Reddit vs Melvin Capital — There’s Always a Richer Fish

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Abstract

“order flow” information — a live feed of who is buying what — from Robinhood, the main trading app used to launch Reddit’s assault on Melvin Capital (and other over-exposed hedge funds). This is well-established, and is a major income stream for Robinhood. It seems to be the reason Robinhood offers zero-commission trades at all.Citadel then uses this to “front-run” Robinhood trades: in the milliseconds before the order is placed, Citadel is able to buy the stock being traded and sell it to complete the trade themselves, keeping any price difference. It’s a tiny profit, but one that would have benefited either the buyer or seller, if only a little. When they do it to millions (?) of trades per day, though, it’s basically a money printer — yes, kind of like the Office Space scheme. Acting on non-public information in this way is illegal, so the accusation needs evidence beyond “Wall Street is scum.” And while I’m ready to believe that Wall Street is scum, we further know that they wouldn’t pay for order flow information if they weren’t profiting off it; they’ve been fined for it before, but for less than the profits they likely made, so there’s little incentive to stop; by my understanding, it’s a major motivation for HFT to begin with; and supposedly, the trade volume for targeted stocks is far higher than what WSB and other “retail investors” could produce alone.Next, Citadel appears to have made a major investment in Melvin Capital while they were losing billions in WSB’s initial assault. This also seems well-established, and the innocent explanation is just that they saw an opportunity to invest at a discount and took it, under the assumption that this will all wash out and Melvin will recover.After that investment, though, Robinhood and others froze trading on WSB’s targeted stocks. Importantly, this freeze is not the result of a “circuit breaker” set by the exchange itself, where the criteria for a freeze is predefined and just part of the rules that everyone agreed to. It’s a private entity playing gatekeeper, essentially a broker refusing to fill client trades for their own gain. Again, this freeze is well-established fact. With the above story, though, it’s more sinister than simply rich people vaguely protecting other rich people, or companies trying to avoid controversy

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and regulation in general.Specifically, Robinhood appears to be actively protecting Citadel, a major and powerful client of theirs. Further, Citadel chose to buy into Melvin Capital while they were still flailing and vulnerable to lose even more, as if they knew about Robinhood’s impending freeze. Ameritrade and others also froze trading, it appears, but Citadel almost certainly has the same relationship with them (though I didn’t verify that).In short, it seems like there’s always a richer fish: WSB successfully brought Melvin Capital to its knees, and a few individuals with fortunate timing did walk away richer. But Citadel — who was likely already profiting from WSB’s assault via Robinhood and others — was able to snap up Melvin Capital at a major discount apparently knowing that Robinhood would protect them from the assault that wounded Melvin. That assault was effectively the entire reason for the discount, meaning that Robinhood’s halt moved this from a shrewd financial move to active and illegal manipulation, allowing Citadel to walk away with all of the gain and none of the risk. So to further abuse the French Revolution metaphor, the proletariat didn’t establish a new order, they just created an opportunity for English royalty to invade and perhaps further consolidate the power of monarchy.To be clear, I don’t mean this to be a cynical take. It’s still really cool, and instructive, that a large group of internet randos working together were able to wound a massive hedge fund. It’s cathartic, even, knowing the predatory nature of hedge funds: from “private equity” firms they own that buy and destroy companies with no regard for labor, to predatory development practices — “vulture funds” — exploiting disasters in Puerto Rico and other places to snap up land, to the harmful effects of their wild speculation in general. But while celebrating that, it also seems important to understand that this kind of momentary frontier justice won’t fix the system alone. Any kind of lasting victory is going to involve government regulation and reform — targeted at the finance industry, not individual traders, if any justice exists in the world — even if regulation is less sexy than a modern, meme-infused version of Les Miserables played out entirely inside of computers.</article></body>

Reddit vs Melvin Capital — There’s Always a Richer Fish

Image credit: “survival of the fittest” by Chris Homan from the Noun Project

There are plenty of GameStop-stock-explainers floating around, but not a lot of focus on players besides r/WallStreetBets and Melvin Capital, respectively the proletariat and bourgeoisie in this story. Check out other explainers if you want to understand Melvin’s sins and the mechanism by which WSB punished them, because that part of the story makes for some good schadenfreude.

Beyond the celebration, I see two main takes coming out of all this: one says this is a victory of free-market capitalism, and the other a victory of socialist collectivism. The former paints this as a kind of libertarian justice fantasy where free individuals form a posse to distribute vigilante justice (if justice even enters the conversation — it’s often just for the lulz), while the latter says this is just a small example of the power of working together in the face of capitalism. Despite being considered polar opposite ideologies, are they both right here?

