On January 31, 3021, Elon Musk interviewed Robinhood CEO, Vlad Tenev, via social media newcomer, Clubhouse. The full live-stream audio is available here (the interview spans 1:16:00-1:31:28).
Musk asked Tenev, “What really happened? Give us the inside scoop.” And Tenev proceeded to give a much more detailed explanation than previously made public.
Most important was a January 29 blog post, which explained the mechanics of stock trades, the role of clearinghouses, and the regulations that clearinghouses can place upon stock brokers like Robinhood. The behind-the-scenes mechanics of stock trading is quite complicated and was probably overlooked or too difficult to understand for many — although it is critical for understanding what happened.
However, all these emails and blog posts from Robinhood didn’t give any details about the exact players behind the scenes and the precise regulations that Robinhood had to satisfy. So, of course, many assumed the worst about Robinhood -- that they were helping the big Wall Street hedge funds by stopping Reddit-inspired traders from buying Gamestop (and other stocks). The criticism against Robinhood has been relentless and intense, and many have left Robinhood for other brokerages that didn’t prevent or limit trades last week (such as Fidelity and E*Trade).
Main Point: It is only in this interview with Elon Musk that Robinhood CEO Vlad Tenev finally gives specific details about who was involved and what specific government rules forced Robinhood to limit trading of Gamestop and other Reddit-inspired stocks.
We’ve included a full transcript of the interview at the end.
However, before we can understand why Robinhood decided to restrict the buying of Gamestop stock and other Reddit-inspired stocks, we must first understand the behind-the-scenes mechanics of the stock market to understand how Robinhood fits in.
The Behind-the-Scenes Mechanics of the Stock Market
We can explain these mechanics by asking and answering three questions:
First: Who keeps a record of who “owns” a stock?
Back in the days of paper stock certificates, the ownership of stock was clearly indicated by whoever had the actual paper stock certificate. Brokers would execute trades and exchange the paper stock certificates, which would eventually make its way to the buyer.
But paper is inefficient and overwhelming when billions of stocks are being traded, so in 1973, the Depository Trust Committee (DTC) was created. By the end of the 1970s, the DTC would digitize stock ownership with computers and centralize records of stock ownership by merging clearinghouses that were originally regional (New York, Canada, Europe, etc.). This made stock trading much more efficient, although it created an extremely complex organization that would have to handle all of this record keeping.
Later, in 1976, the National Securities Closing Corporation (NSCC) was established as a merger of the clearinghouses of the NYSE, AMEX and NASD in order to centralize the clearing and settlement of listed and OTC securities transactions (source: DTCC History). The NSCC plays a major role in Robinhood’s restricting of trades.
Not only does stock ownership have to be transferred from buyer to seller, but the buyer also needs to pay the seller, so stock trading also requires the efficient transfer of money.
Second: Who transfers money from the buyer to the seller?
Clearing brokers/firms and Clearinghouses
Hypothetically, when someone buys stock with money held by his stock broker, it would take time for the money from the buyer’s account (held by the buyer’s broker) to go to the seller’s broker to finally be deposited into the seller’s account. Such a payment process would take several days to execute and make stock trading slow and inefficient.
Stock brokers act as intermediaries between the buyer and seller. But billions of shares of stock are traded and trillions of dollars are exchanged every single trading day -- no two stock brokers could handle that much money being exchanged by actually having trillions of dollars on hand.
We have already seen that clearinghouses transfer ownership of stock from seller to buyer, but clearinghouses also transfer money from buyer to seller. Hypothetically, a stock buyer and seller could meet in person and exchange money, but that would be impractical and inefficient. Or the buyer could send money to the seller via his bank, but that would take 3-5 business days for the transfer to clear. Thus, clearinghouses speed up the payment process by making the payment up front with the assumption that the buyer’s money will eventually clear and thus the clearinghouses will not lose the money they transferred. However, it is also possible that the buyer defaults on his payment, for example, if he doesn’t cover his margin borrowing or he doesn’t have enough money in his bank to complete the transfer.
The clearinghouses ultimately ensure the safety of stock trading by protecting both buyer and seller. Neither buyer nor seller can defraud the other of ownership or payment since the clearinghouse handles the transfer of both ownership and payment.
All of these intermediaries (stock brokers, clearinghouses, clearing brokers/firms) add great complexity to stock trading, but without these intermediaries, stock trading would be extremely inefficient, decentralized, and insecure -- so they serve important purposes.
Third: Are clearinghouses regulated?
