To the moon… and back: the inner workings of financial markets
“Our mission is to democratize finance for all. We believe that everyone should have access to the financial markets, so we’ve built Robinhood from the ground up to make investing friendly, approachable, and understandable for newcomers and experts alike.”
– Robinhood Markets, Inc. Mission Statement
Commission free trading is a great thing, right? Any time you can get the same service while paying less, in this case paying nothing, must be a good thing! To this question, one could debate many different perspectives. Yes, on the surface, commission free trading appears to be a clear win for investors, who benefit from lower costs. Fees, including trade commissions can dig into returns even if they are as low as €5 or €10. This eliminates a significant proportion of hard earned capital appreciation which investors desperately crave. Hence, zero commissions should always be of benefit to investment accounts.
Furthermore, digital brokers, which includes the likes of Robinhood among others, have provided transparency in financial markets which would once have been inconceivable. Trading apps now make tracking asset prices effortlessly simple in real time, allowing even the smallest of investors the opportunity to capitalise on market distortions. However, while smaller investors have rejoiced in this new found transparency, few have actually taken the time to question why and how digital brokers can offer commission free services. Robinhood’s (not-so) secret is simple: selling their order flow, and thus information about which assets are in demand, to other financial intermediaries.
The payment for its order flow model is very simple. First pioneered by financier and now convicted fraudster, Bernie Madoff, it is a way for market makers such as Citadel Securities and Virtu Financial to outsource the task of finding orders to fulfil. Market makers provide liquidity to financial markets by remaining ready to buy and sell securities at all times of the day. In order to offer free commission on trades, Robinhood sells trades to market makers such as Citadel, who pay a small fee in return, usually fractions of a cent per share. The money maker can then flip the trade by taking the other side of the order and returning the asset to the market, profiting the balance between the buy and sell price.
As J.E. Karla described, “If the service is free, you are the product. Robinhood users thought the service was accountable to them, but actually it exists to serve giant Wall Street institutions like Citadel and other market makers”. Simply put, the payment for order flow system makes a lot of money for everybody except Robinhood’s users. The system worked perfectly for Robinhood, that is until a team of amateur investors on the Reddit discussion board ‘WallStreetBets’ bid up GameStop (GME) shares over 1,700%. Some traders declared war on Wall Street hedge funds that had placed short positions against the company, most oblivious to the fact that the very institutions against which they were feuding were in fact profiting from their actions. Market makers are designed to prosper in times of uncertainty and high-volume trading. January 27th alone saw $29 billion worth of GameStop transactions.
Small investors were also mostly unknowing of the fact that share-price volatility creates a requirement for brokers, like Robinhood, to post cash with a clearing house — and meeting these demands can curb trading. A clearing house is the intermediary between buyers and sellers of financial instruments that ensure both sides honour their contractual obligations. Similar to a brokerage making a margin call to reach a maintenance margin, the National Securities Clearing Corporation (NSCC) required Robinhood to post $3 billion in cash as collateral for the risk that GameStop shares may plummet between when their shares are purchased and when they are cleared two days later.
However, Robinhood simply did not have $3 billion in capital to put down as collateral. Instead, it decided to limit GameStop trading and similar companies targeted in the Reddit movement. This left Robinhood with fewer volatile stocks on its balance sheet while also allowing earlier trades to settle, reducing the company’s overall risk exposure, and thus its collateral requirement. Crucially, this is when theories of Wall Street intervention in markets began to circulate. Many believed that Robinhood’s actions, among others, constituted proof that the capitalist economy is structured to do what is best for the business elite. Jim Chanos, famous American investment manager, summarised the events well in a recent interview with the Financial Times. He remarked that “We’re seeing a level of misunderstanding about how markets work that is being brought on by a whole new generation of investors who have never seen a bear market and somehow think that they’re being held back from their rightful place at the table by these evil hedge funds”.
When it comes to understanding the inner workings of the financial world, individual investors have always been disadvantaged in comparison to the investment powers found on Wall Street and beyond. Nevertheless, newfound transparency in the financial markets, brought about by the creation of digital brokers such as Robinhood, illustrates just how powerful retail traders can be when they rally around certain stocks. This is what happened when a team of amateur traders on a Reddit discussion board decided to wage war upon hedge funds.
Somewhat ironically, amateur traders’ misunderstanding of the extent of transparent relationships within the financial system seems to be exactly why the war appears to have been lost. Rebel investors may have succeeded in forcing short sellers to abandon their positions, but the bubble is beginning to burst, and Wall Street powers are likely making billions from new, and much higher priced short GameStop positions than ever before. To compound the irony, in order to take new short sale positions, institutions have had to borrow shares them from their actual owners, the rebel investors, most of whom won’t realise that their broker contracts allow their shares to be lent to other investors for a fee, which the trader will never see.
Hence, traders are lending their shares to the exact institutions which will eventually bankrupt them, making Wall Street billions of dollars in the process. The recent GameStop saga is a perfect illustration that retail investors are collectively powerful enough to win the battle, but Wall Street will always win the war.