In order to get right into it, I’m going to assume that the following Venn diagram is reasonably accurate:
If it’s not, and you’ve found yourself unaware of the recent news stories surrounding GameStop stock (NYSE: GME), here are some articles to catch you up. Also, please let me know how you managed to avoid this story.
Long story short, a swath of day traders organized themselves on the popular website Reddit to wage war against a hedge fund that was betting against GameStop. Robinhood, the popular commission-free retail brokerage, found themselves in the center of the news cycle during this dangerous game of financial tug-of-war as nearly half of their 13 million users got in on the “fun.”
Now let’s take a step back.
If you had known on January 1st, 2021 that GameStop, a dying company, whose share price had recently fallen below $5 was going to be pumped “TO THE MOON” by an army of retail investors, you might have had the same reaction I had when I first caught wind of this: it wasn’t going to end well.
History, as they say, repeats itself and speculative financial bubbles are hardly a new phenomenon. Such hysterics were recorded as early as the 1600s with tulip mania in Holland. Sir Isaac Newton lost his shirt in the 1700s, whereby the term “bubble” was coined. Colluding to spread misinformation was a main plot point in the 1987 classic Wall Street (spoiler alert: the protagonist goes to jail). And years before people were accusing Robinhood of foul play, naked short sales led to market failure for tickets to Super Bowl XLIX. The players are usually different, but the final chapters are not. People and institutions alike lose money. Lawyers and lawmakers ask questions. Sometimes there are changes. Other times there are not.
Either way, as a result of the last few weeks, Robinhood has found itself to be the firm facing most of the questions and scrutiny.
Don’t hate the player or the gamification
As a well documented fintech nerd, I love Robinhood. But that doesn’t make me blind to their challenges. Let’s start with a rather important one: it is tough to be a broker in almost any industry.
That’s not to say that it can’t be a big business or a very profitable one, but the competitive dynamics often make it extremely difficult to differentiate your product in an environment where you have limited control over both your customers (fickle) and the underlying market (volatile) whose products you “broker.”
This makes it particularly hard for new players to break in. Prior to Robinhood, the the last notable new entrant in the retail brokerage was E*Trade (now owned by Morgan Stanley) in 1982! It took more than 30 years for Robinhood emerge and it is safe to say their disruption goes far beyond a talking baby at the Super Bowl.
In terms of the digital product, Robinhood has created a user experience that is far superior to its competition. As I look at both the Fidelity and Vanguard apps on my phone, it is truly stunning to me that neither firm has rebuilt them completely from the ground up. Their user experiences, to be frank, suck. Others might accuse Robinhood of “gamifying” their app to encourage trading, but I find that to be grossly overstated and deeply out of touch with the current state of innovation. Product managers from New York to Silicon Valley are lauded for creating low-friction user friendly experiences and Robinhood should be no exception. Those that champion the free market should remember that individuals have a right to go elsewhere and Robinhood’s growth rate seems to paint a clear message of what people want.
Furthermore, what Robinhood has done on the product pales in comparison to what they have done in terms of marketing. This is a true story of fintech folklore, focused on lowering costs to increase access. In terms of user acquisition, Robinhood famously attracted over a million users with its inaugural viral marketing campaign. And over time, Robinhood’s true to claim to fame, the $0 commission, has allowed referral tactics and good old fashioned word-of-mouth to accelerate into free press by the media, allowing Robinhood to maintain rock bottom user acquisition costs, with some reports estimating that it is as low as $25 vs. an industry averages of over $1000.
The move to $0 commission has turned the retail brokerage industry upside down since Robinhood came onto the scene. In the last few years, most leading firms have jumped on the bandwagon, which should remind us of two basic lesson in economics.
Starting with the law of demand, we should recognize that $0 commissions, all else equal, increase the quantity of demanded retail trades. This point alone muddies any claims about Robinhood’s malicious gamification - how can you independently blame the user interface when the basic economic fundamentals are telling the same story?
Now, you might be arguing that $0 commissions aren’t really “free,” and that there are embedded costs associated with them. Which brings us to our next economic principle: “there is no such thing as a free lunch.” A principle that has recently brought the underlying economics of Robinhood’s business model to light as the world has raced to learn about “payment for order flow:”
The long and short of this practice is that Robinhood and many of its competitors are paid (lots of) money by third parties (often a hedge funds) to execute its orders in the market, instead of an explicit charging the user. And I use the term “user” here (and elsewhere) explicitly. In tech speak, “there is no such thing as a free lunch” has been rephrased as “if you aren’t the customer, you are the product.” Payment for order flow is a clear example of this in action.
