The Real Reason Robinhood Blocked Trading On GameStop

The Real Reason Robinhood Blocked Trading On GameStop
Reda Farran, CFA

about 3 years ago4 mins

Mentioned in story

What’s going on here?

Internet sleuths have been hard at work attempting to explain exactly why several online brokers, including Robinhood, prevented users from buying stakes in certain stocks last week.

Many theories have focused on Robinhood’s relationship with Citadel Securities. Not to be confused with the related but separate hedge fund called Citadel, this is the “market-making” firm that pays Robinhood for the privilege of processing its customers’ trades. But with misunderstanding rife regarding how market makers work and the nature of their incentives, I thought it’d be worth diving into the details – and explaining why these companies are unlikely to have been behind last week’s blockages.

What does this mean?

When you place an order with a broker to buy a certain number of shares in a particular company, there aren’t always other investors willing to sell sufficient shares at that exact moment in time. Given the thousands of stocks out there, such an expectation is clearly unrealistic.

That’s where market makers come in: they literally “make a market” by always standing ready to buy or sell shares whenever you want to make a trade. They create this liquidity by keeping “inventory” on hand: both shares to sell to potential buyers and cash to buy shares from those seeking to sell.

Market makers regularly update two prices throughout the trading day: “bid” (the price at which they’ll buy specific shares) and “ask” (the price at which they’ll sell them). They make money by way of the difference, or “spread”, between that bid and ask.

And the bigger the risk in making a market in a particular stock (when, for example, it’s infrequently traded and/or its price is highly volatile), the wider the spread. In extreme cases, however, market makers might view the risks of making a market in a particular stock as simply too high – and refuse to trade it as a result.

Source: EDUCBA
Source: EDUCBA

There are also occasions when market makers just don’t have enough share inventory to sell to everyone who wants to buy a certain stock. In such cases, they might take out what’s known as a “naked short”: selling shares they don’t yet own, in contrast to a normal short (which involves borrowing the shares first). These naked shorts usually only exist for a matter of moments before the market makers find someone to buy more shares from.

It’s now illegal for hedge funds and other big institutional investors to don naked shorts. In theory, at least, only market makers are allowed to use them – and purely for the sake of providing liquidity. The big risk, however, is that they get caught with their pants down: having a naked short and then receiving a huge order that moves the price of the underlying stock up can quickly lock in big losses.

This risk is what makes managing brokers’ orders so valuable to market makers. For a firm like Citadel Securities, coughing up such “payment for order flow” from Robinhood is worth it: the company can thereby process lots of small trades in a way that won’t leave it caught (naked) short. As a result, Citadel Securities now handles around 40% of all US retail trading by volume.

In summary, executing retail trades is a very low-risk way for market makers to do business. And since market makers typically offer retail investors a better price than if they’d gone to the actual stock market – not least by subsidizing their trading fees – it’s a win-win situation. Until it isn’t…

Why should I care?

Remember, market makers have no particular interest in owning or shorting a stock. They’re simply out to make money from the bid-ask spread – and the more trading volume they handle, the more they make. The wider spread on highly volatile stocks also means that volatility is, if anything, a plus for market makers.

Firms like Citadel Securities therefore have no reason to stop trading such shares unless and until volatility grows so extreme that making a market is too risky. And even then, they wouldn’t stop just one side of a trade – refusing, for example, to sell and only buying the stock instead. That would quickly tilt their inventory in one direction, and taking such a position on shares isn’t what market makers are about.

So did Citadel Securities tell Robinhood to stop taking buy orders on certain hyped-up stocks? We may never know for sure – but both firms have denied it, and as we’ve outlined there doesn’t appear to be any ulterior motive for that happening.

In an interview with Elon Musk over the weekend, Robinhood’s CEO instead cited a sudden decision by its clearing house to up the broker’s capital requirements – something which can happen where there’s risky over-concentration in certain volatile stocks. The only way Robinhood could apparently decrease those reserve demands was by blocking further related buy orders. Mystery solved?

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