Robinhood Isn’t the Real Enemy…
A Brief History of Robinhood
Robinhood is a financial services company that was founded in 2013 to “democratize finance for all.” I only knew that you can trade stocks with $0 commission and, to afford that, Robinhood sold your orders. This deep dive will change the way you think about Robinhood and yesterday’s events.
Robinhood’ revenue comes from four main sources: (1) rebates from market-makers (selling your orders), (2) Robinhood Gold subscriptions, (3) income from lending stocks, and (4) interest on cash.
Here’s a breakdown of each:
Rebates from market-makers: Ever hear of Citadel Securities? Citadel Securities is a market-maker (a firm or individual who actively quotes two-sided markets in a security). Robinhood is a broker (an individual or firm that charges a fee or commission for executing buy and sell orders submitted by an investor). You submit your order to a broker, but the market-maker is the one who processes it because they are setting the prices for anyone looking to buy or sell.
So Citadel gets your order and, based on their algorithms, decides on where to find the best price for your trade. They pay Robinhood for this privilege (more on that later).
Robinhood Gold: a set of investing tools and benefits like margin investing (investing on borrowed money) that are included with this subscription.
Income from lending stocks: This is why short selling exists. Robinhood lends the stock to someone looking to short it, and in return they receive collateral and charge a fee. The proceeds of the fee are usually split between the broker and the original investor. So if I own a share of Apple and let Robinhood lend it to someone, I’d be both compensated and still able to sell it anytime.
Interest on cash: If you have cash sitting in a brokerage account, the broker is making the interest on it.
Why Citadel Buys Your Orders
How does Citadel make money? As a market-maker, they’re pocketing the bid-ask spread (difference between the highest price that a buyer is willing to pay for an asset and the lowest price that a seller is willing to accept. An individual looking to sell will receive the bid price while one looking to buy will pay the ask price). As a result, they are incentivized to facilitate as many trades as possible (this is important for later).
How do they make more trades? By using high frequency trading (HFT) (a method of trading that uses powerful computer programs to transact a large number of orders in fractions of a second). The more trades they make, the better off they are. That’s why they, and other market-makers, pay Robinhood for order flow. Just like how Facebook monetizes your personalized attention, Robinhood monetizes your order information.
Unpopular Opinions
Here are several concepts that I’ve come to believe after this research. These are critical to fully understand because “There are few things as dangerous as a plausible narrative.”
HFT creates substantial value.
High frequency trading gets a bad rap. After my research, I’m inclined to think that it provides value mostly for retail investors. First, this is the reason why Robinhood can even offer commission-free trades. Second, trades are (supposed to be) settling almost instantaneously. Third, HFT firms narrow the bid-ask spread even further in order to increase trading volume and operational efficiency in the market.
There must be a downside though, right? Robinhood has been fined for misleading customers as to how they made money and for their routing methods. Citadel has been fined for not choosing the best execution price on trades. On a larger scale, though, there does not seem to be a major structural issue. After reading Flash Boys I was picturing a more nefarious operation.
Robinhood has minimal impact on the market.
They may have an outsized role in generating momentum, but the r/WallStreetBets crowd wasn’t moving the market. Retail investors are managing billions of dollars, institutions are managing trillions.
Short sellers aren’t all the enemy.
Have we forgotten about the Wirecard scandal from just last year? Banning short selling would have several unintended consequences.
Now for some bigger claims...
Robinhood did the right thing yesterday (for Robinhood).
As much as I love a good conspiracy theory, this time the evidence points in a different direction. Here’s a refresher on what happened yesterday, “On Thursday, Robinhood was forced to stop customers from buying a number of stocks like GameStop that were heavily traded this week.” On Twitter I’d stop after reading just that. However, the article continues:
To continue operating, it drew on a line of credit from six banks amounting to between $500 million and $600 million to meet higher margin, or lending, requirements from its central clearing facility for stock trades, known as the Depository Trust & Clearing Corporation. Robinhood still needed more cash quickly to ensure that it didn’t have to place further limits on customer trading, said two people briefed on the situation who insisted on remaining anonymous because the negotiations were confidential.
