Democratizing equity markets without exploitation: A REAL ROBIN HOOD ON WALL STREET
Wall Street has been excessively elite, pricey, opaque, and complex for far too long. A big portion of it is deliberate and done thus on purpose in order for powerful, long-standing financial institutions to deceive or profit from the unwary by taking their money, with easy access to stock market wealth and cheaper, if not free, financial products and services, that created an opportunity for startup businesses to court Main Street investors.
However, it goes without saying that nothing on Wall Street is free and that wealth doesn’t come easily. These assertions frequently serve as nothing more than a pretext for coercion and abuse. In this instance, one financial company, in particular, Robinhood, likewise employed slick advertising, predatory app features, hip/cool logos, and a legendary brand to conceal the owners’ get-rich-quick schemes (along with outright criminal activity for which it has previously received regulatory sanctions).
But things don’t need to be this way. Equity markets and finance, in general, can be truly “democratized” (lower costs, simpler access, more enjoyable experience, etc.) without exploitation, manipulation, and predators benefiting themselves at the expense of regular investors and the buy side in general. All of that and more are covered in a law review article written by Better Markets published in the Western New England Law Review and titled “Democratizing Equity Markets With and Without Exploitation: Robinhood, GameStop, Hedge Funds, Gamification, High-Frequency Trading, and More.”
In January 2021, a media frenzy reported on a stock market trading frenzy centered around so-called “meme stocks” like Blackberry, AMC, and, most famously, GameStop, whose value rose to unthinkable heights despite bleak business prospects. For instance, GameStop’s share price increased by 1,600% in just 16 days, from January 11 to January 27, even though it was, to put it mildly, exceedingly implausible that GameStop’s economic prospects would have improved by that much in less than two weeks.
An army of retail traders talking about which meme stocks to trade on places like Reddit’s “r/wallstreetbets” significantly contributed to the trading frenzy. Many of those traders also wanted to defeat Wall Street at their own game by harming hedge funds and were viewed as bad actors for unfairly targeting particular companies. Many of those retail traders made the decision to carry out a short squeeze because those hedge funds had sizable, short holdings in those businesses. The “Reddit rebellion” that resulted from this, which cost numerous hedge funds billions of dollars in losses, eventually forced one (Melvin Capital) into liquidation.
Mobile phone-based apps like Robinhood, which allegedly offered “commission-free” trades with a user interface are attractive and engaging and make stock trading simple, enjoyable, if not “delightful,” were the tool of choice for many people trading meme stocks like GameStop shares. These are the main justifications given by Robinhood for its promise to “democratize finance” and bring wealth from Wall Street to Main Street. However, in January 2021, Robinhood abruptly forbade its retail users from purchasing GameStop and other meme stocks. This led to swift and dramatic price drops and enormous losses for the numerous retail traders who had purchased the stock at the peak or on the way up. This generated important concerns regarding Robinhood’s revenue model and interactions with other Wall Street players like Citadel and other high-frequency trading companies.
Despite claiming to “democratize finance” for their retail users, Robinhood and other trading apps’ actions highlighted the influential Wall Street firms that are actually the company’s real clients and how they all enriched themselves at the expense of retail traders, even though no evidence has emerged to suggest anything illegal with regard to the buying halt. Robinhood and other apps alike achieve this by utilizing “payment for order flow”. When retail brokers, such as Robinhood, sell their retail customers’ orders to the highest bidder, this is known as PFOF. According to their description, they can offer “commission-free trading” because of the PFOF revenue. Unfortunately, a lot of traders misinterpret that statement as “free trading,” which it most certainly is not. In actuality, the SEC’s enforcement action against Robinhood established that the PFOF revenue obtained from the retail traders’ orders was greater than what they would have paid if charged a commission. Additionally, trading apps use predatory “digital engagement methods” and other gamification approaches to persuade users to mindlessly participate in the PFOF practice in order to maximize income gained from this riskier practice.
Bringing these predatory practices to Main Street and taking advantage of hard-working Americans is not democratizing Wall Street; it is enriching Wall Street at the expense of Main Street, frequently from those least able to afford the losses that pay for the chauffeur-driven cars, private planes, mansions, and other luxuries the Wall Street billionaires purchase with their unjustly acquired gains. What Main Street investors need is a contemporary Robin Hood who doesn’t steal from the rich to give to the poor but instead gives Main Street investors real opportunity to trade, invest, and grow their money in the equity markets. That democratization can be done without exploitation and must be done.
Payment for order flow
In the 1980s, Bernie Madoff, who would later run a legendary Ponzi scam but was then a market maker focused on technological innovation, realized he could make a tidy profit if he could persuade brokers to route their trades, or order flow, to his business for execution. He also understood that in order to generate this huge profit, the orders he received needed to be mostly uninformed about the market’s direction. As a result, he started compensating brokers for their retail orders, which was a tempting offer for brokers who were previously paying the NYSE 3 cents per share for trade execution. PFOF, or retail payment for order flow, was developed. This approach was obviously profitable for brokers as well as high-frequency trading (HFT) businesses that purchase those orders and profit by collecting the spread between the price they are prepared to pay to acquire a stock (the bid) and the price they are willing to pay to sell the stock (the offer).
