Are You Surprised That Robinhood Turned Out To Be Prince John?
Welcome back! Twice in one week, that’s definitely a new record. But hey, this is one of the few times where the distance between the world of investing and the world of popular culture are at their smallest, so why not take advantage of it and get some more ideas to y’all while you’re at your most-amenable?
Since the last post…three days ago (so much for a dropoff in time dilation post-Trump), Robinhood and other trading platforms/apps have frozen the ability for new investors to buy shares of GME and other stocks being short squeezed, while still allowing for the ability to sell them for the users that hold them (as for shorting GME, Robinhood does not allow for shorting). There have been stories of Robinhood selling users’ shares of GME and other short squeezed stocks without the user’s input. The driving up of GME has transformed into a David vs Goliath analogue of tendies-chasing retail investors up against big, bad hedge funds, but is that actually what’s occurring here? The mania of stories about GME has almost hit the same level as the mania around the stock itself, so it behooves us to step back for a second and get a better understanding of what’s really going on, as well as what this means for retail investors going forward.
First off, if you have no idea what’s going on with GME, WallStreetBets, and hedge funds, read the previous blog post and/or dunk your head into financial Twitter (aka FinTwit). Good? Good. The major update since then is the freezing out of investors on a variety of platforms from purchasing shares in GME and other stocks being shorted. This isn’t the first time that RH users have been prevented or slowed from making trades: the app kept trades from occurring during the large price movements and sharp recession in March 2020, and even had a day of reduced trading possibly caused by not including the 2020 leap day into app’s infrastructure. Whether or not Robinhood deserves to be the focus of the ire is up for debate (I’d throw my vote behind Interactive Brokers and their extremely tone-deaf response), but when over half of your userbase holds GME, you would think that you’d be on the side of your users. However, there are two things working against this assumption:
The nature of accounts on Robinhood. The two main types of brokerage accounts are Cash and Margin accounts. Think of them kind of like Debit and Credit cards. A Cash account requires all trades to be carried out solely on the basis of the account user’s cash availability. If you want to buy a share of VOO (or SPY, or any other S&P 500 ETF), you have to have the cash available to do so at that very moment. So if you’re selling a share of TSLA in order to purchase a share of VOO/SPY/etc., you have to wait t+2 days for the transaction to be cleared and the cash to end up back in your account. Margin allows for some flexibility regarding this: instead of having to wait two business days, a Margin account will see that you have the correct amount of virtual cash to purchase VOO/SPY/etc. while the sale of TSLA clears, and will allow for the transaction to take place on day t with the understanding that books will be balanced two business days later. Why mention this? Well, Robinhood automatically puts users into a Regulatory T margin account, allowing for users to avoid the t+2 waiting period, but requiring RH to keep margin account balances in-order. This means nothing most of the time, but in instances where the market on the platform gets out-of-balance, they need to halt certain things in order to keep settlements in the proper order. In other words, Robinhood had to halt purchasing of GME and other short squeeze stocks in order to keep their overall margin account balance from being unable to cover itself. It’s a weird reverse Tragedy of the Commons, where users as a whole unbalance things enough to freeze out individual investors that are later to the party.
To be perfectly frank: retail investors are not Robinhood’s customers, they are its product. (Almost all) free services aren’t being run out of the goodness of the provider’s heart, it just means that their money is being made elsewhere. Google and Facebook can offer free services because of their ad platforms and the bundling and selling of audience data. News outlets can either offer articles on a subscription basis or they will inundate their pages with ads to make ends meet. Robinhood is no different: with no commission trading as one of their main tenets, they have to make their money elsewhere. This is done via order flow data. Order flow is raw-form trading data, allowing one to see the actual amount of contracts being bought and sold, the price at which they occurred, as well as the interest of buyers and sellers. Order flow data gives viewers an understanding of the ebb and flow of the constituents of a platform, essentially letting them see the overall movement of Robinhood’s users as-a-whole in terms of market sentiment, focus, and magnitude. That’s why we shouldn’t be surprised when Robinhood sides with Citadel over its users when 40% of its revenue is coming from hedge funds and high-frequency trading firms. In fact, while much has been ballyhooed about this being hedge funds like Citadel attempting to crush retail investors for having the gall to challenge them, the truth is much more boring and common: the amount of GME actually owned by the self-described autists from WSB and other retail investors is laughably minuscule. This is titans duking it out in an effort to take cash out of each other’s wallet; retail investors might as well be ants. They’re not upset because “individual investors are beating them at their own game”, they’re upset because the curtain has been pulled away, allowing the public a quick glance at how the sausage is made.
