Robinhood Crypto receives an SEC Wells notice for securities violations

By Amy Castor and David Gerard

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Popular day trading app for degenerate gamblers stockbroker Robinhood Markets runs quite a profitable crypto business on the side.

In the 2021 bubble, the crypto side was a massive chunk of Robinhood’s overall profits. Crypto pays them so well because they can charge trading fees, while stock trading charges 0%.

Anyway, Robinhood Crypto is gazing into the orbital laser cannon of regulatory clarity — they received a Wells notice from  the SEC on May 4. It seems that some of what the crypto side deals in constitutes unregistered securities.

 

 

The Wells notice

Here’s the text from the 8-K that Robinhood filed about the notice. This is all our actual knowledge so far: [8-K]

On May 4, 2024, RHC received a “Wells Notice” from the Staff of the SEC (the “Staff”) stating that the Staff has advised RHC that it made a “preliminary determination” to recommend that the SEC file an enforcement action against RHC alleging violations of Sections 15(a) and 17A of the Securities Exchange Act of 1934, as amended.

Section 15(a) deals with broker-dealers. Section 17A and Rule 17Ab2-1 require an entity to register with the SEC or obtain an exemption before acting as a clearing agency. [Act; LII]

Since Robinhood is a public company, they had to file about the Wells notice immediately. The text of the notice itself has not yet been put up.

If you sell securities on behalf of your clients, you are a broker-dealer. If you facilitate trades between a buyer and a seller, you are a clearinghouse. The SEC requires that these functions be kept separate, for good reason!

Be your own clearinghouse!

After a buyer and seller agree on a price for a trade, a clearinghouse will “clear” or settle the trade between the two parties.

The role of the clearinghouse is to reduce counterparty risk. If you’re an investor, you don’t have to worry about the brokerage going bankrupt, because the clearinghouse ensures the funds are there.

In the US, the main clearinghouse for stocks is the massive SEC-registered Depository Trust & Clearing Corporation. The purpose of the DTCC is to protect investors and the markets by ensuring brokerage firms have the funds to support the trades they make.

As the SEC already pointed out in its lawsuit against Coinbase, the duties of an exchange, a broker-dealer, and a clearinghouse are not to be intertwined — because that would risk massive conflicts of interest.

Robinhood Financial, the stock trading division of Robinhood Markets, is a registered broker-dealer. They clear their trades through the DTCC.

The Robinhood Crypto division is not registered as a broker-dealer. They also function as their own clearinghouse.

This is stupidly risky — as Robinhood has experienced firsthand. In January 2021, Robinhood got a call from the DTCC asking them for $3 billion in overnight capital to mitigate the risks of prices on certain assets collapsing — specifically, popular meme stocks.

Robinhood didn’t have the money! So they responded by limiting buy orders on GameStop (GME) and other volatile securities to reduce the collateral demands.

This crashed the stock and led to a class-action lawsuit, an SEC investigation, and Congressional hearings. But the point is that the DTCC was there to avert disaster.

How the Robinhood crypto casino works

Robinhood was founded in 2013 as a way for people to trade stocks commission-free. Founders Baiju Bhatt and Vladamir Tenev made their money from day traders, who became addicted to the game-like quality of the mobile app.

To lure in more gamblers of greater degeneracy, they expanded the platform in 2018 to include crypto, which is super volatile and like crack cocaine to day traders. In the process, they turned themselves into their own clearinghouse.

Robinhood Crypto is not an exchange — they don’t match sellers and buyers like Coinbase or Kraken. Instead, they pass orders through to a liquidity provider.

Robinhood Crypto used to send orders to Jump Trading, but that relationship ended in 2023 after Jump decided there was a bit too much regulatory heat in the crypto business. Now Robinhood works with other market-making firms, including B2C2. According to their 10-Q for Q1 2024, they send more than 10% of their crypto orders through Wintermute. [CoinDesk, 2023; 10-Q]

Dogecoin (DOGE) was particularly profitable. In the first three months of 2021, more than a third of Robinhood’s crypto business was driven by DOGE. [S-1, June 2021]

Like many crypto firms, Robinhood benefited from a surge in the price of bitcoin in the first quarter of 2024. Its crypto revenue tripled in Q1. [Press release, PDF; 10-Q]

Robinhood Crypto operates to the high standards one expects of a crypto firm — they paid a $30 million fine to New York for compliance failures in 2022.

Crypto securities on Robinhood

Currently, Robinhood Crypto lists just 15 crypto tokens: AAVE (Aave), Avalanche (AVAX), Bitcoin (BTC), Bitcoin Cash (BCH), Chainlink (LINK), Compound (COMP), Dogecoin (DOGE), Ethereum (ETH), Ethereum Classic (ETC), Litecoin (LTC), Shiba Inu (SHIB), Stellar Lumens (XLM), Tezos (XTZ), Uniswap (UNI), and USD Coin (USDC). [Robinhood, archive of May 9, 2024]

They delisted Solana (SOL), Polygon (MATIC), and Cardano (ADA) tokens when the SEC called those out as unregistered securities in June in its lawsuits against Coinbase and Binance.

The SEC just needs to show that one or more of the crypto tokens on Robinhood Crypto are unregistered securities, which shouldn’t be too hard. The SEC has already warned that the “vast majority” of cryptos are unregistered securities.

Consensys recently got a Wells notice, and they are worried that the SEC will determine that ETH is an unregistered security, after Ethereum switched to proof of stake.

Uniswap also got a Wells notice, and we would not be surprised if UNI is called out as an unregistered security.

What securities will the SEC call out if it sues Robinhood? We would guess UNI and, given the Consensys Wells notice, even ETH is a possibility — but they could potentially call out any one of the 14 non-bitcoin tokens as securities.

Not backing down

Robinhood says it’s going to fight! Dan Gallagher, Robinhood’s chief legal officer, insists in a company blog post that the company is not selling securities incorrectly. [Robinhood]

Vlad Tenev said Robinhood would “contest this matter in the courts,” to defend itself and to establish “regulatory clarity.” [Twitter; Twitter]

Robinhood does have regulatory clarity — just not the kind of regulatory clarity that lets them keep making money on unregistered securities with a COI-filled business arrangement. What crypto wants is special rules that allow them to keep violating decades-old securities laws.

What this means

The SEC’s action against Coinbase is existential — if the SEC prevails, a huge chunk of Coinbase’s US business disappears. Robinhood isn’t in that position.

We doubt Robinhood will fight very hard. Crypto isn’t even their main business — it accounted for just 7% of their transaction-based revenue last year. [Axios]

We expect Robinhood will eventually settle, pay a fine, and move on.

The SEC is already suing Kraken and Coinbase and is preparing to sue Uniswap and Consensys. As long as Biden is re-elected in November and Gary Gensler remains the chair of the SEC, we expect the SEC will see all these lawsuits through. The public is still pissed off about the crypto crooks from the last bubble.