab more than $1 billion in fresh capital and hundreds of millions more in loans.

The startup, which set out to “to democratize finance for all,” is now in the awkward position of telling clients they can’t buy whatever they want. An online job ad hints at the complexities the Silicon Valley company faces, with Robinhood seeking a federal lobbyist.

“Obviously this is not a good position for a brokerage firm to be in,” said James Angel, an associate professor at Georgetown University. “No firm wants to turn down customers who want to use their service. I’d be shocked if that lasted very long.”

In ablog post Friday night, the firm described the restrictions as necessary and temporary.

“It was not because we wanted to stop people from buying these stocks,” Robinhood said of its decision to impose limits. “Our goal is to enable purchasing for all securities on our platform. 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.”

A company spokeswoman declined to comment beyond the blog post.

‘Trading and Confetti’

At the center of all the controversy is Robinhood’s highly polished app, which has lured millions of investors with an experience that seemed to defy Wall Street’s usual physics. With a focus on immediacy, the firm lets new arrivals start trading as soon as they set up a bank transfer. It awards them a free stock for signing up. And then there’s the shiniest lure of all: No fee for trades.

It’s no wonder Robinhood created legions of fans who expect to buy stocks, options and even cryptocurrencies with little sensation of guardrails. But this week, that culture slammed into reality. Wall Street trading is a strictly regulated business that can require brokerages to have mountains of cash available.

After Robinhood’s customers picked a fight with hedge funds by sending shares of GameStop and other beaten-down companies into the stratosphere, the market’s central clearing hub required the firm to post much more collateral to limit the risk such volatility can pose to the system. In its blog post, Robinhood said the deposits it had to make for equities jumped 10-fold during the week.

That meant Robinhood needed more money. And to keep its burden from getting bigger, the firm — like some others — began restricting certain trades. Initially, it barred purchases of some of the most volatile stocks. Though it later allowed them in limited amounts, the list of tickers grew. As of Friday night, customers hoping to buy GameStop were allowed one share.

“What Robinhood promised was free trading and confetti when you trade,” said Georgetown’s Angel, who specializes in market structure. But the financial system’s rules apply everywhere. Any investors considering leaving Robinhood to further the crusade they started there “will find, at the end of the day, most other brokers are pretty much the same.”

(Angel humbly noted he put a small short on GameStop mid-week only to watch the price double.)

‘Growing Pains’

Founded in 2013, Robinhood courted long-ignored small-dollar and novice investors with innovations including its zero-commission promise. It offered, for example, fractional stocks to let people who can’t afford to pay around $800 for a share of Tesla Inc. to buy just a piece of one instead. Those features became standard in the industry: free trading is the norm, andCharles Schwab Corp. andFidelity Investments allow customers to buy stock “slices” too.

As the coronavirus pandemic erupted last year, retail investors flooded into the market, looking to earn extra cash and pass time during lockdowns. Robinhood’s customer base surged beyond 13 million. Even amid this week’s turbulence, its app has dominated download rankings. But at times, its popularity has outpaced the build-out of its operations.

The firm repeatedly suffered outages as the coronavirus pandemic erupted in the U.S. last year and sent markets into a tailspin. Later in the year, when hackers accessed thousands of accounts, panicked users discovered the firm had no phone number for customer service.

Financial-technology disruptors need to learn the intricacies of Wall Street’s mechanics and compliance systems faster, said Jim Toes, head of the Security Traders Association.

“We’ve got to find a way to get those growing pains to occur in a much shorter window,” Toes said in an interview on Friday. “We have a lot of fintech companies coming into our marketplace where the in-house expertise is more around technology.”

Clients’ Campaign

In recent months, Robinhood has been enlisting legal help, recruiting attorneys from Goldman Sachs Group Inc., Wells Fargo & Co., Schwab’s TD Ameritrade and WilmerHale, a law firm known for its securities-law expertise.

But this week’s rush for cash contrasted with past snapshots of the firm’s financial health.

Robinhood’s subsidiary that handles trading reported ample capital in a mid-yearfinancial statement. At the end of June, the broker-dealer unit had 14 times the minimum level required by Securities and Exchange Commission rules for capital relative to what trading customers owe. That level exceeded those of larger competitors. The trading unit of Charles Schwab’s TD Ameritrade, for example, had six times the SEC minimum at Sept. 30.

A few months ago, groups of enthusiasts on Reddit began laying the groundwork for the frenzy that swept up Robinhood this week. In online postings, they identified favored short positions by hedge funds, eventually setting in motion a squeeze by bidding up shares of GameStop andAMC Entertainment Holdings Inc. to inflict billions of dollars in losses on money managers.

The degree to which traders relied on Robinhood to carry out their strategy is visible in data from Atom Finance, an investment researcher that plugs into its users’ brokerage accounts.

Just over half of Atom’s users who made trades at Robinhood on Wednesday were active in the volatile stocks that the brokerage ended up restricting one day later. About 17% of users adjusted bets on GameStop, and 25% on AMC.

DTCC’s Demands

But the stock moves had other repercussions. By around 10 a.m. on Thursday, theDepository Trust & Clearing Corp. demanded significantly more collateral from member brokers, prompting Robinhood and rivals to slam the brakes on certain trades. By the end of the day, industry-wide collateral requirements jumped to $33.5 billion from $26 billion — an already elevated level.

Robinhood drew at least several hundred million dollars from bank credit lines, a person with knowledge of the situation said that day. And several of its venture investors participated in a financing round. Robinhood has said it raised more than $1 billion, which it called “a strong sign of confidence from investors that will help us continue to further serve our customers.”

The company has been planning to hold an initial public offering this year. This week’s fundraising, structured as a convertible note, was priced at a discounted percentage to the upcoming IPO, according to people familiar with the matter, who asked not to be identified because the information was private.

Index Ventures,Ribbit Capital andSequoia Capital were among the venture investors involved in the effort, the people said. The final size of the financing is still being determined, one of the people said.

‘Rapidly Shifting Priorities’

While Robinhood works to shore up its finances, customers are furious.

At least18 lawsuits have been filed against the firm in California, Connecticut, Florida, Illinois, New Jersey, Oregon, Pennsylvania and Texas, mostly alleging trading limits amounted to a breach of contract.

Robinhood also was among a slate of entities issued a civil investigative demand by Texas Attorney General Ken Paxton because of this week’s investor restrictions. New York Attorney General Letitia James said she’s reviewing the brokerage’s actions. The SEC said it, too, is examining brokerages’ decisions to limit buying.

“There has been a lot of misinformation out there about why Robinhood did this,” Robinhood Chief Executive Officer Vlad Tenev told Bloomberg Television in aninterview this week. “We first and foremost did it to protect the firm and our customers.”

Robinhood’s job posting for a lobbyist underscores how much work it has ahead to patch things up with those clients and authorities.

“We are looking for a highly adaptable and collaborative person,” the ad reads. Someone “who can handle ambiguity and rapidly shifting priorities with flexibility and patience.”

— With assistance by Lananh Nguyen, Shahien Nasiripour, and Katie Roof

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