Mark Lennihan/Associated Press
Sarah Cabral is a teaching and research fellow in the Carroll School of Management at Boston College. Amy LaCombe is associate dean for undergraduate curriculum in the Carroll School’s undergraduate program. Views are their own.
In this business ethics case study, we will focus on the history making GameStop short and stock price surge that occurred during January 2021. On Thursday, Jan. 28th, 2021 Robinhood CEO, Vlad Tenev, decided to halt the trading of GameStop stock on his company’s stock trading app. Did Tenev make the right choice? Did he have a choice? If not, then what should Robinhood do to make amends for the role it played in causing monetary damages to its customers? In order for students to debate the appropriateness of the decision and response, we will provide an overview of the e-Trading industry Robinhood is a part of and their role within it, in addition to providing a background on the video game retailer, GameStop. Furthermore, the social media company, Reddit, which provided the platform for users to connect and rally behind GameStop and purchase shares, will also be explained and examined.
2. e-Trading Software Developers Industry
The e-Trading Software Developers industry is an industry that allows institutional and retail investors to trade securities online and access and track stock performance. This is a $10.4 billion dollar industry with a 34% profit margin and 325 operators. Within the industry, revenue is expected to increase 3.5% over the next five years, due to increased demand. The projected growth of this industry is based, in part, on the rise of exchange traded funds and index investment vehicles, which are making it easier for people to get general investment exposure. Another growth factor is due to people’s preference for online services that, in the past, used to only be conducted offline. Additionally, trading costs and fees have decreased due to advancements in industry software, increased data storage, and reductions or eliminations of commissions (IBISWorld).
The largest companies in this industry are Charles Schwab Corporation with 23.7% of the market and $3.8 trillion assets under management, Fidelity National Information Services Inc. with 19.7% of the market and $2.5 trillion assets under management, and TD Ameritrade, recently acquired by Schwab, with 12.5% of the market and $1.3 trillion assets under management (IBISWorld and TopRatedFirms). The average account size for Charles Schwab, Fidelity, and TD Ameritrade are $240,000, $112,000, and $110,000, respectively. While the top four industry players account for around 60% of the revenue, the 20 companies in the middle share 10% of revenue, and the bottom 300 companies share 30% of the revenue, making the industry somewhat fragmented with a medium barrier to entry (IBISWorld). Thus, newer and smaller companies hold a small fraction of the industry market share but are fast growing with effective marketing strategies.
3. History of Robinhood
Robinhood is an American app-based stock brokerage company that offers commission free stock and ETF trading (FastCompany). According to their website, “Robinhood’s mission is to democratize finance for all” (Robinhood). It was founded in 2013 and the app was launched in 2015 by two former Stanford University roommates, with the hopes of “democratizing” the financial markets, which were not charging fees to the big investment banks but were charging fees to everyday investors (thestreet.com). Robinhood has a subscription based service that allows members to use instant deposits to trade before the market has opened and after it has closed (FastCompany). Robinhood has $20 billion assets under management with an average account size of $3,500 (BusinessofApps). In 2019, it had 6 million users, up from 3.7 million the previous year (thestreet.com), which is more than the traditional online brokerage of E*Trade. Robinhood’s user base grew to 13 million in May 2020 and is estimated to be near 18 million today based on an estimate by JMP Securities (NYT and Morningstar).
In 2018, Bloomberg reported that more than 40% of Robinhood’s revenue came from selling its customers’ orders to high frequency trading firms or “market makers”, which is a controversial practice on Wall Street (Bloomberg). A “market maker” is a company that offers to both buy and sell a stock at different prices, hoping that the difference between the bid price offered for the amount of stock they want to buy will be lower than the price at which they will ultimately sell. Since investors need to liquidate assets for different reasons at different times, a market maker provides brokerages with the opportunity to sell bundles of stock for cash. The market maker takes on risk by purchasing stock without the guarantee of that stock being later sold for a higher price than that at which it was bought. To compete with exchanges, such as the New York Stock Exchange, market makers, such as Citadel Securities, pay for order flows and offer rebates to brokerages, such as Robinhood Securities (Morningstar). Market makers typically offer better prices than exchanges, and Robinhood makes money off of directing trades to market makers. Market makers execute trades for Robinhood, send Robinhood Securities a record of the trade, and then Robinhood works with a clearinghouse, such as National Securities Clearing Corporation (NSCC), to ensure that the stock gets to the buyer and the money gets to the seller. Market makers provide rebates on trades and pay for order flows, which creates a misalignment of the interests of the brokerage firm, such as Robinhood Securities, and its clients (public.com). They are controversial in how they handle the orders received. Since market-makers have access to the trades before they are actually placed, they technically are able to front-run the trades for their own accounts or engage in other unethical trading practices (Appendix B).
