Wall Street Whirlwind

We hope that you all enjoyed last week’s Weekend Word and gained a little bit of understanding as to what was/is happening with GameStop stock over the last month. Today we look to dive a little deeper into why people are so irate with Robinhood and Citadel Securities, so why don’t we quickly recap before getting into the juicy stuff.

Essentially this all started when some institutions and hedge funds thought it was a prudent move to short GameStop.  Self-proclaimed “degenerates” on the forum Wallstreetbets took this information and sought to “stick it to Wall Street” by essentially inflating the price of GameStop so that these institutions would be forced into the losing side of a short squeeze.  As time went on retail trading platforms like Robinhood and TD Ameritrade limited or stopped trading on multiple stocks that were being squeezed.  This led to cries of fraud and unfair treatment as these retail traders looked to bail out their industry counterparts and that is what we are going to explore today.

If you have been following the events as closely as we have you’ve undoubtably seen claims that Robinhood is either owned by or caved to pressure from Citadel Securities to halt trading on GameStop stock.  This all stems from a controversial practice in the industry called “payment for order flow” or PFOF.  Payment for order flow is a complex process, but the easiest way to describe it is a retail broker (e.g., Robinhood or TD Ameritrade) sends orders to a “wholesaler”, usually a market maker (e.g., Citadel Securities or Virtu Financial) in hopes of getting a better price than the exchange.  They can do this a number of ways, but typically they look at the orders for the stock, compare it to their balance sheet and see if there is a way to process the trades where the sellers and buyers see a “price improvement”.

For example, if I wanted to buy/sell ACE stock, I could buy it on the exchange for $10.25, or sell it on the exchange for $10.  That $0.25 difference is called the spread.  What these wholesalers then do is they might offer to sell me ACE for $10.10, or buy it from me for $10.10, they would then pocket a couple cents of the spread and send the remainder to say Robinhood, and that there lies the problem.

Many of you have been with Laurel Financial Group longer than I have and during that time I am sure you’ve heard Wes, Mike or myself talk about paying for what you get, and free isn’t really free.  Well, how can Robinhood, Schwabe and other companies offer free trading? You guessed it, payment for order flow.  These retail brokers can receive a kickback for the trades they send to the wholesalers, in fact… they’ve made a business out of it.  According to JMP securities in 2020, Robinhood collected roughly $700 million in PFOF, while Schwab/ TD Ameritrade raked in a cool $1.4 billion.  

While there is nothing illegal about this process, in fact there you could argue it is good for retail investors like us.  The reason many people are jumping to conclusions, and grabbing their pitchforks and torches is because the other half of Citadel was the prime hedge fund that Wallstreetbets was taking on.  So, breaking this down to the lowest common denominator: Citadel shorts GameStop, Wallstreetbets uses retail brokers to funnel money into the stock only to find themselves restricted.  Later they find out that the hedge fund they are taking on is paying these retail brokers over $1.14 billion in 2020.  You don’t even need a magnifying glass to see that conflict of interest.

Whooo boy, I think I am a little dizzy.  There are so many pieces to this puzzle that it can make your head spin. Every news outlet, financial focused or not has been forced to cover this story and at the end of the day we are sending this out as an attempt to demystify something that has taken the world by storm.