Just cuz' it smells like market manipulation, doesn’t mean it is...
It is much harder for Citadel to pull off market manipulation than the public thinks, and much easier for Robinhood to have simply made stupid decisions. Irrational decision ≠ conspiracy/collusion...
Let me start today’s long email with an overarching punchline from a bright friend of mine: We think institutions, politicians, executives and “the elites” at large all make perfectly rational decisions, so if they do something stupid or out of the ordinary, it must be that there is some conspiracy or coordinated effort to further advance their intersts.
But that’s often not true. We have powerful and supposedly knowledgable people making decisions every day whose payoffs are not worth the risks. Like when Trump lied about his inauguration crowd number, enacted the Muslim Ban, or refused to wear masks in public – these are things that yield little substantive progress towards his vision of MAGA, but highly costly and risky in terms of dramatically eroding public support.
These weren’t the hills Trump needed to die on, but he and his team of advisors went for them anyways. We can over-think all kinds of explanations as to why these decisions are in fact brilliant strategies made by rational minds, but the truth is – they’re probably just really stupid decisions that somehow got followed through.
This is how I view Robinhood’s decision yesterday and all the ensuing turmoil it caused.
What happened with Robinhood?
Yesterday morning, news broke that Robinhood blocked users from trading several “meme stocks” like GameStop that have been gaining incredible momentum from Reddit forums. They did so in name of consumer protection because of the significant market volatility today, as written in this blog post:
In light of recent volatility, we are restricting transactions for certain securities to position closing only, including $AAL, $AMC, $BB, $BBBY, $CTRM, $EXPR, $GME, $KOSS, $NAKD, $NOK, $SNDL, $TR, and $TRVG. We also raised margin requirements for certain securities.
Amid significant market volatility, it’s important as ever that we help customers stay informed.
You may read my full recap here about GameStop’s amazing rise and how the Reddit retail traders are literally forcing hedge funds to go out of business.
The rise of Reddit posed serious structural questions about financial markets and hedge funds’ market power, but it was mostly people commentating on Twitter and CNBC. What Robinhood did was fundamentally more serious – it’s essentially barring users from further driving up these stock prices, which is seen as a move to protect the big hedge funds who are hurting as the stocks go up. We saw politicians from Ted Cruz to AOC all saying Robinhood’s ban is unacceptable (yeah this is how bad it’s gotten).
Then, the situation further escalated when rumors started to go around that Robinhood made the decision in collusion with hedge fund Citadel and its billionaire founder Ken Griffin, who recently bailed out fellow hedge fund Melvin Capital Management – a direct target of Reddit’s campaign to drive up the GameStop’s stock price to hurt. This tweet below blew up:
I don’t think Ken Griffin is that stupid…
My first thought after reading Justin Kan’s tweet above was “It doesn’t really make sense for Ken Griffin to pressure Robinhood to delist the Reddit stocks because it’s a highly risky move with little payoff.” The compliance regime within any financial institutions today, and especially a top hedge fund like Citadel, is so complex that it would be very hard for Griffin’s team to pull off such a blatant market manipulation move without leaving any incriminating evidence (see section below for detailed explanation of how Citadel and Robinhood work and interact with each other).
At financial institutions, all employees’ text messages, emails, chats in various terminals, etc. are all permanently backed up by the firm’s compliance department and can be subpoenaed by regulators at anytime. Logistically, it is incredibly hard even for Griffin’s team members to coordinate a scheme without leaving a paper trail, let alone saying that multiple hedge funds coordinated to pressure Robinhood.
Now, it is entirely likely that the SEC or FBI end up finding incriminating evidence, and if that’s the case I’m all for bringing justice. But without any evidence, the claim – that Citadel pressured Robinhood to shut down trading for Reddit stocks while also making a profit through loading up short-selling shares – seems to be such a far-fetched rumor to me that doesn’t make much sense realistically.
Maybe Robinhood is just really stupid?
Probability wise, it’s much more likely that Robinhood just screwed up, plain and simple, rather than it was some sophisticated scheme by Griffin.
I think there are reasons that the Robinhood management thought were very legitimate that led them to shut down the trades. For one, because of all the extraordinary market volatility, these retail investors who frenzily chase the rise of GameStop have already attracted attention from the highest level of regulators from the SEC to Treasury Secretary Janet Yellen in the last two days.
