Recently, the nation became enthralled with an underdog story of ordinary people pushing Gamestop’s stock way past its value to stick it to greedy traders only to be stopped by the power of Wall Street…
Only that wasn’t the whole story.
- What really happened with Gamestop
- Why Robinhood had to stop allowing Gamestop purchases
- How the payment order system works
In case you missed it…
Gamestop — along with a few other poor-performing stocks — recently made national headlines for an unprecedented rally.
But they didn’t release a new product, suddenly partner with a titan of industry, or make some major breakthroughs in game delivery.
In fact, nothing had changed at all.
So, why the rally?
The simple version: When some folks online learned that several hedge funds were betting against the beloved, once-thriving company, a small movement was born.
Together, individuals began buying the stock in droves, with the Reddit group, WallStreetBets, becoming a meeting place and headquarters for these every-day activists.
Eventually — and extremely controversially — the trading platform Robinhood shut down all purchases of the stock, ending the unlikely bull run on the struggling company.
This led to an outcry from all over the political spectrum — it was something even AOC and Ted Cruz could agree on.
Was this movement, which had so successfully marketed itself as David, shut down by evil corporations in league with Goliath?
Was Wall Street proving that the game was rigged against the little guy?
Why Robinhood really stopped trades
The media was quick to find the poetic angle that a company modelling itself after the famous “Prince of Thieves” would, in fact, be helping the rich and turning on the poor.
But that story is only effective because so many people don’t understand how trading apps like Robinhood work.
As CEO of Alpaca, Yoshi knows exactly why Robinhood had to stop trades — the complexity of the US stock market.
It wasn’t shady practices, it wasn’t front running…
It was US regulations.
“Front running is illegal. So, nobody does it.” — Yoshi Yokokawa
One reason Robinhood was thought to be in collusion with the hedge funds is because of how trading platforms earn their money.
Alpaca, which facilitates international trades on one of the many exchanges in the US market, is not too different from Robinhood in how it earns its money.
Because of the complexity of the nearly 50 exchanges in the US, trading platforms earn their revenue, not through commission, but through a process where they receive rebates from the market makers who work directly to trade with the exchanges.
Companies like Robinhood and Alpaca are often not licensed to trade in every exchange and, as a result, their revenue comes through the trading volume that sits in their ledgers.
This is called, “payment for the flow.” And it’s one of the things that keeps trades going in such a complicated market landscape.
And this method of earning revenue involves a practice that directly resulted in Robinhood stopping trading for Gamestop stock…
The payment order system
Two things happen behind the scenes when you take positions through a trading platform like Robinhood:
- The trade is executed
- The trade is cleared
The first is pretty simple: The company has to trade that stock at that time at the price it is listed at.
It’s the second one that caused Robinhood to stop Gamestop from being available to its users.
In order to keep these trades on their books, platforms need to be able to clear the trade — i.e., be able to pay for the stock sold.
This doesn’t mean that they need the funds all at once, which would be challenging when billions of dollars are moving through your platform.
If the flow of the stocks between trading platforms and market makers is reasonably steady, that money is easily available. The ledger of the company is stable.
“The payment order system is just really borne out of necessity because there are almost 50 exchanges in the US stock market.” — Yoshi Yokokawa
What this means, however, is that high volatility can interfere with a company being able to clear a payment. And that violates US financial regulations.
The high number of transactions introduced by people rallying around Gamestop did just that — introduced too much volatility to be able to clear all the trades.
Rather than the company wanting to side with supposed buddies in Wall Street — or even just fearing the obvious overvaluation of the stock — it had a duty to ensure that it could make payments to everyone trading on the platform.
Ultimately, the company needed to avoid running afoul of regulation, but it also was helping its users. If the company couldn’t clear trades, it would impact a lot more than just the Gamestop stock.
Finance, innovation, technology — all of these things are often complex behind the scenes, which can be tough to explain when something like this happens.
And as good as the modern-day David & Goliath story sounds, so many people missed the important context needed to make sense of it.
Until next time!
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