Robinhood and Gamestop: a cautionary tale - Initio
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Robinhood and Gamestop:
a cautionary tale
Laurens Verelst – Renaud Joseph
INITIO Groupe Square
Contents
Introduction ......................................................................................................... 2
The players........................................................................................................ 2
The bet ............................................................................................................. 2
The consequences .............................................................................................. 3
Last update ....................................................................................................... 3
The future ......................................................................................................... 3
Appendix 1: List of potential targets for short-sellers (Feb 12, 2021) ........................ 5
Appendix 2: GME - short volume (Jan 26 – March 03, 2021) .................................... 8
About the author ................................................................................................... 8
About Initio .......................................................................................................... 9
Contact ............................................................................................................. 9
Initio Belgium ................................................................................................. 9
1
Introduction
In our previous article (“Robinhood, a force to be reckoned with”, December 2020) we
briefly talked about a growing group of amateur traders disrupting long-standing norms in
capital markets. We concluded that these traders could have a significant impact on the
behavior of small cap stocks and warned short sellers of what we called the “Robinhood
effect”. This phenomenon was again at play last month with the short-squeeze of
GameStop, and the ensuing trading halt unilaterally decided by the discount online broker.
The players
All the elements required to provoke the explosive situation that made the headlines in
the news. First of all, a company with a failing business model. GameStop (GME), a listed
company renting video games through a network of physical stores was a perfect
candidate at a time where pandemic restrictions and online gaming are the norm. At the
time of the bet, GME’s decreasing expected earnings were correctly reflected in its falling
stock price. Second, Melvin Capital, a powerful hedge fund, one of whose strategies is to
bet against such distressed companies by massively short-selling its stocks. Third, Citadel
Securities, a market-maker which Robinhood uses to route and execute trades on their
behalf on the market. Lastly, a group of Redditors 1, passionate about financial bets and
determined to counter the plans of the biggest market players, by instigating a coordinated
purchase of a company such as GME. Finally, Robinhood, a low-cost US brokerage app
targeted at millennials which makes the connection between the 3 aforementioned players.
The bet
The story begins when a group of wannabe traders led in this case by a Reddit well-known
member and deep value investor decided to poke fun at short-sellers in the market and
collectively invest their “game” money into a failing company. If there was some rationality
behind this particular bet, it would be the onboarding of Ryan Cohen on the board of
directors of GameStop. Cohen was the former CEO of Chewy - a very successful online
company selling pet toys and accessories - who gave credibility to the promise of turning
GME into an e-commerce giant. However, in this case most of the frenzy probably arose
from enthusiastic posts on subreddit r/ WallStreetBets stirring the forum members into
pumping a cheap stock for the pure fun of it. The group of Redditors directed their purchase
at GameStop, so as to counter short-sellers in the market, in this case Melvin Capital, a
hedge fund who took the opposite side of the bet.
How does this work? Short sellers look at a company’s fundamentals, try to correctly
identify companies on the verge of bankruptcy and then bet against those companies on
the market. They do this by borrowing shares, which they immediately sell on the open
market hoping to buy these shares back later at a lower price before returning them to
the borrower. In the GameStop story, this bet went fantastically south for the hedge fund
when GME’s stock price was multiplied by a factor of five in just a few days. At this time,
the short-seller starts to feel “squeezed” because his cost of borrowing is going up
drastically. Indeed, shorting a stock is not free, the short-seller needs to borrow the shares
from a broker at a cost. As the company’s stock price increases, the seller’s exposure
increases and the borrower pressures to get his stocks back. The borrowing cost increases
further and further as the stock price goes up and the short-seller has to post even more
collateral. This could ultimately force him to close his short position by buying back the
stock at an inflated price with the direct consequence of pushing the stock price even
higher.
However, in this specific case, most Redditors did not buy GME stock directly but call-
options on the stock, which tremendously magnified the effect of the short squeeze (this
is called a “gamma trap” in the financial jargon).
1
Reddit is a social news aggregation, web content rating, and discussion website. Users
of this social network are called Redditors.
2
At the end of the day, Melvin Capital and other big short-sellers lost around $20 billion
with this particular trade.
