The events of the past week (beginning 25th of January), have challenged the role that retail traders in the global financial markets have traditionally played. The demographic has never had as much influence as it currently does, as it disrupts spaces previously dominated by large institutions such as hedge funds, causing many to rethink their risk models. Brokers are a key means for retail investors to be able to access the markets and compete with institutions, and as Robinhood has discovered, this puts them under a great deal of scrutiny. By delisting stocks central to the WSB bubble, they provoked a great deal of outrage, but as we shall see they had little choice but to do so, and will have changed the landscape of retail trading forever.
For an in-depth analysis of how we ended up in this position, I would highly recommend reading https://cibsoc.co.uk/researchgroup/2021/01/29/a-dangerous-gamestop/, which explains how we reached a situation where one Reddit forum has driven markets. Essentially, there was a co-ordinated “short squeeze”, whereby investors poured resources into the heavily shorted stock GME, causing hedge funds such as Melvin Capital to lose billions of dollars.
Robinhood’s business model
To get a better grip on recent events, it is important to know a little more about how Robinhood operates. The firm operates on a zero-commission basis, and has skyrocketed in popularity since its original launch in 2015. In 2020, it had at least 13 million active users, with it also becoming the most downloaded app on both the Apple and Google app stores this week. Its primary demographic is a younger generation, as it has a median age of 30 with 50% of its user base being first time investors. It grew in popularity even further in the midst of the pandemic as many experimented out of boredom, using its flash style and layout to attract those who could be considered unconventional users.
So, how does it make any money without any commission? The direct contribution from retail investors is almost negligible, with the main source of income being “rebates from market makers and trading venues”. This is when Robinhood receives compensation for sending orders through firms such as Citadel and Virtu rather than on a public exchange from these firms, as they are able to pocket the difference between the buy and sell price of an order. They do this by holding a large inventory of stocks and contracts, and arguably offer better prices than the alternative of exchanges, especially when large quantities are involved. There are a few other means of generating revenue, such as selling user trade information to high frequency trading funds and interest on cash reserves, but this is the most significant having generated $180m in the second quarter of 2020. This “payments for flow” model was also rather ironically developed by Bernie Madoff, and has not been without its controversies for the firm: in 2019, it received a big fine for not following its best execution practice, after not systematically reviewing the history of the services that had been provided.
When the music stopped
On the morning of January 28th, Robinhood delisted several stocks at the centre of the market’s attention, including GME, AMC and BB. This move was immediately met with outrage from almost all of its retail clients, as they could no longer buy any new shares to get in on the action: additionally, this sent the share price down significantly as demand was cut off completely. Cries of foul play were quickly voiced due to concerns of a potential conflict of interest between Robinhood’s “free market” access and the market makers who fund the platform, meaning that markets could have been manipulated to the cost of the common investor.
The reason given by the firm, however, is actually centred around the use of clearing houses. These are institutions which act as an intermediary between buyers and sellers of assets, additionally managing the risk of one side defaulting. To participate in markets, Robinhood has to put up a certain level of capital to ensure that the risk of client default does not become unmanageable. As the price of GameStop rallied from around $90 on January 25th to a peak of over $450 on the 28th, the capital reserve requirements from the DTCC increased from $26bn to $33.5bn. As Robinhood did not feel able to cover this increase, they delisted the stocks to prevent any further risks emerging.
The public outcry from this decision was monumental, with both sides of the political spectrum unusually united. The narrative that had been created stated that there was one rule for one — the hedge funds who still had the ability to trade — and another for the average retail investor. This has led many to lose faith in the idea that markets are actually “free”, and to believe that they are, rather, a rigged playground for the extremely rich. When AOC, Ted Cruz, Donald Trump Jnr and Elon Musk all agree on an issue, the extent to which the general population has taken this as an insult becomes clear. Users were clearly emotional as vows to leave the platform became commonplace, though generally users would not leave while the situation was ongoing.
The (partial) return
In the end, Robinhood was able to raise around £730m in a short period of time, receiving this cash injection from prominent banks including Goldman Sachs, Morgan Stanley and Barclays. This new level of capital allowed it to reintroduce the stocks at the centre of all the controversy, but with added restrictions on the quantity that individuals were allowed to purchase. Though the limits were still unpopular, it meant that trading could continue with the risk of any further volatility-led defaulting minimised. Upon this news, the stocks in question bounced back again, meaning that the battle could continue between the individuals and funds, even if the rules had changed slightly.
The long-term fallout
The situation over the past week has been unprecedented, so regulators are scrambling to devise a plan of action. It is clear that change will come, with prominent figures such as Elizabeth Warren, a US senator, and the incoming chair of the SEC, pledging to take action to prevent further crises of this kind. As investigators and regulators begin their investigations into possible market manipulation from all parties involved, they will be defining the rules of the playing field for years to come around retail trading.
Many have argued that this week’s emotions and frustrations are a symptom of wider inequality within society, with Robinhood scapegoated as a symbol of the corruption and hypocrisy of the rich. Elon Musk’s criticism of short selling, combined with the promise made by Andrew Left, head of research firm Citroen research, to abstain from the practice, sets it up for a very bleak future, where it could possibly be banned (as it is in South Korea). Hedge funds and other financial institutions have been particularly vilified since the 2008 financial crisis, where the idea that banks were “too big to fail” but the individual could suffer the consequences of mismanagement further deepened divisions between Wall Street and the general populace, making this act of defiance personal. Now the people have realised their power and influence over these firms, as well as the economy, it won’t be easy to convince them to go back to the status quo.
Overall, Robinhood may not have had bad intentions in its decision to mitigate risk, but its actions did empower the monolithic hedge fund and considerably hinder the ability of its clients to “get in on the action”. The complicated regulations behind financial brokers and the trading of options have not helped Robinhood to clear its name of market manipulation, so it will take a long term to regain the trust that is essential for its business model, additionally jeopardising the planned IPO for the start of this year.
We can, however, say with much more certainty that zero-commission investing is here to stay, as individuals have realised how they can be empowered by the financial markets, so retail investors will need to be taken seriously when firms are considering risks around equities and similar. The exact future landscape will depend on regulators’ interpretation of events and how the bubble of GME will most likely burst, but retail investors will not be going away. Whether Robinhood remains in the game depends on whether or not the recent threats to leave the platform are empty, or a genuine commitment by retail investors to demand more from their broker.