In the hours leading up to the dawn of January 28, 2021, financial trading firm Robinhood faced a $ 3.7 billion margin call from the clearing house that liquidates its clients ’operations.
For every trade that Robinhood provides, you must have sufficient reservations, issued as security, for the two days it takes to settle. The problem was that Robinhood only had $ 700 million for the guarantee: $ 3 billion was missing and it only had a few hours to get the rest of the money.
Retailers were using the app to buy tons of volatile meme stocks like GameStop and AMC Entertainment, raising their prices in attempts at short releases, which meant Robinhood had to issue proportional amounts of collateral to stay solvent until these operations are resolved.
In the hours between the clearing house notice, first sent at 5:11 a.m., Eastern United States time, and the 10 a.m. deadline for the margin call, Robinhood executives pressured the clearing house for clemency and simultaneously tried to raise money.
Lobbying and fundraising efforts worked. The company also abruptly stopped trading volatile stocks like GameStop during the day, which limited its own immediate risk, but caused a stir in its customers and a hearing and investigation in Congress.
Last week, more than a year after GameStop’s brief pressure was front-page news, Democratic staff of the U.S. House Financial Services Committee released the results of their investigation (pdf), showing exactly how Robinhood averted the financial disaster in a day he should have. passed below.
How Robinhood makes money
If you’ve bought or sold stocks in recent years and your broker didn’t charge you to do so, you’ll probably have to thank Robinhood. Robinhood pioneered non-commissioned securities trading through a business model called order flow payment (PFOF). The company’s popularity among retail investors forced established brokers such as Fidelity and Charles Schwab to eliminate trading commissions in 2019.
In fact, Robinhood does not make transactions for its customers. Rather, it sells its customers ’orders to so-called market makers like Citadel Securities and Two Sigma Securities, which compete to complete those orders.
However, Robinhood must issue a guarantee for its clients ’operations to the National Securities Clearing Corporation (NSCC), which is a division of the Depository Trust & Clearing Corporation (DTCC), the largest securities clearing house. of the USA. The DTCC is a private company that is heavily regulated by the U.S. Securities and Exchange Commission.
A phone call and a fundraising round
At 7:15 a.m. on the day of the margin call, Robinhood legal director Dan Gallagher made a phone call to an unnamed deputy attorney general of the DTCC, according to the House investigation. Gallagher is a former Republican commissioner of the SEC, the DTCC’s chief regulator. He and the DTCC official were “professionally known,” the report says, noting that the two had previously worked together in a law firm. In the call, Gallagher asked that the matter be explained to senior DTCC officials “to discuss how to obtain relief, resignation or exemption.”
At 9:11 a.m., and after several more phone calls between Robinhood and DTCC officials, Robinhood’s security deposit requirements were reduced from $ 3.7 billion to $ 1.4 billion, still leaving the company $ 700 million short.
The justification for granting billions of dollars in exemptions was not explained. According to the report, the DTCC’s director of market risk “conveyed that Robinhood’s surplus capital premium charge was being reviewed to adjust it downwards without commenting on why it was being reviewed or what Robinhood would qualify. for a downward adjustment “.
While Gallagher was negotiating with the DTCC, Robinhood chief financial officer Jason Warnick was calling for investors. By 10 a.m., Warnick had raised $ 1 billion in new investments. He continued to raise funds after the January 28 deadline. As of Jan. 30, the company had raised a total of $ 3.5 billion.
Without this two-pronged approach, Robinhood would have predetermined the DTCC as Lehman Brothers did during the 2008 financial crisis. When a default occurs, the clearing house “takes control of the member’s default portfolio and liquidates it,” he says. the report, to reduce risk to the broader financial system.
The unlikely survival of Robinhood
That Robinhood could get out of this debacle was nothing more than a miracle, says Tyler Gellasch, executive director of the Healthy Markets Association, a commercial group of investors and a former Senate and SEC attorney.
“It’s the equivalent of a four-engine plane that loses all four engines at 30,000 feet and lands safely,” Gellasch says.
Gellasch is critical of the deficiencies in risk management that contributed to Robinhood’s problems. He attributes the survival of the company to his political knowledge. “This shows the power of having an extraordinarily politically connected executive to your team,” he said.
Robinhood’s failure could also have had serious consequences for the broader financial system.
“There’s really no precedent for a company like Robinhood to fail,” Gellasch says. “The sudden collapse of a broker with millions of accounts could very easily have been the spark that ignited a wider market disruption.”
James Tierney, a professor of securities law at the University of Nebraska College of Law and a former SEC attorney, says that while default is a big threat to small brokers, Robinhood seemed confident that, in a sense, it was too big to fail.
“It reminds me of the old saying,‘ If you owe a million dollars to the bank, that’s your problem, but if you owe a billion dollars, that’s your problem, ’” he says.
In an internal message obtained by the congressional committee, Robinhood president and chief operating officer David Dusseault told a colleague that the company could navigate the requirements of the Clearing House. “It simply came to our notice then [sic] great for closing us in, ”he wrote.
In an email to Quartz through a spokesman, Robinhood’s deputy general counsel Lucas Moskowitz says the House committee’s investigation report is “nothing new, confirming once again that January of 2021 was an extraordinary event, once in a generation, that emphasized all market stakeholders. “
Six months later, in July 2021, Robinhood went public and raised nearly $ 2 billion more for its coffers.