Robinhood not out of the woods after GameStop ructions

Moving fast and breaking things is a hallmark of disruptive companies and one revered by investors during the current bull market.

For Robinhood, the Silicon Valley online trading platform with its super accessible and seductive app, disruption has collided head on with the guardrails that protect the financial system.

In the wake of surging customer trading volumes around GameStop and other hot stocks, Robinhood was compelled to raise $3.4bn in two separate infusions of capital in a matter of days.

Backers, led by Ribbit Capital, surely expect the brokerage will ultimately benefit from the publicity and the recent upsurge in downloads of its trading app. Robinhood has achieved tremendous success in attracting a new generation of retail customers, who think they are “sticking it to Wall Street”. It disclosed last year it had some 13m accounts.

But trading up a storm via so-called margin accounts that allow investors to buy stock with borrowed funds can easily get out of hand. Shortcomings in Robinhood’s approach towards risk management have been starkly revealed.

“They [Robinhood] just got hit in the head by a piece of two by four,” explained Larry Tabb, a US market structure expert. “Robinhood’s volume is very concentrated and if they want to facilitate trading in stocks that rise to overvalued levels, they need more capital.”

Robinhood’s fundraising reflects the demands of clearing houses. The legal settlement of an equity trade on Wall Street can take up to two days and during that window, volatile stock prices heighten the prospect of losses among investors.

That places Robinhood on the hook to cover any shortfalls among its clients and as a member of the main US clearing house, it must also meet demands for more cash to protect Wall Street from a cascade of failed trades clogging up the financial plumbing. Vlad Tenev, chief executive of Robinhood, revealed a demand for $3bn on extra margin was sought by its clearing house at the height of the trading storm last week.

“When people lose money it creates real issues and Robinhood will have to address the risks associated with a less sophisticated investor base,” said Greg Martin, a partner at Liquid Stock, a private market platform that has helped Robinhood owners sell their stakes. “I use the app and like the company, but they need to learn from this and be smart about it.”

Chasing hot stocks using borrowed money occurs elsewhere at the likes of Interactive Brokers and Charles Schwab, among other online brokerages. But these platforms also have multitudes of customers buying and selling a variety of exchange traded funds, mutual funds and individual securities that generally trade at reasonable levels of volatility, while generating commissions and fees from asset managers.

In contrast, Robinhood does not earn commissions from its customers. Instead, the bulk of its revenue comes from selling client orders to Wall Street market makers such as Citadel and Virtu, a process known as payment for order flow. Market makers gain information from those flows and profit from that.

So long as the retail day-trading boom continues, Robinhood will prosper. But it is likely to face further bouts of having to pay more collateral to clearing houses to cover client trades whenever hot stocks surge. This will be accompanied by the increased political and regulatory scrutiny over Robinhood and the long contentious industry issue of payment for order flow.

Robinhood may well also have to adapt to a natural culling of the day-trading herd. The recent surge in retail activity will result in many users of the app discovering that being consistently successful in trading is very difficult — just ask hedge funds and other active investment managers.

Even among those fortunate in prospering from the cut and thrust of short-term trading, some will probably start shifting towards an investing stance built on growing returns with less volatility, while preserving capital. That opens the door for other brokers and asset managers to gain at Robinhood’s expense. Among them you will find a true pioneer of “sticking it to Wall Street”.

Plaudits for opening up equity markets to the average retail investor and cutting costs go to the visionary Jack Bogle, who introduced the first index investment trust in 1976, a year after he founded the investor-owned Vanguard. Today, Vanguard manages more than $7tn of assets for investors.

Fiduciaries such as Vanguard focus on helping investors accumulate wealth over time through low-cost funds that track markets like the S&P 500. These products have over the past decade beaten a substantial number of more expensive, actively managed funds, according to Standard & Poor’s.

“Investors that have performed the best over the long term are those that did less and spent less,” said Ben Johnson, director of passive strategies research at Morningstar.

michael.mackenzie@ft.com