The consequences
To understand the consequences of this story we first need to understand the rules of the
game. The business model of Robinhood is quite simple: they make money by routing
transactions originated in its platform to large brokerage companies who then compensate
Robinhood for the additional trading volume. The larger the number of trades, the better
for Robinhood. Moreover, the discount trading firm also allows its customers to use
leverage by offering them to leverage up to two times the amount of equity on their trading
account. This lending operation is also a source of money for Robinhood, but forces the
company to comply with additional margin requirements.
As we explained before, this frantic buy of a thinly traded stock like GME indeed caused
intense volatility on the market and increased activity on the Robinhood app. At some
point, Robinhood was thus required by the NSCC (National Securities Clearing Corporation)
to post an additional $3 billion collateral in its margin account to hedge against potential
default. At that time Robinhood took the decision to halt all trading on GME stock, with
the goal of removing these volatile stocks off its balance sheet thereby reducing the
company’s overall risk exposure. In addition, the company drew on a line a credit from six
different banks to meet higher margin or lending requirements.
This halt on trading prevented a lot of willing investors to buy or sell certain securities via
the Robinhood app, among which GME stocks. This led to a loud revolt against Robinhood
in the news and online forums, accusing the platform to protect hedge funds by restricting
trading. Some investors even filed class-action lawsuits against the discount-broker for
violating its fiduciary obligations towards its clients.
Last update
Last week, the share price of GameStop surged again. Opening at just under $45 last
Wednesday, GME rose by 50% during the day, and even reached $170 on Thursday. It is
still not clear why such a rally happened. One possible explanation is the recent company
announcement that Ryan Cohen, who is a major shareholder in GameStop, an activist
investor and a well-known Redditor, joined the company’s board to speed up the retailer’s
transition towards a digital model of video games distribution. This news along with a
mysterious tweet from Cohen could have signaled the new bullish sentiment for GME’s
share price. Then the buying frenzy resumed as followers of the stock and r/WallStreetBets
Redditors encouraged others to buy and hold GME, in the hope that they could secure
again a hefty return, given how famously well the share did last time around (at least
before the crash). The extra volatility in GME and other stocks led to outages on Reddit
platform and periodic trading halts by the New York Stock Exchange. Robinhood
commented that this would impact all brokerages, but that it had not paused trading.
The future
This raises some important questions for the current business model of the asset
management industry and the way banks and asset managers will conduct business and
approach customers in the future.
The first set of questions will be directed towards the necessity to enlarge the scope of
companies targeted by stricter transparency requirements to all market players, including
online brokers. In the present case, Robinhood was indeed already charged by the SEC in
the past for misleading customers about its revenue sources and failing to satisfy their
duty of best execution. The payment for order flow model was not advertised to clients
either. Furthermore, if the possibility of a unilateral trading halt was indeed disclosed in
3Robinhood’s terms and conditions 2, it left quite a bitter aftertaste in many investors’
mouths at the time of the decision. This calls for greater clarity around the wording used
in the contract, and the way one could formally “agree” on the terms and conditions.
Second, we need to balance the advantage for the end-client to enjoy a cheap and
convenient way to access markets from the comfort of their home with the necessity to
protect the retail investors sometimes against themselves. By allowing its users to
leverage their trades and by failing to test their knowledge and experience in complex
financial products such as options, Robinhood was encouraging unknowing customers to
engage in risky trades. By contrast in the EU, MiFID regulation imposes those clients to fill
out appropriateness tests before being granted access to these complex products. On one
dramatic occasion this led to the suicide of one young Robinhood user who incorrectly
believed he was losing a large amount of money on one trade involving a call option. The
company’s aggressive marketing of options will probably fall under the regulator’s spotlight
in the coming months, and probably be one additional element in the legal investigation
of this case.
Third, the conflict of interest. As mentioned earlier Robinhood’s business model relies on
payment for order flow. This creates a conflict of interest between the broker and its clients
because it incentivizes the broker to execute its clients’ orders with counterparties based
solely on their willingness to pay commissions. In this respect, trading options is even
more lucrative for these companies than trading classical equities: as options are traded
less frequently, there is a larger bid-ask spread for these kinds of securities, and thus a
larger potential profit for the broker. By directing trades orders exclusively to Citadel,
Robinhood allowed a situation where Citadel could front-run trades i.e., know which trades
will be executed and act accordingly. In essence, Citadel was thus buying information from
Robinhood to inform on their own trades. Meanwhile in Europe this payment for order flow
model and its inherent conflict of interest is clearly limited under MiFID II regulation:
“MiFID II also limits the possibility for brokers to receive any remuneration, discount or
non-monetary benefit for routing client orders to execution venues, there is a clear onus
on firms to ensure that the execution quality achievable at a venue is the driver for sending
client orders to such a venue – and not any payment for order flow.”3
Lastly, this cautionary tale also illustrates the unprecedented and intricate connections
between social networks and market finance. If the cross-incentives between Citadel and
Robinhood pose questions, should we also consider such “pump and dump” game played
by bored Redditors as market manipulation?
