The House Financial Services Committee recently released its report on the rise of meme stocks during Q1 of last year. The year-long investigation showed how Robinhood (NASDAQ:HOOD), along with its market makers, like Citadel Securities, were vastly unprepared for the influx of retail traders. Trading in popular meme stocks, like GameStop (NYSE:GME) and AMC (NYSE:AMC), revealed alarming systemic issues in the platform’s infrastructure.
During late January of last year, Robinhood restricted trading in several meme stocks following the meteoric rise of GME stock. The report calls this event the Meme Stock Market Event (MSME). Before the restrictions were enacted, Robinhood users owned $2.6 billion of GME and $1.3 billion of AMC. After the restrictions were enforced, those values dropped down to $1.2 billion and $411 million, respectively. These restrictions limited retail market participation and “undermined confidence in market integrity.”
With that in mind, let’s get into the details of report.
House Report Reveals Systemic Issues of Robinhood
The report notes that the stock market has changed in recent years, led by Robinhood’s commission-free trading strategy. Still, the company utilizes payment for order flow (PFOF) in order to generate profit. PFOF involves routing a customer’s order to a market maker, like Citadel, in exchange for a fee, or rebate. Subsequently, the House believes that Robinhood’s PFOF strategy creates further complexity and fragility in the stock market. This is due to the platform’s high order flow and unique formula for calculating PFOF rebates.
On Jan. 28 of last year, the Depository Trust and Clearing Corporation (DTCC) waived $9.7 billion in collateral obligations for six of its member firms. Robinhood was one of these firms. Furthermore, the popular retail platform would have defaulted on its collateral deposit obligations if the DTCC did not invoke this action. Meanwhile, Robinhood executives were very well aware of this. Securities unit President Jim Swartwout texted COO Gretchen Howard on Jan. 28 that the company had a “huge liquidity issue.”
Additionally, the House accuses Robinhood of relying on “incomplete statistical models” leading up to the MSME. On top of that, the company did not incorporate Financial Industry Regulatory Authority (FINRA) “best practices” for its stress tests. Ultimately, the report revealed that the rise of retail trading created “novel issues” for market stability.
The House Committee explained that most of the involved firms it spoke to do not have explicit plans to address collateral requirements during times of heavy volatility. The House recommends that these firms should enact further liquidity rules, stress tests and tailored trading halts.
On the date of publication, Eddie Pan did not hold (either directly or indirectly) any positions in the securities mentioned in this article. The opinions expressed in this article are those of the writer, subject to the InvestorPlace.com Publishing Guidelines.