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Meme Stock Report Exposes Robinhood's Shady Practices

The House committee report exposes Robinhood's problematic practices that have impacted meme stocks like GameStop and AMC.

The U.S. House Committee on Financial Services has released an extensive and detailed report following its lengthy investigation into the January 2021 Meme Stock Market Event.

The report takes an in-depth look at meme-stock trading activity, with commission-free broker Robinhood  (HOOD) - Get Robinhood Markets Inc. Report as a focus. Here's what investors need to know.

Figure 1: Meme Stock Report Exposes Robinhood's Shady Practices

Figure 1: Meme Stock Report Exposes Robinhood's Shady Practices

(Read more from Wall Street Memes: GME and AMC: Legislators Concerned About Market Makers' Role)

The Meme Stock Committee's Findings

As revealed by the year-long investigation conducted by the House committee, during the Meme Stock Market Event, commission-free broker Robinhood exhibited problematic business practices involving inadequate risk management and a culture in which it prioritized its growth over the stability of the markets.

The committee found that, prior to the event, Robinhood was unprepared to comply with regulatory capital obligations. That led it to limit its clients' access to the stock market.

The broker had also failed to update the stress test it used to predict collateral obligations to clearing agencies. That's even after it received a Financial Industry Regulatory Authority (FINRA) notice before the event that called for stress tests to be done to preserve conservative best practices.

Also, Robinhood's disproportionate order flow, along with a unique formula for calculating payment per order flow (PFOF) rebates, has stretched many market makers and introduced more risk to the stock market.

The commission-free trading culture popularized by Robinhood was possible only due to the active participation of market makers paying rebates to broker-dealers for customer orders.

Another finding by the House committee was that broker-dealers were facing increased operational and liquidity concerns that led Robinhood to expand trading restrictions during the Meme Stock Market Event. However, the restrictions imposed by Robinhood were the most far-reaching compared to other clearing brokers. See below.

Figure 2: Approximate duration of formal trading restrictions placed on equities.

Figure 2: Approximate duration of formal trading restrictions placed on equities.

Payment per Order Flow Under SEC Scrutiny

By not charging fees on trading, Robinhood today gets nearly 80% of its revenues from PFOF practices.

Based on the Meme Stock Market Event, public hearings, and the investigation as a whole, the committee has introduced a bill that would require the Securities and Exchange Commission (SEC) to conduct a study on the subject:

"H.R. 4617 [requires] the Securities and Exchange Commission to carry out a study on payment for order flow, to require the Investor Advocate of the Commission to provide recommendations on payment for order flow, and for other purposes."

The SEC would be required to issue reports with all findings on this study to Congress and thereby issue rules consistent with the results of the study, including both prohibiting and limiting the practice of payment per order flow, if warranted.

The SEC would be required to issue the report with all findings and determinations to Congress within 180 days. The SEC will then issue rules consistent with the results of the study within 18 months, including prohibiting or limiting payment for order flow if warranted. The SEC may issue such rules before the completion of the study if the SEC determines it is necessary or appropriate.

Recent statements by SEC Chair Gary Gensler indicate that the SEC is putting in place a plan that will require trading firms to compete with each other to execute retail investor trades with greater transparency.

Gensler also believes that a closer look at the practice of PFOF is valid and that an order-by-order competition model may be seen as a more transparent option for conducting retail trades.

(Disclaimers: this is not investment advice. The author may be long one or more stocks mentioned in this report. Also, the article may contain affiliate links. These partnerships do not influence editorial content. Thanks for supporting Wall Street Memes)