Robinhood and Gamestop: a cautionary tale - Initio

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Robinhood and Gamestop: a cautionary tale - Initio
Robinhood and Gamestop:
   a cautionary tale

      Laurens Verelst – Renaud Joseph
          INITIO Groupe Square
Robinhood and Gamestop: a cautionary tale - Initio
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

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Robinhood and Gamestop: a cautionary tale - Initio
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.
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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

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Robinhood’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.
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Appendix 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

                                                                                                   5
RKT    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)

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TMBR    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.

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Appendix 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.

                Maxime Liénart has over 5 years of experience in Asset Servicing
                and Global Custody with roles combining both operational
                coordination (orders processing and monitoring) and client knowledge
                as their dedicated representative. He serviced and built a solid
                relationship with a broad range of institutional investors, and
                specialized more recently in the Luxembourg offshore funds industry.

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About 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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