Another way that Robinhood makes money is on the interest it charges to “lend” its clients shares to third parties, such as hedge funds, who may want to “short” the stock. Additionally, Robinhood generates revenue by charging interest to the retail investors who utilize margin accounts. When investors sign up for a Robinhood account, they have the option of opening up a margin account, either a “Gold” or “Instant” account, where they agree to allow Robinhood to lend those shares. That margin account allows hedge funds to buy the stock “on credit” or on a loan from Robinhood. It is a line of credit with interest tied to movements in the price of the stock. When an investor believes that a stock price will go down, he/she can borrow the stock from Robinhood and “short” it. If there is a high demand to borrow that stock and short it, the interest on the borrowing of that stock is high. If there is not a lot of demand to borrow a stock and short it, the interest rate is quite low as the risk is lower to the broker (medium.datadriverinvestor.com). Robinhood holds the actual stock for its investors at the National Securities Clearing Corporation (NSCC), whose parent company is the Depository Trust & Clearing Corporation (DTCC), and then lends out that stock to hedge funds and other agents with margin accounts who may want to “short” that stock (Appendix A). As more demand for shorting that stock appears, Robinhood collects more interest on that loan of the stock and is allowed to keep all of the money earned on the loaning of those shares, as long as the agents and funds have the ability to pay that interest and loan back. If the hedge funds continue to lose because the price goes up (and they have shorted it), it threatens their ability to pay Robinhood back for the loan as well. This allows Robinhood to survive financially without collecting commissions like traditional retailers.
4. History of GameStop
GameStop is the world’s largest video game retailer and was founded in 1984 by Harvard business school classmates. The first store opened in Texas, and this Fortune 500 company currently operates over 7200 stores in 14 countries (5starsaver.com). GameStop shares are traded on the New York Stock Exchange and the Frankfurt Stock Exchange. The company generates revenue by selling gaming consoles and physical video games and accessories. In 2011, GameStop achieved $10 billion in revenue. However, just as streaming services resulted in decreased demand for physical DVDs and CDs, video games are now available to download or stream, making physical discs more obsolete. According to Sony, around half of the video games sold by their company in 2020 were digital. As entertainer reporter, Adam Epstein, writes, “GameStop is the Blockbuster of video games—a relic of old consumption habits, barely scraping by in a digital world” (Quartz). Reflecting the new consumer preference for digital games, GameStop’s revenue in 2019 only reached $6.4 billion, and the company laid off hundreds of employees and had plans to close 1,000 stores (Quartz).
One year ago on March 23, 2020, GameStop’s stock price closed at $4.22. On January 27, 2021, less than one year later, the stock closed at $347.51 due to an increase in demand for its stock, proving one of the largest increases in an individual stock price in the history of the NYSE (finance.yahoo.com). The surge was due to a group of individual investors who decided to purchase GameStop stock, after determining that the stock was undervalued, followed by significant institutional buying. The platform that the individual investors used to communicate with one another is the social media platform, Reddit.
5. Reddit and The GameStop Short
Reddit was founded in 2005 to be “the front page of the internet” (mashable.com), where people went to get all of their information, rather than clicking through multiple sites each day. Today, Reddit is the seventh most viewed website in the United States and 18th in the world (mashable.com), providing internet users with up to date news, affinity groups and a place where users can create their own communities.
One of the subcommunities in Reddit (called a subreddit) is a group called WallStreetBets, where participants discuss stock and trading options. This group noticed that hedge funds had taken a large “short” position on GameStop stock (guardian.com). That means these hedge funds bet that the GameStop stock would go down. When investors “short” a stock, they sell a borrowed stock, believing that the price of that share will go down with the hope of buying it back later at a lower price, thus earning money on the sale and buy back of the stock. There is an unlimited risk since the price of the stock can rise infinitely, allowing the short-seller to lose an infinite amount of money. The price of that stock can increase forever, making the process of short selling incredibly risky. This is different from buying a share of stock, since the price of the stock cannot fall lower than $0, meaning the investor cannot lose more money than he or she already paid to purchase the share.
