The major players in the GameStock saga faced tough questions from members of the House Financial Services Committee on Thursday, as the rapid rise and collapse of the videogame retailer’s stock has shined a spotlight on some of the more obscure, and some would argue troubling, aspects of equities-market structure in the U.S.
Robinhood Chief Executive Vlad Tenev defended his company’s decision in late January to temporarily restrict trading in so-called meme stocks, including GameStop Inc. GME, -11.43%, as necessary for meeting collateral requirements at its clearinghouse.
“Any allegation that Robinhood acted to help hedge funds or other special interests to the detriment of our customers is absolutely false and market-distorting rhetoric,” he said.
Ken Griffin, founder of Citadel Securities, a major source of revenue for Robinhood, also denied that he had any influence on this decision. Griffin’s hedge fund recently made a large investment in GameStop short-seller Melvin Capital, and this arrangement led to allegations that Robinhood was influenced by its relationship with Griffin.
The practice of payment for order flow, whereby market makers like Citadel Securities pay stock brokers like Robinhood to route customer orders their way, was a major focus on the hearing.
Rep. Brad Sherman, a California Democrat attacked these arrangements, saying “Everybody I’ve talked to in this industry says when you’re broker is being paid for order flow you get a worse execution.” He added that a zero-commission trading model creates a system where “you’re the product,” while market makers are the true customer.
Griffin countered by pointing out that trading costs in terms of both bid-ask spreads and broker commissions have steadily come down in recent decades. “It has allowed the American retail investor to have the lowest execution cost they’ve ever had in the history of U.S. financial markets,” he said.
Legislators keyed in on the importance of options trading to Robinhood’s revenue model. Rep. Sean Casten, the Illinois Democrat noted that prior to 2018, Robinhood’s revenue per user was fairly steady at about $10 per user per year. After it started offering options in 2018, revenue per user rose sharply, reaching $50 a year for each user in 2020, “consistent with taking on options,” he said.
Indeed, regulatory filings show that Robinhood earned roughly two-thirds of its payment-for-order-flow revenue from options trading, even though it involved only 13% of its customers.
Rep. Joyce Beatty, an Ohio Democrat, noted Robinhood gets paid “much higher” rates than its competitors for order flow, and she asked why companies like Citadel pay a premium for Robinhood trades. Tenev said it’s because Robinhood receives payment for order flow as a percentage of the bid-ask spread for a security traded, rather than a flat rate.
Critics, however, have said that this practice incentivizes Robinhood to push customers into the most illiquid securities with large bid-ask spreads. For instance, options typically have much larger bid-ask spreads than equities and are riskier investments.
Republicans were largely unified in the argument that the GameStop saga only highlights that the financial services industry is overregulated. The Ranking Republican on the committee Rep. Patrick McHenry attacked what he sees as the unfairness of the the accredited-investor rule, which enables sophisticated investors to buy securities of non-public firms, but not the general public. An investor is considered accredited if he earns more than $200,000 per year or has $1 million in wealth.
“If you’re wealthy you’re good to go, if you’re not, you’re deemed too dumb to be trusted with your own money,” he said. Better Markets, a nonpartisan group that promotes the public interest in markets objected to this line of reasoning.
Democrats also focused on the issue of “gamification,” or features in Robinhood app that critics say encourage more frequent use of the app than is financially beneficial. “Robinhood has gaming features that seem to manipulate retail traders into making rash and reckless and potentially ruinous investments,” said Ritchie Torres of New York.
In December, securities regulators filed a complaint against the company for “aggressively marketing itself to Massachusetts investors without regard for the best interests of its customers” and for “use of strategies such as gamification to encourage and entice continuous and repetitive use of its trading application.”
The Financial Industry Regulatory Authority earlier this month announced that it would be reviewing app-based broker dealers’ practices with respect to gamification, and whether features in these apps count as marketing securities that are unsuitable for investors.
The Securities and Exchange Commission and FINRA have previously reviewed the practice of payment for order flow without forcing radical reform, but today’s hearing makes it clear that Democrats will be pressing regulators to take a second look. Chairwoman Waters said in her closing statement that “I’m more concerned than ever than retail investors are being fleeced.”