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Meme stock madness – how the ‘superbroker’ business model challenges market infrastructure and risk management

Vinod Jain, senior analyst at Aite-Novarica Group, looks at how the meme stock events of January 2021 challenge the “superbroker” business model.

The “superbroker” business model pioneered by Robinhood took advantage of digital advancement, accelerated the adoption of gamification, revolutionised the account opening process and made it easier than ever to participate in the stock market. With so much to offer, it looked revolutionary and still is. But the meme stock events of January 2021 challenge the business model, revealing deficiencies exploited by this new generation of retail superbrokers.

In June 2022, the US House Financial Services Committee (Committee) published a report on the meme stock market event (MSME). It is noteworthy to share insights and views on various aspects of this report as below:

  • Payment for order flow (PFOF): Retail trading platforms provided commission-free trading to customers by routing customers’ orders to selective market-making firms in return for a fee, which is called PFOF. Most broker-dealers calculate PFOF rebates as a flat fee per share, but Robinhood had an innovative approach by calculating PFOF rebates on the spread between the purchase and sale price of each security. During the MMSE, the spread between buy/sell widened, forcing the broker-dealer to rush and renegotiate the PFOF amount with Robinhood.
  • Retail trading: Robinhood routed retail client orders to six market makers for equities: Citadel Securities, G1 Execution Services, Morgan Stanley, Two Sigma Securities, Virtu and Wolverine. During the MSME, Robinhood was not a member of any stock exchange and was not able to access public exchanges for liquidity to fulfill large orders. It was not under any regulatory burden to prove best execution to its clients. It took Nasdaq membership in April 2021.
  • Client Onboarding: Institutional client on-boarding systems struggle to onboard a single client on the same day, but Robinhood was able to attract 300,000 new account opening applications on 28 January 2021, which increased to 730,000 new accounts opening applications on 29 January. The superbroker system, which enables a fast and immediate account opening approval process, needs to have the ability to throttle the auto account creation/approval process during volatile market conditions.
  • NSCC Risk Management: The National Securities Clearing Corporation (NSCC) manages the credit risk posed by its members by calling for margins from members, maintaining a “Watch List” and an “Enhanced Surveillance List”, and levying Excess Capital Premium and Value-at-Risk charges. On 28 January 2021, the NSCC charged Excess Capital Premium aggregating $9.7 billion to six firms: Robinhood Securities, Axos Clearing, Instinet, Wedbush Securities, LEK Securities, and Vision Financial Markets. Robinhood managed its risk exposure based on the NSCC’s Value-at-Risk charge, but it did not consider NSCC’s Excess Capital Premium charge in its calculation.

The NSCC charged a $3.7 billion collateral charge to Robinhood on 28 January 2021, comprising the Value-at-Risk charge, which totaled $1.3 billion ($850 million from AMC and $250 million from GameStop, and the Excess Capital Premium charge, which totaled $2.3 billion. The curious event happened when the NSCC was able to provide a waiver to Robinhood on these charges from $3.7 billion to $1.4 billion, which resulted in a net margin deposit of $734 million. Looking at historic data from 1 January 2019 to 12 February 2021, eight firms accounted for ~90% of the Excess Capital Premium charged across 307 occasions. Such a high number of waivers tends to create an atmosphere of acceptable practices.

  • Trading restrictions: The fine print in the account opening terms and conditions allows Super brokers to have unlimited power over the account holdings. This was evident when Robinhood placed Position Closing Only (PCO) restrictions wherein account holders were not allowed to purchase certain stocks but could only sell the stocks. Along with Robinhood, other firms such as Interactive Brokers, Apex, Axos Clearing, and E*Trade also placed PCO restrictions on certain volatile stocks.

Given these consequences, it is not unlikely to expect that next will come a new series of regulatory measures and industry initiatives enabling authorities to be better placed in the future to oversee such MMSE – such as SEC regulations on PFOF, T+1 settlement, examination of the role of market makers, transparency in short-selling, and a review of gamification on retail investors.

The list is not over yet, as the recent market volatility in the crypto current market has also impacted institutional and retail investors. So, expect more regulations, and more industry initiatives, in this market.

Hopefully, however, the new regulations might also facilitate more innovation in retail trading.