The online brokerage needed funding to sustain a surge in trading in GameStop and other talked-up stocks.
The last few weeks have brought Robinhood, the online trading app, under the spotlight. It’s one of the reasons thousands of retail investors were able to become part of the GameStop craze that has rattled the US stock market.
GameStop runs a chain of video game stores across the US, Europe and Australia. It has been incurring financial losses for a few years as more gamers download new releases rather than take a walk to its outlet to buy a disk.
Its poor financial health meant its share was a target of short-sellers who bet that the value of a company will eventually go down.
Short-sellers borrow shares from brokers and then immediately sell them on the market. When the price is down they buy back the shares cheaply and return them to the broker while pocketing the difference as a profit.
In this case, the short-sellers were large Wall Street hedge funds such as Melvin Capital, which has $8 billion under its management.
This fact rubbed an odd group of traders who mingle and share tips on social media website Reddit. It was on a Reddit forum, r/WallStreetBets, that a bunch of them decided to prop up GameStop, which they saw as an underdog performer beaten down by Wall Street sharks. And so they started to buy the GameStop stocks.
When short-sellers saw that the stock price was rising on the back of a renewed demand from the Reddit crowd, they panicked and also joined the buying spree.
They had to because they needed to cover their short positions, which basically means they desperately had to buy the shares to return them back to the brokers while the price was still reasonable.
A whole lot of people started to join the rally to make a few quick bucks, especially after some Reddit traders shared snapshots of their accounts which showed they had converted an investment of a few thousand dollars into millions within days.
This is where Robinhood and its online trading app buddies come into play. Since it was launched seven years ago, the app has attracted more than 13 million users with its no-commission and easy-to-use appeal.
Traditional brokerage houses have largely been the preserve of wealthy people and institutional investors such as banks. Not so on Robinhood - all you need is to download the app, deposit $1 to open an account, and you become a trader.
The app even offers users to make margin trade, which means it lends them money to dabble in the equity market. For instance, an investor who has $1,000 in a Robinhood account can trade shares of up to $2,000 in value.
As the news of GameStop rally spread, the interest in the app also shot up - so much so that on January 29 alone it saw more than 600,000 downloads.
Increased trading via its online platform means a greater profit for Robinhood, which makes money by routing the transaction of its users through high-frequency traders.
But the surge in trading in stocks of beaten-down companies such as GameStop and AMC, a struggling cinema chain, is risky as the price of shares might go down when the speculative frenzy ends.
If you sell or buy a share on Robinhood, the equity transaction is immediately settled - you pay for a stock and it becomes yours. That doesn’t mean the equity transaction is complete.
Robinhood and other brokerages rely on clearing agents to complete the backend process of equity transactions which take 48 hours. Two days in the world of the stock market is an eternity and a lot can change in that period.
To cover that duration, the clearing agents require brokerages to give them collateral in the shape of deposits. Robinhood has raised $3.4 billion in the last few days for that purpose.
This has allowed the company to ease restrictions that it had imposed last week to curtail trading in a few stocks. However, Robinhood users entering the market now can buy only up to 20 GameStop stocks.