PFOF has turned out to be bad for investors and the markets. Brokers who are required to seek out the best execution for customer trades are clearly put in a conflict of interest by this. However, can the best execution truly be expected from brokers if they are selling their orders to the highest bidder? This inherent conflict is perhaps best illustrated by a December 2020 SEC enforcement action against Robinhood, which made public statements that it provided its users with superior execution even though it was aware from the internal analysis that its acceptance of unusually high PFOF payments resulted in noticeably lower execution quality than its rivals. Even after taking into account the $5 per trade commission that rival brokers charged, the SEC discovered that Robinhood clients still lost $34 million as a result of the company’s order execution procedures. This demonstrates a crucial point: PFOF may allow brokers to provide trading without charge, but so-called “commission-free” trading differs from “cost-free” trading. Instead, this strategy turns an upfront, obvious, fixed cost into a covert, variable cost from which high-frequency trading companies like Citadel and retail brokers like Robinhood profit handsomely. This does not benefit retail investors. PFOF damages markets by increasing market fragmentation, especially when it routes orders to HFT companies that either execute transactions using their own inventory or route to private “dark pools,” which prevents those orders from ever interacting with orders on open exchanges.
PFOF supports predatory digital engagement practices that harm retail users, including gamification
Because of PFOF’s economics, brokers profit more when their customers trade more frequently. Additionally, it means that brokers profit more from riskier transactions because HFT businesses make money by purchasing order flow and keeping the difference between the bid and the offer; these spreads are higher for less liquid and riskier items like options. Consequently, brokers can increase their profits from PFOF by encouraging their clients to trade more riskier products. This is exactly what apps like Robinhood do by utilizing so-called “gamification” techniques, and other predatory digital engagement practices (DEPs) that are “built on a Silicon Valley playbook of behavioral nudges and push notifications, which has attracted inexperienced investors into the riskiest trading.”
The predatory DEPs used by trading apps to entice users and encourage them to trade include offers of free stocks to get users to sign up, misleading claims of “commission-free” trading, which takes advantage of the well-known rule that people tend to overvalue, and thus use more of, products that are marketed as “free,” and so-called “educational and informational” tools that are actually designed to provoke thoughtless trading, by making it seem like information that should be acted upon. Additionally, by making it incredibly simple to trade these dangerous goods in just a few quick clicks, applications like Robinhood have sparked a rise in options trading among retail customers and actively encourage their users to do so.
These predatory DEPs that drive frequent and dangerous trading are harmful to retail consumers, contradicting the apps’ stated goal of democratizing finance. The performance of retail participants who trade regularly has long been known to be bad. Unsurprisingly, this has continued to be the case for Robinhood users only. Similar to this, retail consumers have historically performed poorly when participating in hazardous options trading. The HBO documentary “Gaming Wall Street” has numerous detailed stories, including that of a self-described “upper middle” homeless” man who thought he might have found hope in GameStop stock only to be frustrated (although he eventually found some degree of stability, not thanks to stock trading, but instead duality). It’s important to keep in mind that behind these studies about poor trading performance is real human suffering. A 32-year-old Navy medic who used a $15,000 credit card cash advance and later a $60,000 home equity loan to fund his trading on Robinhood ultimately lost nearly a million dollars; at the time of the article, he had less than half of his initial investment; and, most tragically, the heartbreaking tale of Alex Kearns, a 20-year-old college student who traded options on Robinhood and who tripped up while trying to cover his losses.
It’s crucial to remember that retail traders do not constantly lose money from frequent trading and option trading because they are stupid or because they lack market knowledge. There is little doubt that a large portion of retail participants is well-versed in business, finance, and economics. They are up against intelligent professionals who frequently have postgraduate degrees and access to cutting-edge technology in the zero-sum game of stock trading, which is the problem. Who would stand a chance in those situations? It would be comparable to the World Series champion Atlanta Braves playing a local recreational baseball team. The local league players could be quite excellent. Still, the professional players on the Braves play baseball exclusively every day and have access to the greatest trainers, gear, tools for training, and analytical methods. How much chance did they have? By encouraging its consumers to participate in a game they have little chance of winning, Robinhood is not leveling the playing field.
True democratization is feasible, but not through the Robinhood/PFOF model
Finance can and should be made more democratic, but the Robinhood/PFOF model is not the way to do it. Making it simpler for Americans on Main Street to genuinely profit from the stock market is true democratization. Retail investors could experience this, but it’s highly unlikely if they follow the frequent trading pattern that platforms like Robinhood and others that make use of predatory DEPs promote. Instead, for the majority of individual retail investors, using the stock market to make money and achieve realistic but ambitious financial goals typically means forgoing the frequent attempt (and, yes, excitement) to make a quick buck in favor of a longer-term buy-and-hold strategy that enables clients to take advantage of compound returns to increase their wealth. To put it another way, it would promote and empower clients to view themselves as investors rather than just traders.
Nevertheless, predatory sales, marketing, and trading strategies that leverage fictitious thoughtless activity and endorphin highs to produce financial lows should not be used to abuse and manipulate Main Street traders and investors. Americans from Main Street still yearn for and deserve a true Robin Hood.