Remember when I mentioned that Citadel wants more trades? They probably weren’t conspiring to limit trades on the hottest stock in the market. This seems to be a risk management issue for Robinhood. Understanding this requires learning more about their business.
Remember how Robinhood is a broker? Well, there are two kinds of brokers: introducing brokers and clearing brokers. Introducing brokers “match an entity seeking access to markets with a counterparty willing to take the other side of the transaction.” A clearing broker “takes responsibility for the transaction, and guarantees that it will go through in the end.”
Robinhood built their own clearing firm, and under those regulations they need to maintain greater capital reserves. With the velocity of trading in GameStop and AMC shares, Robinhood was running out of capital on-hand. I don’t know what would’ve happened without suspending trading, but it wouldn’t have been good. However, that’s not to say they weren’t at fault.
Will they recover? Who knows. As Kevin Plank says, “Brands are all about trust. That trust is built in drops and lost in buckets.”
The Real Enemies
There are two nefarious forces at work: (1) leverage and (2) a lack of fundamental understanding.
Leverage
Leverage has been the enemy all along, and now it’s common knowledge. Something that has frequently been used by institutional investors is now being used by retail investors, and just like that it’s been disabled (for retail investors).
I would elaborate more, but this Epsilon Theory article does a fantastic job.
What I can give you is this passage from The Great Gatsby, where “Jordan nearly runs over a workman with her car, then tells Nick she’s not concerned about being a careless driver because, ‘it takes two to make an accident.’”
It should read “Hedge funds nearly run over retail investors with their leverage, then tell Robinhood they’re not concerned about being careless investors because, ‘it takes two sides to make a financial crisis.’”
Fundamentals
I don’t mean this from a growth vs value perspective. That’s a whole other topic. I mean understanding how things work and where the similarities and differences lie.
Stock prices aren’t based on “fundamentals.” Don’t believe me? If that meme didn’t do the trick, this is from Chamath Palihapitiya’s interview on CNBC yesterday:
There are fundamental momentum investors in the market that are organized capital i.e. hedge funds, and disorganized loosely affiliated capital i.e. r/WallStreetBets, and I think what you’re seeing is the push and pull of that and the realization should be that if every person was forced to publish their fundamental research, it would be hard to distinguish the best version of research from r/WallStreetBets and the best version of research from a hedge fund. They don’t have an edge, and this is what you’re exposing is that that edge is gone and now all of a sudden retail can be on the same footing and they don’t have to be the bag holder to Wall Street."
Or how about this one:
Scott: They (GME) should be allowed to exist at whatever their stock should be valued at based on what their earnings are, and the stock was like $17, $18 not that long ago.
Chamath: Who says that? Who says that? Do you want to make the same argument against Tesla? It’s gone 10x in a few months. You don’t know what it’s worth. Let’s be honest, okay.
I’d post a link to the full interview but CNBC keeps removing it from the internet.
How about the concept of short selling being eerily similar to our banking system. Banks are able to “create” money due to fractional reserves and loans. Here’s a good explanation from End the Fed:
The bank loans out money that has been warehoused and stands ready to use in checking accounts or other forms of checkable deposits, and that newly loaned money is deposited yet again in checkable deposits. It is loaned out again and deposited, with each depositor treating the loan money as an asset on the books. In this way, fractional reserves create new money, pyramiding it on top of a fraction of old deposits. Depending on reserve ratios and banking practices, an initial deposit of $1,000, thanks to this ‘money multiplier,’ turns into deposits of $10,000.
Now let’s look at how short selling works. Ever see the statistic that GameStop had 140% of their shares sold short? That’s incredibly misleading. It’d be like saying banks have 1,000,000x more assets than the amount of “real” dollars in existence. Here’s a great explanation from Twitter.
It’s easier than keeping track of money. Even with the created synthetic long shares, there is still the same number of votes and the same amount of dividends being paid out. If the equation to find short percentage is shorted shares/long shares, you have to include the synthetic long shares in the denominator.
Besides all this, there is plenty more to learn: Nominal share price shouldn’t mean anything in and of itself. As Buffett says, we should aim to pay lower fees, including taxes (who knew that gains on stocks held less than a year are taxed as ordinary income). As Buffett also says, it’s not about timing the market, it’s about time in the market.
Can’t wait to see what today brings.