Robinhood should get some credit for their hand in the democratization of investing. Their app in no small part drove the industry toward no commission trades and their UX was a breath of fresh air in an industry where most platforms were hot garbage to use. But Robinhood was never on the user’s side: their goal was to provide large investment firms a peek into a representative sample of individual investors in order to help determine the movement of the markets. Even then, that’s not the most-damning part of what Robinhood has done. No, Robinhood deserves the majority of your scorn not for the packaging of order flow data or their freezing of trades on short squeezed stocks, but for their gamification of investing. There is so much research out there that demonstrates the underperformance of active retail investors relative to their passive counterparts . By creating a platform that actively nudges and encourages its userbase (again, the product and not the customer) to trade as much as possible, they are both providing their institutional customers with a larger and more robust set of order flow data as well as lowering the investment returns of their userbase. While noise is (deservedly) directed toward the obfuscation of how a user’s account really works on the platform regarding margin calls and account balance, they are silently reducing active investors’ returns by encouraging them to trade as much as possible through no trading fees, flashy graphics, and active encouragement. Everyone clamors about deaths from shark attacks because of their flashiness, but there’s no outrage for deaths from high blood pressure because they’re not eye-catching, despite utterly dwarfing shark attacks in terms of annual deaths.
So, where does that leave individual investors? As far as I see it, there’s two paths available.
Creation of a decentralized trading app, treating users as the customer and not the product. There has been movement toward decentralized trading platforms, creating a distributed trading network that has no one controlling interest to allow for a trading experience that isn’t subject to the whims of a central operator or its largest revenue drivers. This decentralized environment concept is one that’s been a major driver of blockchain-based applications and is a way to offer a trustless infrastructure (aka an exchange system that does not require a third-party intermediate to validate both sides of a transaction, not a wild west frontier where the spoils go to the person with the quickest draw) for those using the service. There is a lot of promise and headway being made on this idea, but it suffers from slow adoption, partially driven by a lack of uptake from the establishment unless it can be bent or broken to suit their aims.
Create a platform where there is a virtuous benefit alignment between the provider and the userbase. When alignment occurs between both sides, it serves in the best interest of the provider to make sure their users benefit in order for their own benefit. Look: there is no way for altruism to ever exist in a profit-seeking marketplace, so expecting it to occur is folly. But, if you align incentives on all sides of the platform, you can guarantee that the provider will work toward the benefit of its customers. What would that entail for retail investors? For one, nudge users toward a buy-and-hold passive investment strategy and actively discourage users from overtrading to the point that they ruin their returns. Charge users a fee, but tether that fee to portfolio performance and keep it low enough that the benefit of the platform outweighs its cost (but allows the provider to turn a profit). Offer funds and securities that favor buy-and-hold investments and don’t chase short-term moonshots. Offer position- and offering-agnostic education on investing, creating a more-informed userbase that can more-accurately discern the right investment vehicles for their personal goals (who then purchase more products on the platform, recouping any “lost” revenue from offering free education). Finally, make absolutely damn sure that any future third party group has their alignment in lock-step with the two original groups; a potential scenario would be allowing non-profits, pensions, endowments, etc. to create funds on the platform to encourage retail investors to invest in them and provide them with a steady annual income stream.
Does the second option sound too good to be true? Well, keep watching this space: Novatero will have some big news before too long.
Until then, remember that no matter how the whole GME event shakes out, retail investors are inherently playing from behind the 8-ball when it comes to investing. Active retail investors underperform passive retail investors, and while there is mixed evidence on the ability of active institutional investors to outperform, that alpha is pretty much swallowed up (and more) by fees to reward said managers. Unless you’re one of the massive industry titans, your chance of profiting by ways other than the long-term buy-and-hold are left up to speculative fliers like GME, and then only if you get in before the bubble bursts or the titans take away the ball. Change is long and hard and uphill, but if there’s a will and a receptive public, there’s a way. Stay tuned.