Why Did Robinhood Restrict Trading During the Short Squeeze?

The recent short squeeze phenomenon was unlike anything investors have seen before, with some stocks multiplying several times over in very short periods on no news. In the midst of the volatility, trading platform Robinhood decided to restrict trading of certain stocks, a move which upset many of the company's loyal customers. In this Fool Live video clip, recorded on Feb. 2, Fool.com contributor Matt Frankel, CFP, and Industry Focus host Jason Moser discuss why Robinhood may have decided this was the best move. 

Jason Moser: Let's kick off this week's show with clearly a story that's gotten a lot of attention over the past week. Really deservedly so. This has become something for the history books, I think. We can go a million different ways with it, but it is the GameStop (GME 0.92%) situation with Robinhood. When we say GameStop, there are other stocks including there, AMC (AMC 10.62%) being one. Last week, this story really unfolded and it took a lot of weird turns and left a lot of individual investors feeling left out in the cold, to be honest. But let's open up with this GameStop story and talk specifically right now at least. We're not going to dig in. Everybody knows what's happened here at this point. Let's talk about Robinhood in particular, because we're a financial show. Robinhood, we talked a lot about here over the past year plus and how it's working to democratize investing for all and really bring it to more people. I think you and I both agree that is a very admirable mission and something we can get behind. It also comes at a cost. The way that Robinhood's business model was set up, we're starting to see the vulnerabilities there and it is certainly playing out. I've got to imagine their leadership has a few more gray hairs today than they did a week ago.

Matt Frankel: When you compare Robinhood to some of these big brokers that have $1 trillion dollars under management or something to that effect, they just don't have the capital to allow for frequent trading in these stocks that are being short suites that are spiking, and GameStop was just one of them. At one point, Friday I think, Robinhood put out a list of 50 stocks that it was restricting.

Moser: Starbucks (SBUX 0.36%) was on that list.

Frankel: General Motors (GM 0.05%) was.

Moser: That seemed a little bit out there. [laughs] Maybe there was a faulty AI, I don't know.

Frankel: They've backed off a little bit. But on some of the high volatility stocks, it's like GameStop, you're still limited to four shares. Jason tried to buy five before the show and he, you could do it. [laughs]

Moser: Not true. [laughs]

Frankel: They're still limiting some of these high volatility stocks. The reason they gave, it makes sense to a degree, that their clearinghouse makes them some keep a certain amount of capital just to cover the what ifs. There's a line from Ocean's 11 that I remember that, "A casino has to hold in reserve enough money to cover every chip played on its floor." It's a similar type of situation here. Not calling Robinhood a casino, although a lot of people treat it like it's a casino.

Moser: Yeah, it feels like one right now.

Frankel: But it's a similar situation. They have to have enough money. Because when you make a trade, it takes a few days for that trade to settle, and there's money moving around. If someone moves in and out of a GameStop position 10 times in a day, that's a lot of money, they are waiting days for it to settle. It really creates it a capital problem of money being able to move around and cover potential losses in the in between time when shares are moving from one place to another. Long story short, Robinhood said, "Whoa, this is getting out of hand. We need to bring in some new capital and limit the trading on some of these stocks." I know they raised a billion dollars last week, I think I read a little over 2 billion today, or maybe it was over the weekend. But they raised a few billion dollars more of capital that allowed them to kind of back off some of their trading restrictions. But they're not comfortable raising it beyond the levels that they're at right now, like I said four shares at GameStop, they're up to 75 shares of AMC, it was one at one point, which AMC is not an expensive stock. [laughs] If I wanted to invest in that, and you told me I could buy one share for $14, why would I do that?

Moser: Yeah.

Frankel: Robinhood has millions of customers. They are big platform right now.

Moser: Yeah.

Frankel: They are considered a smaller player because their average account balance skews lower, they're newer investors, few $100 in your account as opposed to like six-figure 401(k)s and IRAs and stuff like that. The Robinhood is considered a smaller player but they have millions of customers. These millions of customers are not happy that they're being told what they can and cannot buy at any given time. That's really the issue. It's not that everyone on Robinhood wants to buy a hundred shares of GameStop. I'm not generalizing Robinhood investors like that. But the point that Dave Portnoy is making, and I think Mark Cuban said the same thing, that people should be able to make their own decisions. They need a platform that can accommodate that. That's why you're seeing a lot of blowback on that.