The Paradox of Achieving Scale

Written by
Ross Andrewsarrow icon

The Paradox of Achieving Scale

Written by
Ross Andrews

*Disclaimer, we have no information about the Robinhood situation other than what has been publicly reported, this article is based on my first-hand knowledge of pain-points other hyper-growth startups have experienced and drawing parallels to the situation the played out last week.

Welp, last week had a little bit of news about the startup world. $GME, Robinhood, Melvin Capital, WallStreetBets, and a host of other parties made news as a group of retail investors begin heavily buying Gamestop stock, forcing several hedge funds with short positions (betting that the stock would go down) to have to cover their positions at a massive loss. Then, all of a sudden, popular broker-dealer app Robinhood restricted buys of $GME and several other securities. While I disagree with their decision to restrict trading, this move was most likely the result of their own success, and the paradox of scale that many hyper-growth startups face.

The first thing you must know is that Robinhood is a broker-dealer, what is the difference from a traditional broker? Broker-dealers buy securities from their own account on behalf of their clients. So when you deposit money with Robinhood, you are dropping money into a bank account that is in their name, and when you buy a stock, they buy it on your behalf, they hold the stock on your behalf, and when you request to sell the stock, they sell it on your behalf, calculate their profit (or loss) that they incurred on your behalf and then pass those profits or losses on to your account.

Because they are holding these securities on your behalf, the SEC has mandated liquidity rules for broker-dealers, essentially requiring them to have a certain amount of liquid capital against the potential losses that their depositors are exposed to (both securities that they are purchasing and selling, as well as options contract), why? Well, they are holding these securities and contracts on their books, yet they aren’t allowed to make decisions on when you buy or sell because that decision lies within the users and account holders. So broker-dealers require a large amount of liquidity on their books to be able to cover these potential liabilities.

Robinhood is a private, venture-backed startup with billions of dollars raised to help finance their growth, but also to give them enough cash on their balance sheet to enable them to be able to hold your deposits and enable you to trade freely. They undoubtedly have expert analysts who track their growth, both in accounts and deposits, and run scenarios to plot best and worst-case scenarios to make sure that they remain compliant and solvent.

Then the $GME frenzy happened, and for the purposes of this post, we will focus on the internal operations of Robinhood and what most likely happened (though none of this has been confirmed). As buying of Gamestop's stock continued at a torrid and rented pace, the amount of liquidity that Robinhood needed spiked so quickly that with internal liquidity, in order to meet the SEC mandated deposit requirements, had to put up so much money that the company was functionality insolvent. What does that mean? They had to put so much cash in reserves to cover the deposits and orders of all these new and expanding accounts that they no longer had enough money in the bank to operate as a business, that is they couldn't meet their obligations.

Now there are other factors here, yes they sell data to hedge funds and other trading firms, yes they paused trading, and all the while these other institutions were able to make adjustments to their positions and quite possibly save their own ass. I’m not going to discuss if anything behind the scenes was happening, but at the very least, this was negligence that had a real economic impact and for that changes must be made, and not just at Robinhood, simply put, grew too fast and the leadership that was able to scale up a tiny little startup (which isn’t easy to do and should be celebrated) was ill-prepared for what happened, signaling that it might be time to bring in some more experienced leadership.

This isn’t the first time this has happened and I have even heard stories of multi-time, successful, and experienced founders losing track of their own startup as it scales and not keeping infrastructure up to par. Robinhood should serve as a cautionary tale that both founders and investors need to be increasingly more in tune to the scale of the business and the demands that are needed from leadership. Could a more experienced CEO have spotted this issue with enough time to appropriately capitalize and avoid a trading freeze? What if the investors who also have a governance responsibility have stepped in when they noticed a lack of diligence being performed? It’s hard to know from afar what happened, but the paradox of scale might have finally caught up to Robinhood.

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