Aside from the fact that libertarian-justice-posses only seem to materialize in the real world to punch down, not up, I think there is an overlooked piece of the puzzle that really highlights why the libertarian take is short-sighted. I’m no expert, so most of this comes from Wikipedia, which itself is being furiously edited right now. Corrections are welcome, as I mainly started writing this to piece it together for myself and decided to publish mostly as a reality check.

The overlooked piece I’m talking about is Citadel LLC, a major finance company that engages in high-frequency trading (HFT), and who appears to be the real winner here. They’ve been mentioned in memes and Twitter threads, but a lot of conflicting claims have been made about them, so I wanted to look deeper. My current understanding of their role really demonstrates the need for people to continue to work together at scale, in a fashion that we typically call government, in order to see any real change.

So Citadel’s first involvement is that they buy “order flow” information — a live feed of who is buying what — from Robinhood, the main trading app used to launch Reddit’s assault on Melvin Capital (and other over-exposed hedge funds). This is well-established, and is a major income stream for Robinhood. It seems to be the reason Robinhood offers zero-commission trades at all.

Citadel then uses this to “front-run” Robinhood trades: in the milliseconds before the order is placed, Citadel is able to buy the stock being traded and sell it to complete the trade themselves, keeping any price difference. It’s a tiny profit, but one that would have benefited either the buyer or seller, if only a little. When they do it to millions (?) of trades per day, though, it’s basically a money printer — yes, kind of like the Office Space scheme. Acting on non-public information in this way is illegal, so the accusation needs evidence beyond “Wall Street is scum.” And while I’m ready to believe that Wall Street is scum, we further know that they wouldn’t pay for order flow information if they weren’t profiting off it; they’ve been fined for it before, but for less than the profits they likely made, so there’s little incentive to stop; by my understanding, it’s a major motivation for HFT to begin with; and supposedly, the trade volume for targeted stocks is far higher than what WSB and other “retail investors” could produce alone.

Next, Citadel appears to have made a major investment in Melvin Capital while they were losing billions in WSB’s initial assault. This also seems well-established, and the innocent explanation is just that they saw an opportunity to invest at a discount and took it, under the assumption that this will all wash out and Melvin will recover.

After that investment, though, Robinhood and others froze trading on WSB’s targeted stocks. Importantly, this freeze is not the result of a “circuit breaker” set by the exchange itself, where the criteria for a freeze is predefined and just part of the rules that everyone agreed to. It’s a private entity playing gatekeeper, essentially a broker refusing to fill client trades for their own gain. Again, this freeze is well-established fact. With the above story, though, it’s more sinister than simply rich people vaguely protecting other rich people, or companies trying to avoid controversy and regulation in general.

Specifically, Robinhood appears to be actively protecting Citadel, a major and powerful client of theirs. Further, Citadel chose to buy into Melvin Capital while they were still flailing and vulnerable to lose even more, as if they knew about Robinhood’s impending freeze. Ameritrade and others also froze trading, it appears, but Citadel almost certainly has the same relationship with them (though I didn’t verify that).

In short, it seems like there’s always a richer fish: WSB successfully brought Melvin Capital to its knees, and a few individuals with fortunate timing did walk away richer. But Citadel — who was likely already profiting from WSB’s assault via Robinhood and others — was able to snap up Melvin Capital at a major discount apparently knowing that Robinhood would protect them from the assault that wounded Melvin. That assault was effectively the entire reason for the discount, meaning that Robinhood’s halt moved this from a shrewd financial move to active and illegal manipulation, allowing Citadel to walk away with all of the gain and none of the risk. So to further abuse the French Revolution metaphor, the proletariat didn’t establish a new order, they just created an opportunity for English royalty to invade and perhaps further consolidate the power of monarchy.

To be clear, I don’t mean this to be a cynical take. It’s still really cool, and instructive, that a large group of internet randos working together were able to wound a massive hedge fund. It’s cathartic, even, knowing the predatory nature of hedge funds: from “private equity” firms they own that buy and destroy companies with no regard for labor, to predatory development practices — “vulture funds” — exploiting disasters in Puerto Rico and other places to snap up land, to the harmful effects of their wild speculation in general. But while celebrating that, it also seems important to understand that this kind of momentary frontier justice won’t fix the system alone. Any kind of lasting victory is going to involve government regulation and reform — targeted at the finance industry, not individual traders, if any justice exists in the world — even if regulation is less sexy than a modern, meme-infused version of Les Miserables played out entirely inside of computers.