Why Robinhood Blocked Gamestop. (Full Explanation)

We made the decision, uh, in the morning to limit the buying of about 13 securities on our platform. So, to be clear, uh, customers could still sell those securities if they had positions in them, and they could also trade in the thousands of other securities on our platform. So, uh, it was a difficult decision, um, and, uh, and that’s what we had to do as part of normal operations.

As part of normal operations, on Thursday morning, Robinhood gave us the news that it would be limiting or suspending the trading of about 13 different securities on their platform, including GameStop, which of course has been making a lot of headlines recently. Now, the official reasoning given by Robinhood was that it was a decision made to protect the firm because they have to make various uh, deposits at various exchanges and clearing houses, uh, in order to act as a brokerage. According to Robinhood, these deposits would have gone up substantially, which could have posed a potential issue with their business.

So, what did they do? They just stopped people from trading these 13 various companies, including GameStop. Well, that's not entirely true because if you had shares, you were still allowed to sell them, but you just weren't allowed to buy any more shares. They've since adjusted slightly—now if you are a pre-existing customer, you can't buy more shares but if you're a new customer, guess what, you can buy a grand total of five shares in GameStop.

Of course, this whole situation has led to an incredible amount of news around Robinhood and rumors flying around the internet. So, in this video, I'm going to try and explain how Robinhood makes its money and also why they might have had to take this step.

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So, let's firstly talk about how Robinhood executes your trades. Firstly, you're not getting direct access to the stock market when you log on to your brokerage account. That's the first thing to understand. It’s not like, you know, going down to a local market and you find a seller of a particular good that you're looking for and you're the buyer and you can make that exchange happen.

In reality, there are thousands of stocks; there are tens of thousands of traders. So, what Robinhood is, is it's a brokerage platform. What that means is, you the trader or investor fills out a buy or sell order saying, "Say, I want to buy 5,000 shares of GameStop at this price." You then give that over to Robinhood, and Robinhood tries to then go out and find you the best deal and actually execute that trade.

Now, usually, a stock broker like Robinhood would charge you for that service—they'd charge your brokerage fee. Robinhood doesn't. Instead, Robinhood takes your buy order to a market maker. For the purposes of this video, you can imagine the market maker to be like the stock broker for the stock broker. So, the market maker is going to be the one that actually executes the trade.

Now, this is pretty much the same job as usual except for one key difference: instead of the market maker charging Robinhood to execute the trades, instead, the market maker actually pays Robinhood for the trades. Now, market makers are usually large banks, financial institutions, or hedge funds.

So why would a market maker want to purchase order flow from Robinhood? Well, that's the next part of the story that we need to understand. A major way that Robinhood makes money is by selling order flow to other traders or hedge funds. What this means is that the other traders can take the other side of the trade, and this is called front running.

Think about it this way: you go to a car dealership; you want a specific model of car and you have a chat with the guy, but, unfortunately, they don't have that exact model in their dealership. However, the guy looks up on his database and it turns out the dealership across town does have that exact car you're looking for. So, you say, "Look, thank you very much for your time, but I'm going to go over to this other dealership to get the model that I wanted."

So, you start driving over to the other dealership. In the meantime, that first dealer that you just saw calls up the other dealer and says, "Hey, you've got a customer coming over to you, and he wants this specific model of car." Dealer number two, over across town, then walks outside and bumps up the sticker price on that model by 10.

Now, when you arrive, you're none the wiser that the price has just gone up by 10 and you've driven across town. You really like this car, so you end up buying it. Thus, the second dealership makes more money and sends a little bit of a kickback to dealer number one.

Now, this, in a way, is what Robinhood is doing with your trades. They're telling someone else about all of the trades that are about to come through so that someone else can get to the market faster, and by the time you get there, the price is a little bit more expensive than what you're anticipating.

Now, most of the time, this price difference is incredibly small, insignificant. You probably won't even notice it. But as we'll talk about in a second, this can lead to some other effects that are bad for the investor. It's kind of a classic case of, you know, how it's like Google, it's like YouTube, it's like Facebook where you think you're the customer, but in reality, you're actually the product.

Now, these big banks and hedge funds make a hell of a lot of money knowing what orders are about to come through into the market slightly ahead of time so they can get on the other side of that trade. For example, what they would do is, you know maybe there’s a whole bunch of buy orders that are about to come in for GameStop. What they can do is get in before that at a slightly lower price, and then, in a lot of cases, they end up selling their position to you for that slightly higher price.

Now, let's go back to the situation at hand with GameStop. As I explained in my previous video, GameStop was a heavily shorted stock—still is—but essentially the Redditors over on Wall Street Bets collectively banded together, bought the stock, and triggered a short squeeze on GameStop. This caused a lot of hedge funds that were shorting GameStop to lose a lot of money and end up in some serious financial trouble.