Whether big incumbent players like it or not, the trend to diversify savings into discount-
online brokers is here to stay, and it challenges the way future relationships between
clients, brokers and companies will be established in a world where the classical trusted
intermediary is disappearing.
2
Robinhood’s terms and conditions document reads (p.11) : “Robinhood may, in its
discretion, prohibit or restrict the trading of securities, or the substitution of securities”,
https://cdn.robinhood.com/assets/robinhood/legal/Customer%20Agreement.pdf
3
ESMA, 2016 Global Capital Markets Conference. Perspective from the Buyside,
December 2016.
4Appendix 1: List of potential targets for short-sellers (Feb 12,
2021)
As we mentioned, being a company with an obsolete business model, a thinly traded low-
price stock, and a high short-interest, GME was only one of the potential targets for a
short-seller. As a means of illustration, we display below a list of the top 50 companies
with short interest higher than 20%, an indicator of companies which could suffer the
same fate as GameStop.
Ticker Company Exchange Short Float Outstanding Industry
Interest shares
GME GameStop Corp. NYSE 41.95% 51.03M 69.75M Retail (Technology)
SKT Tanger Factory NYSE 40.86% 90.14M 93.47M Real Estate
Outlet Centers Operations
ISUN iSun Inc Nasdaq 39.72% 1.70M 5.31M Renewable Energy
Equipment &
Services
LGND Ligand Nasdaq 38.91% 15.34M 16.08M Biotechnology &
Pharmaceuticals Drugs
Inc.
KOSS Koss Nasdaq 38.16% 1.98M 7.62M Household
Corporation Electronics
TRIT Triterras Inc Nasdaq 37.73% 23.25M 83.20M Fintech
GSX GSX Techedu Inc NYSE 36.31% 128.58M 128.69M Personal Services
CLVS Clovis Oncology Nasdaq 35.78% 80.68M 103.20M Biotechnology &
Inc Drugs
FIZZ National Nasdaq 34.91% 11.65M 46.65M Non-Alcoholic
Beverage Corp. Beverages
AXDX Accelerate Nasdaq 34.73% 30.82M 57.03M Scientific & Technical
Diagnostics Inc Instruments
GOGO Gogo Inc Nasdaq 33.49% 33.26M 85.25M Communications
Services
SPWR SunPower Nasdaq 31.93% 80.92M 170.16M Semiconductors
Corporation
OTRK Ontrak, Inc. Nasdaq 31.91% 7.41M 17.42M Healthcare Facilities
LAZR Luminar Nasdaq 31.35% 34.38M 218.82M Electronic Equipment
Technologies Inc & Parts
5RKT Rocket NYSE 31.33% 112.90M 100.37M Consumer Lending
Companies Inc
TR Tootsie Roll NYSE 31.10% 16.11M 39.34M Food Processing
Industries, Inc.