The subreddit group decided to make several posts beginning on January 22, 2021, on Reddit to purchase the GameStop shares, driving up the price some 600% in four days, thus forcing those large Wall Street firms who bet that the stock would go down, to lose billions in its portfolio (guardian.com). As more demand for GameStop took over the market, the price went soaring to its high of $347.51 on January 27, 2021. Gamestop saw its market capitalization go from $3 billion to $25 billion in a week and 50 million shares of the company changed hands in the span of an hour on Monday, January 25th (nationalreview.com). The Redditors' purchases of GameStop shares alone did not account for the dramatic price increase, however. The consequences of their purchases did. What caused the price to sky-rocket is a long-established practice on Wall Street called a "short-squeeze." Hedge funds often use this tactic against each other. Because hedge funds had leveraged themselves out to short GameStop so aggressively with the hope of squeezing out the last of its potential upside, the Redditors realized that all they needed to do was generate enough upward pressure on the stock price by buying up shares to breach a certain threshold where hedge funds began to lose significant amounts of money. Once that threshold was breached and hedge funds were starting to lose millions with every cent the stock rose, these hedge funds were forced to close out their short positions. Since shorting represents the sale of a borrowed share, in order to close out their positions, the hedge funds were forced to buy the GameStop shares at their current market price. The billions of dollars worth of buy orders by hedge funds to close out their positions and prevent further losses is what shot the price of the stock up so dramatically. And because the Redditors had already bought shares to create that pressure on the hedge funds, the value of their shares rose exponentially.
6. Decision point: January 28th
In the early morning hours of January 28, 2021, Robinhood CEO, Vlad Tenev, received a frantic call from the company’s operations team. The call was based on a letter the team had received at 4 a.m. from the National Securities Clearing Corporation (NSCC). Robinhood routinely receives letters from the NSCC each morning at 4 a.m., so receiving the letter was not the cause for alarm. Rather, it was the contents of this particular letter, a request for the company to show that it had $3 billion in cash, that resulted in the call to Tenev. NSCC, like other clearinghouses, ensures that the purchase and sale of stock goes through smoothly for both the buyer and seller. The volume of stock traded through Robinhood spiked so much that the NSCC needed to see more money in Robinhood’s account to make sure that the buy orders would, in fact, clear. Because of the volatility of stocks like GameStop, NSCC determined that Robinhood needed to have more capital in order to cover a potential collapse in stock prices between the purchase date and the clearing date two days later (Appendix A). Because the deposit requirement of the clearinghouse well-exceeded Robinhood's on-hand liquid capital, the existing trade orders would not have been able to settle unless they satisfied the deposit requirement. Tenev ultimately decided that day to halt buy orders of GameStop stock and negotiate the deposit requirement down to $700 million. Did Tenev make the right choice? Did he have a choice? How is Robinhood going to make this right?
Adamczyk, Alicia. "'You Will Lose Your Money Very, Very Quickly': What Investors Need to Know about GameStop's Stock Surge." CNBC. January 27, 2021. https://www.cnbc.com/2021/01/27/what-to-know-about-gamestops-stock-spike.html.
Andrews, Chris. "The Largest Brokerage Firms By Assets Under Management in 2021." Best 10 Brokerage Firms. https://topratedfirms.com/brokers/ratings/top-rated-brokerage-firms.aspx.
Bruhn, Asger. "Robinhood Lends "Your" Shares to Short Sellers (and Keeps All the Proceeds)." Medium. January 31, 2021. https://medium.datadriveninvestor.com/robinhood-lends-your-shares-to-short-sellers-and-keeps-all-the-proceeds-78353ca33fb9.
Epstein, Adam. "The Video Game Industry Is Leaving GameStop behind." Quartz. https://qz.com/1965538/why-did-hedge-funds-short-gamestop-in-the-first-place/.
Fiegerman, Seth. "Aliens in the Valley: The Complete and Chaotic History of Reddit." Mashable. December 03, 2014. https://mashable.com/2014/12/03/history-of-reddit/.
