In the pre-dawn hours of Jan. 28, 2021, the financial trading firm Robinhood faced a $3.7 billion margin call from the clearing house that settles its customers’ trades.
For every trade Robinhood facilitates, it needs to have sufficient reserves, posted as collateral, for the two days it takes for trades to settle. The problem was that Robinhood only had $700 million for collateral—it was short $3 billion and had just a few hours to get the rest of the money.
Retail traders were using the app to buy up tons of volatile meme stocks like GameStop and AMC Entertainment, boosting their prices in attempted short squeezes—which meant Robinhood had to post commensurate amounts of collateral to stay solvent until those trades settled.
In the hours between the clearing house’s notice—first sent at 5:11 am US eastern time—and the 10 am deadline for the margin call, Robinhood executives pressed the clearing house for leniency and simultaneously tried to raise money.
The lobbying and fundraising efforts worked. The company also abruptly halted trading on volatile stocks like GameStop for the day, which limited its own immediate risk, but prompted an uproar from its customers and a congressional hearing and investigation.
Last week, more than a year after the GameStop short squeeze was front-page news, the US House Financial Services Committee’s Democratic staff released the results of its investigation (pdf), showing exactly how Robinhood averted financial disaster on a day when it should have gone under.
How Robinhood makes money
If you have bought or sold a stock in recent years and weren’t charged by your broker to do so, you probably have Robinhood to thank. Robinhood pioneered no-commission securities trading through a business model called payment for order flow (PFOF). The company’s popularity with retail investors forced established brokers like Fidelity and Charles Schwab to eliminate trading commissions in 2019.
Robinhood doesn’t actually execute trades for its customers. Rather, it sells its customers’ orders to so-called market makers like Citadel Securities and Two Sigma Securities, who vie to complete those orders.
Still, Robinhood has to post collateral for its customers’ trades to the National Securities Clearing Corporation (NSCC), which is a division of the Depository Trust & Clearing Corporation (DTCC), the largest securities clearing house in the US. The DTCC is a private company that is heavily regulated by the US Securities and Exchange Commission.
A phone call and a fundraising round
At 7:15 am on the day of the margin call, Dan Gallagher, Robinhood’s chief legal officer, placed a phone call to an unnamed deputy general counsel at the DTCC, according to the House investigation. Gallagher is a former Republican commissioner of the SEC, the primary regulator of the DTCC. He and the DTCC official were “professionally acquainted,” the report says, noting the two previously worked together at a law firm. On the call, Gallagher asked to escalate the matter to senior DTCC officials “to discuss how to obtain relief, waiver, or an exemption.”
By 9:11 am, and after several more phone calls between Robinhood and DTCC officials, Robinhood’s collateral deposit requirements were reduced from $3.7 billion to $1.4 billion, still leaving the firm $700 million short.
The justification for granting billions of dollars in waivers wasn’t explained. According to the report, the DTCC’s market risk director “conveyed that Robinhood’s Excess Capital Premium charge was being reviewed for downward adjustment without commenting on why it was being reviewed or what would qualify Robinhood for a downward adjustment.”
While Gallagher was negotiating with the DTCC, Robinhood chief financial officer Jason Warnick was calling up investors. By the 10 am deadline, Warnick had secured $1 billion in new investment. It kept fundraising after the Jan. 28 deadline. By Jan. 30, the company had raised a total of $3.5 billion.
Without this dual-pronged approach, Robinhood would have defaulted to the DTCC like Lehman Brothers did during the 2008 financial crisis. When a default happens, the clearing house “assumes control of the defaulted member’s portfolio and liquidates it,” the report says, to reduce risk to the broader financial system.
Robinhood’s unlikely survival
That Robinhood was able to get out of this debacle was nothing short of a miracle, says Tyler Gellasch, executive director of the Healthy Markets Association, an investor trade group, and a former Senate and SEC lawyer.
“It is the equivalent of a four-engine plane losing all four engines at 30,000 feet and landing safely,” Gellasch says.
Gellasch is critical of the risk management shortcomings that contributed to Robinhood’s troubles. He chalks up the firm’s survival to its political savvy. “This shows the power of having an extraordinarily politically connected executive on your team,” he said.
Robinhood’s failure could have had serious consequences for the broader financial system, too.
“There isn’t really a precedent for a firm like Robinhood to fail,” Gellasch says. “The sudden collapse of a broker-dealer with millions of accounts could very easily have been the spark that ignited a broader market disruption.”
James Tierney, a securities law professor at University of Nebraska College of Law and a former SEC lawyer, says that while defaulting is a big threat to small brokers, Robinhood appeared confident that it was, in a sense, too big to fail.
“It reminds me of the old saying, ‘If you owe the bank a million bucks, that’s your problem, but if you owe the bank a billion bucks, that’s their problem,’” he says.
In one internal message obtained by the Congressional committee, Robinhood president and COO David Dusseault told a colleague that the company would be able to navigate the clearing house’s requirements. “We are to [sic] big for them to actually shut us down,” he wrote.
In an email to Quartz through a spokesperson, Robinhood deputy general counsel Lucas Moskowitz says the House committee investigation report is “nothing new, once again confirming that January 2021 was an extraordinary, once in a generation event that stressed every stakeholder in the market.”
Six months later, in July 2021, Robinhood went public, raising another nearly $2 billion for its coffers.