The relationship between Robinhood and Citadel Securities has raised concerns about Wall Street ethics

The relationship between Robinhood and Citadel Securities has raised concerns about Wall Street ethics
Source: Brendan McDermid, Reuters
As GameStop’s stock value soared, one of the main brokerage apps, Robinhood, stopped transactions for the stock. The move has not only angered investors, but has led to calls for investigating the entire industry.

The last week of January was a volatile one for the stock market. That volatility was due to the sudden buying frenzy of GameStop stock (and, eventually, other similarly troubled companies like AMC Theatres), which was instigated by a Reddit thread entitled “r/wallstreetbets."

The GameStop story, like the stocks themselves, has had many ups and downs. It initially seemed like a “David and Goliath” tale about outsider traders making a winning bet on the stock market. It quickly became a story about keen new investors being stymied by established Wall Street firms and an industry built around gatekeepers.

As GameStop’s stock value soared, one of the main brokerage apps, Robinhood, stopped transactions for the stock. New investors were cut off just as they had joined the fun. The move has not only angered investors, but has led to calls for investigating the entire industry.

What’s the story behind the GameStop stock?

To understand why Reddit had gone all-in on GameStop, a video game retailer that has been struggling in recent years, you must understand the concept of “shorting stocks.”

TIME provides one of the simplest explanations of the concept:

“When you buy stock in a company, you’re (typically) making a bet that something will happen that leads that company’s stock to grow in value: a popular new product, a big executive hire, a great quarterly report, and so on. But if you think a company is going to tank, you can “short” that firm—basically, you borrow a number of shares in that company at the current price, then sell them in the hopes that you can then buy the same number of shares again later for a lower price, give those shares back to the lender by an agreed-upon time, and pocket the difference.”

There is nothing illegal or (arguably) unethical about shorting stocks. Instead of betting that a stock will go up, investors bet that it will go down. All the same, shorting stocks has its detractors. Elon Musk, the billionaire chief executive officer of Tesla and Space X, has previously expressed his disdain for the practice, particularly after investors attempted to short Tesla stock.

Redditors realized major Wall Street firms were shorting GameStop’s stocks, so they decided to take advantage of the situation. By rallying a large group of people to buy the stock, the value of GameStop’s stocks skyrocketed. As the jump in value was enriching these Redditors, it was costing the short sellers – including large hedge funds – billions.

In that way, the soaring price of GameStop (as well as AMC and the Nokia telecommunications company, among others) was viewed as both a financial win and a moral victory over major Wall Street firms.

Which is why Robinhood’s choice to intervene struck users as a betrayal. Robinhood was “robbing from the poor” to protect the rich, including Citadel Securities.

Robinhood’s official reason for suspending transactions was “market volatility,” with some claiming the app was simply shielding its users from an inevitable crash. Most users weren’t buying it, though. They inundated the app with one-star reviews.

Why so angry?

Robinhood, which has billed itself as an investing app for the common person, received a deluge of anger over its choice to block users from buying the hot stocks. That anger, including a call for a class-action lawsuit for market manipulation, was rooted in the perception that Robinhood was acting on behalf of billion-dollar hedge funds instead of “the little guy.”

Much attention was given to Robinhood’s connection to Citadel Securities, a financial service company that serves as a “market maker” for the app. Irate Reddit investors accused Citadel of pressuring Robinhood into stopping the trades, in effect protecting the big-money investors from taking even larger losses while cutting independent investors out of the game.

The actions of Robinhood didn’t just anger potential investors. Politicians as disparate as Republican Senator Ted Cruz and Democratic Representative Alexandria Ocasio-Cortez called for an investigation into the matter, as did Musk and other business leaders.

It’s hard to imagine Robinhood bouncing back from all the bad press. So why would Robinhood ruin its reputation to protect a multibillion-dollar company?

The relationship between Robinhood and Citadel

To answer that question, one must understand the roles both Robinhood and Citadel play in investing.

The Robinhood app was created to provide a way for individuals to invest in the stock market without paying high commission fees. On their site, they say, “We’re on a mission to democratize finance for all.” When Robinhood was founded in 2013, the goal was to encourage younger people who generally don’t have a lot of money to try investing.

But it wasn’t initially clear how the app would make money without charging commissions as traditional brokers would. As The Washington Post explains, one way Robinhood has found to generate income is by selling information about the investing habits of its users to major investment firms. Among those firms was Citadel Securities, a market maker.

The Post lays out the nature of Robinhood and Citadel’s relationship:

“Robinhood and other brokerages cannot execute trades directly, so they usually work with market-making firms. Robinhood is required by law to work with market makers that can give their users the best market prices for a given trade. When Robinhood directs a transaction to one of these third parties, the market maker learns which security is being bought or sold before the trade happens. Citadel and other market makers pay Robinhood a small fee for this privilege, which gives the market-making firms information about retail trading patterns.”

Citadel is Robinhood’s biggest market maker partner, accounting for more than half of its trades, but the app also works with Two Sigma, Virtu, Wolverine and G1 Execution Services.

These relationships between brokers and market makers are built into the system. Most broker apps like Robinhood, including the popular China-based alternative Webull, work with market makers. Brokers are required to disclose this information to their users, but the recent GameStop ruckus has led to demands that the practice be investigated by the United States Securities and Exchange Commission.

In addition to the calls for an investigation by members of Congress, Texas Attorney General Ken Paxton has demanded investigations into 13 investing companies, including Robinhood, Citadel and Webull.

“Wall Street corporations cannot limit public access to the free market,” Paxton stated, “nor should they censor discussion surrounding it, particularly for their own benefit. This apparent coordination between hedge funds, trading platforms, and web servers to shut down threats to their market dominance is shockingly unprecedented and wrong. It stinks of corruption.”

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