Foxman, Simone, Julie Verhage, and Suzanne Woolley. “Robinhood Gets Almost Half of Its Revenue In Controversial Bargain With High Speed Traders.” Bloomberg. October 15 2018. https://www.bloomberg.com/news/articles/2018-10-15/robinhood-gets-almost-half-its-revenue-in-controversial-bargain-with-high-speed-traders.
"Frequently Asked Questions." Robinhood. https://robinhood.com/us/en/support/frequently-asked-questions/.
"GameStop: How Reddit Amateurs Took Aim at Wall Street's Short-sellers." The Guardian. January 28, 2021. https://www.theguardian.com/business/2021/jan/28/gamestop-how-reddits-amateurs-tripped-wall-streets-short-sellers.
Groom, Christie. "GameStop - The History of the World's Largest Video Game Retailer." 5 Star Saver. September 12, 2018. http://5starsaver.com/favorite-stores/gamestop-worlds-largest-video-game-retailer.
Moses, Jeremy. “E-Trading Software Developers.” IBIS World. June 2020.
Pisani, Bob. "There's Now a Record Number of 401(k) and IRA Millionaires, According to Fidelity." CNBC. February 13, 2020. https://www.cnbc.com/2020/02/13/fidelity-there-is-now-a-record-number-of-401k-and-ira-millionaires.html#:~:text=Fidelity says a record 441,000,last quarter's balance of $105,200.
Popper, Nathaniel. "Robinhood Has Lured Young Traders, Sometimes With Devastating Results." The New York Times. July 08, 2020. https://www.nytimes.com/2020/07/08/technology/robinhood-risky-trading.html.
"Robinhood: Most Innovative Company." Fast Company. January 01, 2000. https://www.fastcompany.com/company/robinhood.
Sraders, Anne. "How Does Robinhood Make Money?" TheStreet. February 10, 2019. https://www.thestreet.com/investing/how-does-robinhood-make-money-14856528.
Tenreiro, Daniel. "Why Robinhood Halted GameStop Trading." National Review. January 29, 2021. https://www.nationalreview.com/2021/01/why-robinhood-halted-gamestop-trading/.
"What Happened This Week." Robinhood. Under the Hood. January 30, 2021. https://blog.robinhood.com/news/2021/1/29/what-happened-this-week.
Widman, Jake. "What Is Reddit?" Digital Trends. March 29, 2021. https://www.digitaltrends.com/web/what-is-reddit/.
Appendix A: How NSCC Works
It takes settlement time on trades (up to 2 days), so that is why the NSCC requires brokerages to increase their collateral when there is high volatility in trading. It allows the NSCC to make sure that the brokerage firms have the assets to back up the potential losses on the trades.
For the sake of simplification, let’s walk through a hypothetical. If I were to sign up to some brokerage app like Robinhood, I could buy and sell securities available on the public market. These include stocks like GME or exchange-traded funds (ETFs). Some brokers also now allow customers to purchase cryptocurrencies, though there may be restrictions in trading or transferring these to off-platform wallets. Here’s what this hypothetical process might look like (coindesk.com):
1) I would buy a share of a stock, let’s call it $STOCK, on this app.
2) The order would go to the app’s internal order management system (OMS).
3) The OMS would route the order to an exchange or to another broker-dealer.
4) After the order is matched, the exchange would tell the app.
5) All of the exchange’s orders would go to the continuous net settlement process, which aggregates all of a company’s trades into one long and one short position on the NSCC and this can take up to two days.
Appendix B: SEC Press Release
SEC Charges Robinhood Financial With Misleading Customers About Revenue Sources and Failing to Satisfy Duty of Best Execution
FOR IMMEDIATE RELEASE
Washington D.C., Dec. 17, 2020 —
The Securities and Exchange Commission today charged Robinhood Financial LLC for repeated misstatements that failed to disclose the firm’s receipt of payments from trading firms for routing customer orders to them, and with failing to satisfy its duty to seek the best reasonably available terms to execute customer orders. Robinhood agreed to pay $65 million to settle the charges.