PGEN Precigen, Inc Nasdaq 30.28% 78.76M 178.60M Biotechnology &
Medical Research
SRG Seritage Growth NYSE 28.26% 34.27M 38.64M Real Estate
Properties Operations
VXRT Vaxart Inc Nasdaq 28.20% 108.76M 109.47M Biotechnology &
Medical Research
BBBY Bed Bath & Nasdaq 27.78% 114.36M 126.01M Retail (Specialty
Beyond Inc. Non-Apparel)
REV Revlon Inc NYSE 27.64% 6.81M 53.33M Personal & Household
Products
RVP Retractable AMEX 26.89% 14.48M 33.82M Medical Equipment,
Technologies, Supplies &
Inc. Distribution
PETS Petmed Express Nasdaq 26.63% 19.59M 20.27M Retail (Drugs)
Inc
MDGL Madrigal Nasdaq 26.06% 10.10M 15.44M Biotechnology &
Pharmaceuticals Medical Research
Inc
APT Alpha Pro Tech, AMEX 25.72% 11.53M 13.58M Medical Equipment,
Ltd. Supplies &
Distribution
BLNK Blink Charging Nasdaq 25.54% 34.06M 35.95M Utilities - Electric
Co
VTVT vTv Nasdaq 25.39% 12.96M 44.68M Biotechnology &
Therapeutics Inc Medical Research
OPK Opko Health Inc. Nasdaq 25.34% 404.66M 670.00M Biotechnology &
Drugs
ICPT Intercept Nasdaq 25.32% 27.50M 32.99M Biotechnology &
Pharmaceuticals Medical Research
Inc
LCI Lannett NYSE 25.11% 31.18M 41.40M Biotechnology &
Company, Inc. Drugs
SRNE Sorrento Nasdaq 24.96% 240.43M 262.94M Biotechnology &
Therapeutics Inc Medical Research
OXBR Oxbridge Re Nasdaq 24.57% 3.96M 0K Insurance -
Holdings Ltd Reinsurance
CVNA Carvana Co NYSE 24.16% 68.55M 69.43M Retail (Specialty
Non-Apparel)
6TMBR Timber AMEX 23.96% 6.41M 12.03M Biotechnology &
Pharmaceuticals Medical Research
Inc
IRBT iRobot Nasdaq 23.74% 27.47M 28.13M Electronic Equipment
Corporation & Parts
WKHS Workhorse Nasdaq 23.52% 109.72M 120.53M Auto & Truck
Group Inc Manufacturers
RUBY Rubius Nasdaq 23.40% 32.55M 80.92M Biotechnology &
Therapeutics Inc Medical Research
KNDI Kandi Nasdaq 23.29% 57.89M 72.38M Auto & Truck
Technologies Manufacturers
Group Inc
FUBO Fubotv Inc NYSE 23.20% 87.76M 67.56M Online Services
SDC SmileDirectClub Nasdaq 23.03% 91.37M 113.55M Medical Equipment,
Inc Supplies &
Distribution
RVLV Revolve Group NYSE 22.89% 25.54M 25.75M Retailers -
Inc Department Stores
SCVL Shoe Carnival, Nasdaq 22.78% 8.61M 14.10M Retailers - Apparel &
Inc. Accessories
DVAX Dynavax Nasdaq 22.76% 98.44M 110.17M Biotechnology &
Technologies Medical Research
Corporation
EBIX Ebix, Inc. Nasdaq 22.55% 25.35M 30.96M Computer Networks
TLRY Tilray Inc Nasdaq 22.48% 136.83M 158.26M Pharmaceuticals
KPTI Karyopharm Nasdaq 22.10% 64.23M 73.60M Biotechnology &
Therapeutics Inc Medical Research
INO Inovio Nasdaq 21.31% 203.25M 204.55M Biotechnology &
Pharmaceuticals Medical Research
Inc
OMER Omeros Nasdaq 21.04% 58.94M 61.65M Biotechnology &
Corporation Drugs
CEMI Chembio Nasdaq 20.89% 17.37M 20.18M Pharmaceuticals
Diagnostics Inc
BKE Buckle Inc NYSE 20.89% 29.06M 49.41M Retail (Apparel)
Source: https://www.highshortinterest.com/all/2, Feb 12, 2021.
7Appendix 2: GME - short volume (Jan 26 – March 03, 2021)
(Source: http://shortvolumes.com/?t=GME, March 2nd, 2021)
About the author
Laurens Verelst joined Initio in 2018 after having worked as a
financial management consultant for two years. He is a CFA level III
candidate who is passionate about everything related to the
investment management industry ranging from new trading &
investment strategies to technological advancements like robo-
advisors. He has a soft spot for fund and portfolio management and
the academical and technological advancements that could propel the
industry forward.
Renaud Joseph joined Initio in 2020. He worked for more than 3
years at the Bank of New York in the collateral management
department. He is passionate about a multitude of fields of finance
such as asset management, risk manage
8About Initio
Initio is an international business consultancy firm specialized in management and
strategy. Every day, our consultants contribute to the successful delivery of your
business projects.
Initio operates in Brussels and Luxembourg and his part of the SQUARE GROUP, an
international strategy and management consulting firm.
Contact
Initio Belgium
Boulevard General Wahislaan, 17
Brussels, 1030
Belgium
+32 (0)2 669 77 44
brussels@initio.eu
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