Robinhood’s in better shape than it looks

So here we are: about to have a hearing about GameStonk. Robinhood CEO Vlad Tenev is going to have to explain himself tomorrow. What happens next for Robinhood?

Perhaps you recall last month, when GameStop stock shot up by as much as 500 percent, hitting a peak of $483 on January 28th, thanks largely to memes and a shitposting finance subreddit. (I’m sure there will be entire academic books written on r/WallStreetBets. There is a paper already.) Many of the retail traders involved in the GameStop buying frenzy were using Robinhood, and the company became part of the meme — even though it had to limit trades on GameStop. The run-up had a populist theme: the little guys were gonna show the hedge funds; they were gonna make those dang short-sellers pay. The GameStop meme was a ton of free publicity for Robinhood, though the public outcry about limited trades means the House of Representatives is now inquiring.

The House Financial Services Committee is going to have a hearing! This will be fun political theater, but it’s unlikely to have any kind of serious outcome. That’s probably why Robinhood is still planning to go public this year. Robinhood topped Apple’s mobile app store for days, and more than half a million people downloaded it, CNBC reports.

“They actually have an incredible opportunity with new users right now,” said Catherine Lamberton, a professor of marketing at the University of Pennsylvania’s business school, Wharton. The GameStonk saga is actually evidence that Robinhood has changed power dynamics in the market, she said. “They have an opportunity to keep growing with this.”

Sure, Robinhood limited GameStop trading near the peak, enraging some of its customers. But in March 2020, during the pandemic-related market crash, you may recall Robinhood had three major outages in a little more than a week. In some ways, this makes sense: Robinhood is a startup, and it was having a painful growth moment. At the time, Tenev and his co-CEO Baiju Bhatt chalked that failure up to “stress on our infrastructure.” They hadn’t predicted an event of that scale — and hadn’t planned for it. 

Of course, the more famous service outage didn’t happen until January 2021, but the basic contours are the same. Robinhood hadn’t planned for an event of that scale, and when the clearinghouses raised their cash requirements, whoopsies! If this had been Twitter, there would have been a fail whale. People get mad enough when social media networks go down — but this is money. Even so, what happened last March, and again around GameStop, fit into a larger pattern of tech startup behavior.

“This is a normal startup thing,” said Lana Swartz, an assistant professor of media studies at the University of Virginia and author of New Money: How Payment Became Social Media. Essentially, the move is to bring a platform to market, get it to scale, and worry about everything else later.

A lack of customer service is expected in social media companies, Swartz said. “But as Silicon Valley companies are trying to take over more and more parts of our life, that modus operandi — ‘Sorry, we don’t work now and you signed the terms of service, so it’s on you! You consented to this!’ — that way of doing things isn’t going to cut it,” Swartz said. That’s why the most interesting questions at the hearing are likely to be about the terms of service agreement, not hedge funds, short-sellers, or payment for order flow.

The question here is what small investors were led to believe and what actually happened, said Anat Admati, a professor of finance and economics at the Stanford School of Business. Robinhood does say in its terms of service that it can decline trades — but how many of its users read the terms of service? “The broader issue is that we agree to all kinds of things online,” Admati said in a telephone interview.

What’s more, with complex financial transactions, “we’ll work out the details later” is difficult to pull off, Lamberton said. “This isn’t an area where one can dabble,” she said. Lamberton wants to know how Robinhood might handle a similar mass retail event in the future: is it its goal to never let the GameStop situation happen again? Or would it instead figure out how to let mass retail events occur without its own internal system capsizing? “That decision will change their platform and also how they fit with Wall Street,” she says.

There are a lot of free things online, and the question is always how they make money, Admati said. In Robinhood’s case, that will be one of the subjects House politicians are likely to dive into — a controversial practice called “payment for order flow.” This allows market makers to bundle trades and make money through arbitrage. It could also theoretically let banks front-run retail investors, a practice which is illegal. Also, as Bloomberg’s Matt Levine notes: “The wholesaler is ordinarily filling your order at a price that is better than what’s available in the public market, so ‘front-running’ — going out and buying on the stock exchange and then turning around and selling to you at a profit — doesn’t work.”

The guest list suggests this is where we will focus. There is, first of all, Citadel Securities, which does payment for order flow for brokerages that include Robinhood. There is Melvin Capital, a hedge fund that was fabulously successful last year and had to be bailed out this year due in part to its GameStop short positions. Citadel, a hedge fund, bought a stake. To make matters more confusing, Citadel and Citadel Securities are not the same thing, though they were founded by the same guy, Ken Griffin. 

The thing about payment for order flow is that Robinhood makes money when people make more trades. The company sends push notifications about positions you own, and you can set up custom price targets if you like to receive more. This is only a problem for Robinhood’s users; in general, day traders mostly don’t make money.

This is particularly true for Robinhood, actually! During “herding events” like GameStonk, when Robinhood traders crowd into a stock, “large increases in Robinhood users are often accompanied by large price spikes and are followed by reliably negative returns,” the authors of a study on Robinhood users write. Another paper views Robinhood traders as, essentially, noise.

Focusing on a hedge fund conspiracy is missing the point. Robinhood and Citadel Securities make money when people trade. It is reasonable to ask whether to limit push notifications that might prompt people to impulse-trade.

We will also hear from the Reddit representatives, CEO Steve Huffman and r/WallStreetBets user Keith “DeepFuckingValue” Gill, also known as Roaring Kitty on YouTube. I imagine this will be about day trading, and someone will have to explain r/WallStreetBets, which: good luck! I hope Gill wears his formal headband.

It’s possible Tenev will have a disastrous performance, setting Robinhood up for a world of hurt. But the questions focused on payment for order flow, hedge funds, and whether short-sellers are evil (they aren’t!) will miss the Silicon Valley thing. Part of the problem was the terms of service agreement itself — no one reads them. Robinhood absolutely had the right to restrict trades, and furthermore, Robinhood is not liable for service failures regardless of cause, including those caused by software malfunctions. There is also an arbitration clause. 

What I’m getting at here is that Robinhood doesn’t have to change anything. It’s scaling rapidly. Users have agreed it can have whoopsies whenever it likes. Robinhood makes money regardless of whether its users do. Disputes go to arbitration, not court. Investors are piling in. If Tenev can ride out this hearing (and perhaps a similar one from the Senate), he’s in an excellent position for an IPO. All he has to do is let the politicians get their soundbites and not say anything horrible, and he wins.

Robinhood ran a Super Bowl ad celebrating its customers. If that’s not confidence, I’m not sure what is.