According to the SEC’s order, between 2015 and late 2018, Robinhood made misleading statements and omissions in customer communications, including in FAQ pages on its website, about its largest revenue source when describing how it made money – namely, payments from trading firms in exchange for Robinhood sending its customer orders to those firms for execution, also known as “payment for order flow.” As the SEC’s order finds, one of Robinhood’s selling points to customers was that trading was “commission free,” but due in large part to its unusually high payment for order flow rates, Robinhood customers’ orders were executed at prices that were inferior to other brokers’ prices. Despite this, according to the SEC’s order, Robinhood falsely claimed in a website FAQ between October 2018 and June 2019 that its execution quality matched or beat that of its competitors. The order finds that Robinhood provided inferior trade prices that in aggregate deprived customers of $34.1 million even after taking into account the savings from not paying a commission. Robinhood made these false and misleading statements during the time in which it was growing rapidly.
“Robinhood provided misleading information to customers about the true costs of choosing to trade with the firm,” said Stephanie Avakian, Director of the SEC’s Enforcement Division. “Brokerage firms cannot mislead customers about order execution quality.”
“Robinhood failed to seek to obtain the best reasonably available terms when executing customers’ orders, causing customers to lose tens of millions of dollars,” said Joseph Sansone, Chief of the SEC Enforcement Division’s Market Abuse Unit. “Today’s action sends a clear message that the Commission will not allow brokers to ignore their obligations to customers.”
“There are many new companies seeking to harness the power of technology to provide alternative ways for people to invest their money,” added Erin E. Schneider, Director of the SEC’s San Francisco Regional Office. “But innovation does not negate responsibility under the federal securities laws.”
Without admitting or denying the SEC’s findings, Robinhood agreed to a cease-and-desist order prohibiting it from violating the antifraud provisions of the Securities Act of 1933 and the recordkeeping provisions of the Securities Exchange Act of 1934, censuring it, and requiring it to pay a $65 million civil penalty. Robinhood also agreed to retain an independent consultant to review its policies and procedures relating to customer communications, payment for order flow, and best execution of customer orders, and to ensure that Robinhood is effectively following those policies and procedures.
The SEC’s investigation was conducted by Jonathan Warner and Ainsley Kerr of the Market Abuse Unit and Matthew Meyerhofer, Victor Hong, and Andrew Hefty of the San Francisco Regional Office. The case was supervised by Steven Buchholz and Mr. Sansone of the Market Abuse Unit and Monique C. Winkler of the San Francisco Regional Office. Examinations of Robinhood conducted by Michael Marren, Catherine Cotey, Michael Wells, David Kinsella, and John Broderson of the SEC’s Chicago Regional Office and Jerry Schoenborn, Shanti Radkar, Marcus Chan, and Stephanie Wilson of the SEC’s San Francisco Regional Office contributed to the investigation. The SEC also acknowledges the assistance of the Financial Industry Regulatory Authority.
This case hopes to highlight the power of social media in influencing actions with the purchase and sale of stock. It is largely a new field as E-trading software is gaining popularity. This is allowing individual investors to participate in trading in a way that was usually reserved for the big investment banks. Social media is influencing the actions of these individual investors, creating a lot of volatility and uncertainty in the markets, with respect to certain stocks.
This case also hopes to show that there are investors who are betting against companies, and this “shorting” of a stock allows there to be another market where investors are betting on the direction of the stock price. This can be risky if a person “shorts” a stock because the stock can go up forever, causing excessive losses. The fact that there are investors betting on both possible directions of the stock (short and up), allows there to be liquidity in the market and strengthens the market if there is a stock price that is overinflated.
This case hopes to highlight how conflicts of interest may put companies in a position where they have to act in a way that goes against their stated culture. Robinhood was founded to “democratize” the stock market, but when it halted trading, it went against its stated purpose and did not allow its individual investors to purchase shares of Gamestop stock. It is complex and nuanced, but we hope that students can see that short-term financial survival can influence people to make a decision that will potentially compromise their mission or purpose. It is important to have these discussions early on as evidence shows that “scripting” or anticipating difficult situations can be a powerful tool to combat this tension and keep companies from compromising their values.
Finally, this case hopes to spark a class discussion about whether a company should try to make amends for decisions made that may go against the best interest of its customers. If so, what are some possible suggestions to make those amends? There are several stakeholders involved with business decisions and what responsibility does a company have to its customers when their own financial survival is at risk? How can they repair that relationship? Is that even possible? These are some questions we hope that the case will raise in class discussions.