Clearinghouses are regulated by the US government agency, the Securities and Exchange Commission (SEC). Clearing brokers/firms are members of clearinghouses and must also follow rules set by the SEC. The clearinghouses facilitate the transfer of trillions of dollars, but clearinghouses must mitigate their own risk when buyers pay for stock via margin (borrowing from their broker) or in case a buyer defaults (for example, the buyer didn’t actually have enough money in the bank to buy the stock). Thus, clearinghouses require clearing brokers/firms to hold a certain amount of money on hand to cover such financial risks. The amount required fluctuates based on market conditions and other factors.
Summary: Stock trading is a complicated process that involves more than just stock brokers. The most crucial intermediary between stock buyers and sellers are clearinghouses, which digitally transfer stock ownership from buyer to seller and which safely transfer payment from buyer to seller (so that neither side can cheat the other). However, clearinghouses must mitigate the risk of the buyer failing to pay by requiring clearing brokers (such as Robinhood) to hold a certain amount of cash on hand to cover their buyers.
So what happened with Robinhood?
The following explanation is based mainly on Elon Musk’s interview of Robinhood CEO, Vlad Tenev, which is transcribed below.
- The initial spark leading to Robinhood’s restrictions began at 3:30am PST on Thursday, January 28, 2021, when the National Securities Closing Corporation (NSCC) contacted Robinhood and required Robinhood to post a $3 billion dollar deposit to cover stock trades for the day ahead.
- Robinhood didn’t have $3 billion dollars on hand to deposit. In their seven years of existence, Robinhood cumulatively raised about $2 billion dollars in venture capital funding. So it was basically impossible for Robinhood to pay $3 billion dollars in just a few hours before market open on January 28.
- Robinhood is actually three companies: Robinhood Financial runs the app and is a stock broker; Robinhood Securities is a clearing firm, which clears and settles trades; and Robinhood Crypto handles the trading of cryptocurrencies. If Robinhood did not also operate a clearing firm, it probably would not have been forced by the NSCC to deposit $3 billion dollars to cover trades and thus would not have had to restrict trades.
- Robinhood was able to negotiate the required deposit amount down to $700 million, but Robinhood would have to restrict trades in order to reduce the financial risk to clearinghouses. Simply put, Robinhood is too small a company to be able to handle billions of dollars of stock buying. Other stock brokers (Fidelity, E*Trade) that did not restrict the buying of Gamestop are much larger and hold much more cash on hand. Robinhood’s decision to restrict trades of Gamestop is more tied to how small of a company it is rather than to some sort of evil motive.
- Elon Musk probed Tenev on how the NSCC calculated their $3 billion dollar deposit request. Tenev made clear that the NSCC calculation was not entirely clear, but it did take into account things like market volatility, the high concentration into specific stocks (such as Gamestop), the amount of value-at-risk (VAR), and the NSCC’s own discretionary requirements.
- Musk asked several questions that attempted to understand more deeply why Robinhood was forced to restrict trades: Was Robinhood being “held hostage”? Who “controls” the clearinghouses? Who “controls” the NSCC? Did Robinhood have a choice, or were they truly forced to restrict trades? Who was “holding a gun” to Robinhood’s head? Tenev flatly denied that there were any shady dealings and called it a conspiracy theory to think that hedge funds or powerful Wall Street figures were behind the NSCC’s request. Plenty of people watching the live-stream, however, asserted that Wall Street owns the clearinghouses, so there could have been foul play.
- Based on looking into the NSCC and its parent, the DTCC -- it seems that some individuals in charge of these groups are indeed connected to Wall Street (and likely also connected to the major hedge funds). The twenty directors on the leadership of the DTCC include people who previously worked for Lehman Brothers, Accenture, Morgan Stanley, PricewaterhouseCoopers, Merrill Lynch, and who are former mutual fund managers. However, the leadership of the DTCC also includes individuals who were not formerly employed by Wall Street companies and individuals who were or are still tied to government agencies such as the FDIC. So we shouldn’t automatically assume the worst about the NSCC. It is easy to imagine that some Wall Street hedge fund managers called in favors with friends/associated within the DTCC and/or NSCC. But we have no proof. So we can only speculate.
- Since the NSCC request on January 28, 2021, Robinhood has raised $3.4 billion dollar, in order to better cover the trades of its customers (see Robinhood blog post). That is more capital raised than in its past seven years of existence. This fundraising is promising and shows that Robinhood is committed to doing whatever it takes to ensure that its customers can continue to trade freely.