This means that Robinhood’s market makers (i.e. the customers that pay them) likely made boatloads of cash no matter which way GME stock was headed. It’s biggest customer, the well known hedge fund Citadel, touches an estimated 40% of all US equity transactions and was generating more than enough cash to reload another hedge fund, Melvin Capital, with fresh capital to double down on their GME shorts.
Taking from the rich and giving to… other rich people.
Despite the media’s rather singular focus on Robinhood, it is important to reiterate that payment for order flow is an industry wide practice. In 2020 alone it generated roughly $3B in revenue, with TD Ameritrade (not Robinhood) being the largest recipient of these payments.
It also isn’t a particularly new practice. Robinhood may have been the first company to recognize that payment for order flow could support a $0 commission model, but “high frequency trading” and “dark pools” go back to at least the early 2000s. Many of the questions being asked today have similar themes to those raised in Michael Lewis’s excellent book “Flash Boys,” which ironically brought the practice to light in 2013, the same year that Robinhood was founded.
Informed critics of the practice, including Lewis himself and famed VC investor Bill Gurley all seem to point at the same issue: payment for order flow represents a massive conflict of interest for brokerage firms. They aren’t wrong. When most major brokerages halted purchases of GameStop stock in late January, the internet quickly rushed to a narrative that firms like Citadel had forced the decision upon brokerages firms in order to serve their institutional clients. It’s an attractive story exactly because the optics of payment for order flow make it look plausible. I myself questioned if Robinhood CEO, Vlad Tenev, was telling the truth in this CNBC interview where he denied the claim. But if you take a step back, the narrative doesn’t really make sense. Market makers like Citadel are paid on volume! In the most basic sense, limiting trading on a handful of high volume stocks hurts their business too. They too would fear the risk of reputational damage that firms like Robinhood would face in the wake of halted trading. Market makers have continued to make more money in recent years because of the interest in retail trading… they, are encouraged to support it!
And for Robinhood, it’s important to remember our earlier point about how challenging it is to to be a broker. They were facing all of the problems of a cyclical downturn “squeezed” inside of a one week window. None of their options were particularly attractive. Could they have restricted buys and sells of stocks like GME instead? Of course, and instead of being accused of “siding with Wall Street,” they would’ve been accused of “keeping people’s money hostage.” In a euphoric bubble, the key assumption is that someone is always going to be left holding the bag. Robinhood’s decision to allow sells at least put their traders a bit closer to the metaphorical “exit in the crowded movie theatre.” Couple that with the news that they had simultaneously raised $3.4 billion dollars to meet their capital requirements and it becomes much clearer how severe their predicament was.
King Richard and the Sheriff(s) of Nottingham.
In the backdrop of this epic battle between Wall Street and MainStreet.com, Washington couldn’t resist the opportunity to get involved either. Legislators were unanimously up in arms over the retail blockade, so much so that Ted Cruz even offered to support AOC’s efforts to launch an investigation.
Political views aside, it is appropriate for our politicians to ask questions. They don’t all necessarily need to be authorities on the finer details of our nation’s financial plumbing. But when they start to pull back the curtain, it isn’t clear to me that they will find the answers they seek.
Like it or not, payment for order flow is a legal practice. The arguments in favor of it have merit too. The overall impact of centralized market makers is tough to measure, but its proponents argue that they provide more liquidity, giving investors a better price than they could receive otherwise. And whether you agree or not, you have to keep the free lunch principle in mind. You can charge customers a commission, or let Citadel reap the profits, but all of these options have tradeoffs, and ultimately someone will need to pay for trade execution.
In addition, the government’s own depository rules were complicit in clogging the financial plumbing that stopped most major brokerages (not just Robinhood) from trading in stocks like GME. In some sense, it is hypocritical of any legislator to cast blame on a private institution, when they themselves are the ones who make the rules that govern them.
Which brings us to the one person who might just be in a position to address that: the new chair of the SEC (and former MIT Sloan professor) Gary Gensler. I had the chance to meet him once during business school and I found him to be as intelligent and thoughtful as he was measured and gracious. The task of being SEC chairman is certainly not an easy one, but his presence at the helm gives me some hope that that the right questions will be asked and any possible regulatory changes will be considered carefully. Should you find yourself wanting to stay close to this story over the months and years ahead, he is the guy to watch.
And should you prefer to keep your eyes elsewhere, let us recall that while the legendary Robin Hood was considered to be an outlaw by many, his reputation as a champion of the people endured. Yes, it has been a rough couple of weeks for the popular fintech app, but I’m willing to take my cue from history on this one, and remain excited to read the next chapter of their story, whatever it may be.
Another great piece TN :) *personal gripe* but Vanguard's UX is absolutely horrendous and they will fail magnificently with affluent millennials who demand a friction-less experience. Somebody help them!!