Now, one of these hedge funds was Melvin Capital Management, which actually needed a cash injection just to stay afloat. However, they are denying claims they are going bankrupt. But then on Thursday, Robinhood sent out an email to all of its customers that it is suspending trading, so you can't buy into, I think it was like 13 different stocks—most notably GameStop.

Now, there are a couple of explanations for this, and we don’t currently know the full story. There are just a lot of rumors, some that make more sense than others. But here's what we do know: A hedge fund called Citadel provides execution or market-making services and is actually one of Robinhood's biggest customers. This means that they're providing the vast majority of Robinhood's revenue.

Now, where it gets interesting is that Citadel is an investor in the hedge fund Melvin Capital and was one of the two firms that provided 2.75 billion dollars of extra capital to help Melvin stay afloat earlier in the week. Now, this has led some people to speculate that Citadel has wielded their revenue-providing power over Robinhood to get Robinhood to stop allowing their customers, their investors, to buy into GameStop in order for Citadel to protect their investment in Melvin Capital.

Now, it is worth mentioning that both Robinhood and Melvin Capital have denied these rumors, and some news outlets have also been reporting that Melvin Capital has actually closed their short position on GameStop, so that wouldn't really have any relevance anymore. But what does seem clear is that the hedge funds are some of Robinhood's biggest customers. That's obviously a problem if the site Robinhood is being used to attack hedge funds.

So, it's a possibility that Robinhood may have stopped the buying of these different companies on their platform in order to protect their own customer relationships. Now, another potential explanation is that a lot of Robinhood investors trade on margin. Now, what this means is that someone takes on a loan in order to invest.

Now, with so many investors piling in so much money at such a volatile time, like this poses a serious threat to Robinhood if the bubble pops, which, in all honesty, is probably pretty likely that it will. Then, a lot of these traders might end up owing Robinhood a lot of money. If a lot of traders are owing Robinhood a lot of money, then that could potentially lead Robinhood down towards the road of bankruptcy.

This is probably what the CEO was talking about when he was referring to needing to make higher deposits to the clearing houses in order for Robinhood to continue offering its services. According to Bloomberg, these deposits went up across the board. Now, despite the Robinhood CEO saying that they have absolutely no liquidity issue over the last 48 hours, we've also seen some cash injections into Robinhood's business.

First, it was reported in Bloomberg that Robinhood was drawing down on credit lines it had from banks, including JP Morgan, Morgan Stanley, Goldman Sachs, and Barclays. Then, on Friday, it also got a 1 billion cash injection from some existing investors, including Sequoia Capital and Rivet Capital, and this appears to have plugged the hole that there was in the business because now, as we're seeing, there's a little bit more trading of GameStop being allowed through by Robinhood.

Now, but overall when you read all the news that’s coming out about Robinhood, there’s going to be a lot of rumors, so it’s going to be very difficult and maybe some time before we actually understand the truth or the full story; the truth behind the full story. But what we do know is that right now, Robinhood is definitely being used by retail investors as a weapon against hedge funds, and clearly this has some complications and conflicts with their business model, I suppose is the way to say it.

And the CEO himself said that the Robinhood app was now the most popular app in the App Store, so it just shows you just how many people are getting on board this, you know, anti-hedge fund movement and are downloading Robinhood to use it against the hedge funds. Clearly, the whole situation has caused a lot of investors to get very angry that Robinhood has stopped allowing people to freely trade however they want to because I think that's really the thing that's making people angry is that it's their money, they should be allowed to do what they want with it.

They should be allowed to buy whatever stocks they want, and I totally agree with that. But at the same time, I also think that this is an important lesson for investors using apps like Robinhood, which are no brokerage. When it's no brokerage, they're not making any money through brokerage fees, so you as the user of the app, they're not really making money off of you.

So there's always going to be some sort of compromise, whether it be in customer service or another area. In this case, you can see that Robinhood has to structure its business model differently so that they can still make that revenue for themselves.

So overall, I find this really interesting with how it's all being managed, and man, Robinhood is really copping the backlash now, and I can totally understand why. In fact, yesterday, they copped over a hundred thousand one-star reviews on the Google Play Store. How crazy is that?

Unfortunately, Google flexed its muscle and just removed all of those reviews, which was really sad. But that is pretty insane; it had like a four-and-a-half, five-star review or something rating before, and the internet dragged it back down to a one star. But anyway, that is the current situation with Robinhood, with GameStop, with the different rumors that are going around as to why it's happening, why it's playing out as it is.

I'd love to hear your thoughts and opinions. Leave that in the comment section down below. Leave a like on the video if you did enjoy it, and if you wanted to learn about my personal investing strategies that I use and you would like a step-by-step guide as to how to start investing, then check out Profitful. The links are in the description down below.

But that will do me today, guys. Thank you very much for watching, and I'll see you all in the next video.

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