- Based on Robinhood CEO’s explanation of the situation and Robinhood’s $3.4 billion fundraising, it seems that Robinhood is not 100% at fault and probably does not deserve the harsh criticism it has received. The truth is, stock trading is an incredibly large and complex endeavor that includes many intermediaries, most important of which are the clearinghouses, which set rules for clearing brokers such as Robinhood Securities. Robinhood cannot just break such rules if it wishes to remain a legitimate stock broker and clearing broker. Sadly, many will not look into the specifics of Robinhood’s decision and will continue to think the worst of Robinhood. We hope our analysis can shed some light on what actually happened.
- However, we still are left wondering who made the decision to request a $3 billion dollar deposit from Robinhood and what criteria they used to make that decision. This part of the story is still unclear and is most troubling. We do not know if the US government will investigate this, or whether Robinhood will ever disclose more details. Robinhood CEO is scheduled to testify before Congress on February 18, so perhaps more details will come out at that time.
Summary/Takeaway: On January 28, 2021, the National Securities Clearing Corporation (NSCC) requested a $3 billion dollar deposit from Robinhood to cover the risk of its customers' volatile stock buying. Robinhood was unable to pay, so Robinhood had to restrict trades until it could raise more money. Robinhood has subsequently raised $3.4 billion dollars. There was probably not any shady business happening, but we cannot know for sure until we find out who made the NSCC decision and what criteria they used to set the $3 billion dollar deposit request.
Transcription of Elon Musk’s January 31, 2021, Interview of Robinhood CEO Vlad Tenev
The original audio file is here (the interview spans 1:16:00-1:31:28)
Note: This transcription is lightly edited to smooth out the language and to eliminate filler words (um, well, etc.).
[Vlad Tenev]: “Robinhood is actually a couple of companies: An introducing broker/dealer called Robinhood Financial and that basically is the app you know and love, it processes trades, you are a customer of Robinhood Financial. Then there’s the clearing broker/dealer, Robinhood Securities, that clears and settles the trades, and then we have Robinhood Crypto, which is our Crypto business. All of these are different entities that are differently operated.
Wednesday of last week [January 27, 2021], we had unprecedented volume, an unprecedented load on the system. A lot of these so-called meme stocks were going viral on social media and people were joining Robinhood and there was a lot of net buy activity on them. And Robinhood at this time, I think, was number one on the iOS app store, and pretty close, if not number one on Google Play as well.
Thursday morning [January 28, 2021], I’m sleeping but at 3:30am PST, our operations team receives a file from the NSCC, which is the National Securities Clearing Corporation. So, basically as a clearing broker (this is where Robinhood Securities comes in), we have to put up money to the NSCC based on some factors including things like the volatility of the trading activity, concentration into certain securities, and this is the equities business, so it’s based on stock trading and not options trading or anything else. So, they [NSCC] gave us a file with a deposit request and the request was around $3 billion dollars, which is an order of magnitude more than what it typically is.”
[Musk]: “Now, why was that so high? Like, it sounds like this was an unprecedented increase and demand for capital. What formula did they use to calculate that?”
[Vlad Tenev]: “Just to give context, Robinhood (up until that point) has raised around $2 billion dollars in total venture capital up until now. So it’s a big number, like $3 billion dollars is a large number . . . We don’t have the full details, it’s a little bit of an opaque formula, but there’s a component of it called the VAR, which is value-at-risk and that’s based on fairly quantitative things, although it’s not fully transparent, so there are ways to reverse engineer it. But it’s not publicly shared. And then there’s a special component which is discretionary, so that kind of acts as a multiplier.”
[Musk]: “Discretionary meaning like, it’s just their opinion?”
[Tenev]: “Yeah, but I’m sure there is definitely more than just their opinion.”
[Musk]: “Well I mean, I guess what everyone wants to know is, did something maybe shady go on here? It seems weird that you’d get a sudden $3 billion dollar demand . . . suddenly, out of nowhere.”
[Tenev]: “I wouldn’t impute shadiness to it or anything like that.”
[Tenev]: “And actually, the NSCC was reasonable subsequent to this, and they worked with us to actually lower it, so it was unprecedented activity. I don’t have the full context about what was going on in the NSCC to make these calculations.”
[Musk]: “Is anyone holding you hostage right now?”