Application: This case is most appropriate for courses in business ethics, corporate social responsibility, and introduction to management.
Key Words: Ethics, corporate social responsibility, company values
Suggested Uses: This case would be valuable for business ethics classes to show how financial survival and/or short-term thinking can get in the way of values and mission. It could also be used in a finance ethics class, to show how the market and individuals can be influenced by outside forces and larger and more powerful players in the market, which could lead to a discussion whether that should be so.
- Clearinghouse - A clearinghouse is a designated intermediary between a buyer and seller in a financial market. The clearinghouse validates and finalizes the transaction, ensuring that both the buyer and the seller honor their contractual obligations.Every financial market has a designated clearinghouse or an internal clearing division to handle this function.
- Conflict of interest - A conflict of interest occurs when an entity or individual becomes unreliable because of a clash between personal (or self-serving) interests and professional duties or responsibilities.
- e-Trading - Electronic trading involves setting up an account with a brokerage of your choice, including providing your contact and financial information—to facilitate electronic transfers between your bank and the brokerage.
- Hedge funds - A hedge fund is just a fancy name for an investment partnership that has freer rein to invest aggressively and in a wider variety of financial products than most mutual funds. It's the marriage of a professional fund manager, who is often known as the general partner, and the investors, sometimes known as the limited partners. Together, they pool their money into the fund.
- Institutional traders - Institutional traders buy and sell securities for accounts they manage for a group or institution. Pension funds, mutual fund families, insurance companies, and exchange traded funds (ETFs) are common institutional traders.
- Interest - Interest is the cost of borrowing money, where the borrower pays a fee to the lender for the loan.
- Market maker - A market maker (MM) is a firm or individual who actively quotes two-sided markets in a security, providing bids and offers (known as asks) along with the market size of each.
- Payment For Order Flow (PFOF) - Payment for order flow (PFOF) is the compensation and benefit a brokerage firm receives for directing orders to different parties for trade execution. The brokerage firm receives a small payment, usually fractions of a penny per share, as compensation for directing the order to a particular market maker.
- Retail traders - Retail traders, often referred to as individual traders, buy or sell securities for personal accounts
- Short - A short, or a short position, is created when a trader sells a security first with the intention of repurchasing it or covering it later at a lower price. A trader may decide to short a security when she believes that the price of that security is likely to decrease in the near future. A covered short is when a trader borrows the shares from a stock loan department; in return, the trader pays a borrow-rate during the time the short position is in place.
- Short squeeze - A short squeeze occurs when a stock or other asset jumps sharply higher, forcing traders who had bet that its price would fall, to buy it in order to forestall even greater losses. Their scramble to buy only adds to the upward pressure on the stock's price. Short-sellers borrow shares of an asset that they believe will drop in price in order to buy them after they fall. If they're right, they return the shares and pocket the difference between the price when they initiated the short and the actual sale price. If they're wrong, they're forced to buy at a higher price and pay the difference between the price they set and its sale price. Short sales have an expiration date, so when a stock unexpectedly rises in price, the short-sellers may have to act fast to limit their losses.
- What options did Tenev have when he received the letter from the clearinghouse on January 28th 2021?
- Did Tenev make the right choice to halt the trading of GameStop stock? Who lost and who benefited?
- Did Robinhood break a promise to allow users to trade as they see fit? If yes, why? If no, why?
- Massachusetts Secretary of the Commonwealth William Galvin, the state's top securities regulator, accuses Robinhood of failing to protect consumers, stating, "Treating this like a game and luring young and inexperienced customers to make more and more trades is not only unethical, but also falls far short of the standards we require in Massachusetts." Do you agree? Why or why not?
- What should Robinhood do in response to the consumer consequences of the January 28th 2021 decision?
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Leonhardt, Megan. "AOC Wants Robinhood to Give Customers the Profits from Payment for Order Flow. Here's What She's Talking about." CNBC. February 19, 2021. https://www.cnbc.com/2021/02/19/aoc-wants-robinhood-to-return-payment-for-order-flow-profits.html.
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Wilhelm, Alex. "Robinhood Raises $1B after Trading Halts to Keep Its Platform Running." TechCrunch. January 29, 2021. https://techcrunch.com/2021/01/29/robinhood-raises-1b-after-trading-halts-to-keep-its-platform-running/.