Vinod Jain, senior analyst at Aite-Novarica Group, looks at how the meme stock events of January 2021 challenge the “superbroker” business model.
The “super broker” business model pioneered by Robinhood took advantage of digital advancement, accelerated the adoption of gamification, made it easier than ever to participate in the stock market, and revolutionized the account opening process to commission-free trading.
With so much to offer, it looked revolutionary—and it still is. But the meme stock event in January 2021 challenged the business model and revealed deficiencies that were exploited by a new generation of super broker retail trading platforms.
In June 2022, the U.S. House Committee on Financial Services published a report on the Meme Stock Market Event (MSME).
The report shared insights on various aspects of this incident, including:
- 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, calculating PFOF rebates on the spread between the purchase and sale price of each security. During the MSME, 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 & Co., 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 the regulatory burden to prove the best executions to its client. It took Nasdaq membership in April 2021.
- Client Onboarding: Institutions’ client onboarding systems struggle to onboard a single client on the same day, but Robinhood was able to attract 300,000 new account opening applications on January 28, 2021. This increased to 730,000 new accounts opening applications on January 29, 2021. The super-broker system enables an immediate account opening and approval process, but the super broker also needs to be able to throttle that process during volatile market conditions.
- NSCC Risk Management: 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 January 28, 2021, NSCC charged Excess Capital Premium, aggregating US$9.7 billion to six firms: Robinhood Securities, LLC; Axos Clearing LLC; Instinet, LLC; Wedbush Securities Inc.; LEK Securities Corporation; and Vision Financial Markets LLC. 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. NSCC charged a US$3.7 billion collateral charge to Robinhood on January 28, 2021, comprising the Value-at-Risk charge, which totaled US$1.3 billion (US$850 million from AMC and US$250 million from GameStop stock), and the Excess Capital Premium charge, which totaled US$2.3 billion. The intriguing event happened when NSCC was able to provide a waiver to Robinhood on these charges, from US$3.7 billion to US$1.4 billion, which resulted in a net margin deposit of US$734 million. Looking at historic data, from January 1, 2019, through February 12, 2021, eight firms accounted for about 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.
Next comes the series of regulatory measures and industry initiatives to be better placed in the future to oversee similar MSMEs—such as SEC regulations on PFOF, T+1 settlement, examination of the role of market makers, transparency in short-selling, and review of the gamification super-broker business model targeting retail investors.
The list is not over yet; the recent volatility in the cryptocurrency market has also impacted institutional and retail investors. Expect more regulations and more industry initiatives to emerge in this market, too.
Hopefully, these regulations will facilitate more innovation in retail trading.