Robinhood or Sheriff of Nottingham? Conflicts of interest in the GameStop affair

Washington’s attention has rightfully turned to the trading frenzy in GameStop and other stocks through the newly popular retail trading app Robinhood. The popular uprising on social media manifests as massive bubbles in company stocks despite bleak earnings prospects for those investments. During the recent trading frenzy, Robinhood and other retail facing apps temporarily suspended traders’ ability to place buy orders, something with very little precedent, in GameStop and other select stocks. 

That decision caused an uproar that has led Washington politicians to take notice. The first congressional hearing is scheduled for Feb. 18. The policy discussion has become noisy as both political parties retreat to comfortable talking points before gaining a full appreciation of the problem. 

Initial comments from Democrats oddly referenced opposition to stock buybacks, which have no relevance but are an evergreen bugaboo of progressives. Republicans urge trust in the free market, despite some evidence that violations of the federal securities laws may have occurred. And sure, people should be free to trade in whatever stocks they choose, even if most sophisticated investors see those trades as irrational speculative bets on a dying industry. 

The upcoming hearings are a chance to focus attention on what’s really at issue here, namely conflicts of interest. The players in this drama are Robinhood, Citadel, Citadel Securities and Melvin Capital. Some media outlets have implied that Robinhood may have stopped trading in GameStop, at the expense of its retail clients, to help Citadel Securities, the high-speed trading firm that Robinhood sends customer trades to for execution in exchange for hundreds of millions of dollars. Some might argue that this perverse arrangement would make Citadel Securities the largest “client” of Robinhood. 

Citadel Securities pays Robinhood a sort of kickback, called payment for order flow (PFOF), that partially subsidizes Robinhood’s policy of zero retail commissions on trading.  Customers don’t see the cost of their trade, but a recent settlement Robinhood entered into with the Securities and Exchange Commission (SEC) over misrepresentations by Robinhood about these hidden costs is a reminder that there is no free lunch in retail trading. PFOF is a practice pioneered by, wait for it…Bernie Madoff.

Some speculate that Citadel, a separate company also founded by Ken Griffin, was worried that a hedge fund it invested in, Melvin Capital, was overexposed to positions in GameStop and other stocks being bought by the Robinhood traders. Did Robinhood halt trading in GameStop principally to help Citadel, to the detriment of Robinhood’s retail clients? Or did Robinhood halt trading because it was pressured to by clearing agencies, as Robinhood’s CEO claimed in a recent interview with Elon Musk?

The extent to which the Robinhood CEO’s defense holds up depends on specifics of any discussions that Robinhood executives had with executives at Citadel Securities and with Robinhood’s clearing agent, none of which have been made public. Congressional committees should use this opportunity to ask specific questions about what communications occurred between Robinhood and Citadel Securities just before the decision to halt trading. They should also ask questions about what conversations the clearing agents had with Citadel Securities prior to their decision to demand billions in capital immediately from Robinhood.

Committees can ask those questions publicly, under oath, and obtain answers and documents faster than the SEC through requests for information and ultimately subpoenas. What came up in those discussions? Which counterparties communicated with each other? Did anyone get an inappropriate heads-up about the trading halts? The House and Senate committees should ask in writing that Robinhood CEO provide committees detailed descriptions and document production of all related communications.

In a market distorted by complexity and conflicts, payment for order flow further erodes trust that the markets are free, fair and transparent. In an interview with CNBC, Robinhood’s CEO told Andrew Ross Sorkin that they made the decision to restrict buying in certain names to “protect the firm and protect our customers.” While Citadel Securities pays Robinhood hundreds of millions of dollars for order flow, and their customers pay nothing to trade, the question will always remain: To whom was he referring when he said he was “protecting our customers”?

Beyond the specifics of the GameStop/Robinhood affair, the hearings will show that practices like payment for order flow and rebates are rocket fuel for the structural conflicts of interest that exist here. The conflicted payments that payment for order flow and rebates often represent can be the sweetener to convince institutional investors to send trades to execution environments, where they can be taxed by latency arbitrage practices by high-speed trading firms. 

The UK Financial Services Authority has estimated that these latency arbitrage practices cost global investors $5 billion per year. A timely academic study of zero commission traders in PFOF platforms shows they pay a much higher spread. These hidden taxes make the Sheriff of Nottingham a more apt reference from the Robinhood tale.

At a minimum, these hearings should lead to a bipartisan call for the SEC’s Division of Economics and Risk Analysis to do a study of the cost rebates and PFOF. Both sides of the aisle should agree that we need an honest estimate of the costs of these practices as the SEC prepares to take steps to address them. We’ve already seen their impact on the front page of the paper.

J.W. Verret is an associate professor at George Mason University Scalia Law School and a former Republican senior counsel and chief economist at the U.S. House Committee on Financial Services.

Editor’s note: A previous version of this op-ed conflated Citadel and Citadel Securities, which are two separate and distinct businesses with the same founder. Citadel is a hedge fund business (which invested in Melvin Capital), while Citadel Securities is a market making business that executes trades for Robinhood and other retail broker dealers.