[Tenev]: “No, no. Thanks for asking. But anyway, so this was obviously nerve wracking and I actually was asleep at this point [3:30am PST], the operations team was fielding this at 3:00 and then we got back, we put our heads together, and our Chief Operating Officer, basically said, ‘Let’s call up the higher ups at the NSCC and figure out what’s going on. Maybe there’s some way we can work with them. And basically there was another call and they lowered it to something like $1.4 billion dollars from $3 billion, so we were making some progress, but still a high number. And then we basically proposed, ‘Well, let’s explain how we’ll manage risk in the symbols throughout the day,’ and then we proposed marking these volatile stocks that were driving the activity as position closing [sell] only. And then about an hour before market open, 5:00 in the morning, they came back and they said, ‘Okay, the deposit is $700 million,’ which we then deposited and paid promptly and then everything was fine. So that essentially explains why we had to mark these symbols position closing only and also why, we know this was a bad outcome for customers. Part of what’s been really difficult is, Robinhood stands for democratizing access to stocks, and we want to give people access and that’s been very very challenging. But we had no choice in this case, we had to conform to our regulatory capital requirements, and the team did what they could to make sure we were available for customers.”
[Musk]: “Who controls this organization, this clearinghouse?”
[Tenev]: It’s a consortium, it’s not quite a government agency, I don’t really know the details of all that. To be fair, there was legitimate turmoil in the markets. These are unprecedented events with these meme stocks and there was a lot of activity, so there probably is some extra amount of risk in the system that warrants higher requirements, so it’s not entirely unreasonable. But we did operational processes to make sure that customers who had positions could sell their open positions because obviously restricting someone -- we got a lot of questions about, ‘Okay, you had to restrict buying, why didn’t you also restrict selling?’ And the fact of the matter is, people get really pissed off if they’re holding stock, they want to sell it, and they can’t. I think that’s categorically worst. And lots of other brokers were in the same situation. Robinhood was in the news, but you sort of heard this industry wide, other brokers basically restricted the same activity.
[Musk]: “All right, so it sounds like this organization calls you up and they basically have a gun to your head -- either hand over this money, or else. What people are wondering is, Did you sell your clients down the river, or did you have no choice? If you had no choice, that’s understandable. But then we gotta find out why you had no choice. And who are these people saying you have no choice.”
[Tenev]: “Yeah, I think that’s fair. We have to comply with these requirements that financial institutions have. The formula behind these requirements, it would obviously be ideal if there was a little more transparency, so that we could plan better around that. But to be fair, we were able to open and serve our customers and 24 hours later, our team raised over a billion dollars in capital, so that when we opened Friday, we’ll be able to relax the stringent position limits that we put on these securities.”
[Musk]: “Will there be any limits?”
[Tenev]: “Well, there’s always going to be some theoretical limits. We don’t have infinite capital. And on Friday there were limits. There’s always going to have to be some limits. I think the question is, Will the limits be high enough to the point where they won’t impact 99.9+% of customers. You know, if someone were to deposit $100 billion dollars and to trade in one stock, that wouldn’t be possible.”
[Musk]: “All right. I guess people just want to know, if you had no choice, then you had no choice. It’s a gun to the head situation. Then that’s understandable. But whoever put that gun to your head should be willing to answer to the public.”
[Tenev]: “Yeah, listen, I know there’s processes and these are unprecedented times and to be fair to those guys, they’ve been reasonable, so we are, I think the one thing that is maybe not clear to people is that Robinhood is a participant in the financial system, so we have to work with all these counterparties, so we do get a lot of questions about, Why do you work with market makers? Why do you work with clearinghouses? Vertically integrating and getting, I mean, [it’s] hard enough to build an introducing broker and a clearing broker/dealer, not too many people have done that, but the financial system that allows customers to trade shares is sort of a complex web of multiple parties and everyone says it could be better, it could be improved, [but] it’s just the necessity of trading equities in the U.S. that you have to do all these things.”
[Musk]: “Vlad, to what degree are you beholden to Citadel? I mean, if basically, Citadel isn’t happen, then what happens?”
[Tenev]: “Yeah, so there’s a rumor that Citadel or other market makers pressured us into doing this and that’s just false. Market makers execute our trades, they execute trades of every broker dealer. This was a clearinghouse decision and it was just based on the capital requirements. From our perspective, Citadel and other market makers weren’t involved in that.”
[Musk]: “But wouldn’t [Citadel] have a strong say in who got put in charge of that organization [NSCC] since it’s an industry consortium, not a government consortium? Or not a government regulatory agency?”
[Tenev]: “I don’t have any reason to believe that. I think that’s just like, then you’re getting into the conspiracy theories a little bit, so I just have no reason to believe that’s the case.”
[Musk]: “Okay. All right. Well, I guess we’ll see what happens with future transactions [unclear]. Hopefully that was insightful and at least a little bit entertaining. Are you not entertained?”
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