If the “Reddit bubble” goes sideways, Robinhood would be slammed big time. Robinhood didn’t want to get in trouble with either the SEC or some other consumer protection watchdog, so they thought they were being smart preemptively shutting things down.
Plus, the market makers that Robinhood trade shares with are also getting hurt by the unprecedented market volatility. All this could pose some systemic risks to the market function, and it is not at all unreasonable to think that the Federal Researve might feel the need to step in and tighten up macroprudential policies.
In hindsight none of these reasonings were enough to justify Robinhood’s horrible decision that would probably only result in more regulator scrutiny and public backlash. But, preemptively, it did make sense, at least at some level, for Robinhood to have done what it did.
Why are people making such obviously stupid mistakes?
I’m essentially making two statements above:
It is much harder for Citadel to pull off market manipulation than the public thinks.
It is much easier for Robinhood to simply have made stupid decisions than the public thinks.
Given all the bad stuff that this all-emcompassing identity called “Wall Street” has done to this country, people want to see David (the Reddit retail traders) beat Goliath (the hedge funds), but they also really want to believe that there must be some backdoor scheme by these evil, corrupt billionaires who are coordinating a conspiracy against the markets.
The correlations are almost perfect: Robinhood is subject to the control of greedy, corrupt hedge funds like Citadel who have a vested interest in seeing these stocks tank, so if Robinhood delists the stocks after these hedge funds get hit massively by retail traders, it must be collusion.
Sure, that may be the case, but the line of logic doesn’t really hold when you take into account of all the nuances of how these complex financial behemoths actually operate on a day-to-day basis, and there’s actually little to no evidence that’s what happened. I will now explain in greater detail.
How Citadel and Robinhood work
Based on my very outsider understanding and my conversations so far with people that work in the industry: Citadel has two arms – first there is Citadel Securities, which is a market maker. Robinhood is a brokerage firm, so it goes to market makers like Citadel Securities to fulfill its retail traders’ orders. For example, say GameStop is actually trading at $300/290 ($300 to buy and $290 to sell), Robinhood would displays on its app that you can buy GameStop at, say, $295. Then, if 300 Robinhood users end up paying $1 million at that price, Robinhood would then take all these orders to an actual market maker like Citadel Securities to fulfill these orders, since these market makers literally make the market by trading and supplying shares.
Robinhood makes money by front running the orders they fulfill for their users, but then later making some profits through selling/buying the orders from market makers at a different price. The difference in prices is tiny, but the volume is huge, and that’s why Robinhood is able to offer zero-commission trading and still make money. They are thus democratizing stock trading because users don’t pay a fixed transcation fee.
This whole business model is vulnerable to volatility, and that’s why Robinhood might be legitimately worried about meeting their financial requirements, such as SEC net capital requirements and clearing house deposits, which would really fluctuate a lot based on the market volatility.
But anyways, besides Citadel Securities, there is Citadel – which is the asset manager/hedge fund that actually invests money into markets. Citadel Securities is run by Peng Zhao and not run by Ken Griffin, who runs the latter hedge fund. The branches are not supposed to talk to each other given the “Chinese wall” between the investing and market maker arms.
Griffin, and hence his hedge fund, is the one that injected liquidity for Melvin Capital recently. What Robinhood does (theoretically) should have no impact on Citadel’s hedge fund business; Robinhood talks to Citadel Securities the market maker… The added complexity is that Griffin injected liquidity to Melvin so he is now personally incentivized for the Reddit stocks to go down.
So how could have Griffin manipulated the market? He can either tell the market maker arm of Citadel to pressure Robinhood, since that’s the branch that directly supplies Robinhood. Or, maybe, he just happened to hear from Robinhood/his colleagues in the market maker arm that Robinhood was about to shut down trades for Reddit stocks, so he swooped in to short more shares and profit from the stock going down.
The former action is market manipulation; the latter is insider trading; both are incriminating. But the thing is, for Griffin, Citadel, and Citadel Securities to all come together to do either of this, it would require massive hurdles to get over various regulatory layers that are already built into the corporate structure. In other words, it would very likely leave so many traces that the SEC can find immediately. This is why I think it’s unlikely that Griffin actually committed anything illegal.
This thread is probably the best explanation of what happened if you’d like to read more:
To be continued…
I have to note that all this unfolded within the past 24 hours and we still don’t have enough information on what truly happened. If you disagree or have new information that may substantively contradict my arguments, I’m more than happy to update my stance/thoughts, so please feel free to supplement new information and voice your opinion on the matter.
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