Robinhood, Democratizing Finance, and Novice Traders

The growing wealth gap and income inequality concerns have increased interest in financial service tools and strategies that expand market access to non-conventional participants, the general public.

The most famous of these is Robinhood – a commission-free online brokerage platform. The app offers new investors an easy way to trade stocks. Its founders state that eliminating barriers to invest in the stock market can reduce inequality.

As is always the case, there can be downsides to financial innovation. The classic example was the short-term trading in GameStop stock earlier this year on online trading platforms (1). It had little if nothing to do with constructively building long-term wealth for investors or “democratizing finance.”

And it makes us wonder if Robinhood would only reinforce the wealth gap. Is the platform democratizing finance or encouraging risky behavior?

Robinhood’s Profound Influence

Vlad Tenev and Baiju Bhatt, who met as undergraduates at Stanford University, founded Robinhood in 2013 (2). The duo has argued that putting the investing tools used by the privileged into the hands of non-professionals can help reduce inequality. Tenev likes to quote Thomas Piketty, the author of Capital in the Twenty-first Century, who has called the wealth gap an investing gap (3).

Notably, the investing advantages enjoyed by the rich are beyond access to the stock market. Unlike the newcomers who make up most of Robinhood’s base, the wealthy investors have access to sophisticated financial information and opportunities; moreover, they can also afford to lose the money they risk on stocks.

Robinhood, the commission-free trading platform’s offers are so popular that it has driven other big brokers to stop charging and cut their commissions per trade.

“Robinhood is the first company to offer premier user experience and design in a mobile app on finance. They have also dramatically lowered the investing costs, encouraging the entire population to purchase stocks,”

said Brian Barnes, the CEO of M1 (4), one of Robinhood’s competitors that focuses on long-term investments and savings.

How Does Robinhood Monetize?

Robinhood generates revenue in multiple ways, including investing in money its users have sitting in their accounts, similar to banks, and charging users for a “gold” access level, which offers users a margin account from which they can borrow to trade. However, Robinhood makes most of its money from trading volume; the more a user trades, the more the company makes; a process also called PFOF.

For those unversed, PFOF, payment for order flow is compensation or benefit a brokerage company receives for directing orders to particular market makers for trade executions (5). Notably, they are only profitable at a high volume. It means platforms like Robinhood would only be interested in driving users to keep on trading.

In a way, the interests of users can often conflict with the company. The average individual builds wealth via long-term investments instead of rapidly trading in and out of stocks. According to Barnes,

“Robinhood is more financial entertainment than wealth building or investment management. It has only created an incredibly exciting, fun, and legal casino in our pockets.”

Charlie Munger, Warren Buffett’s ninety-seven-year-old business partner, while criticizing the frenzied day trading, Robinhood has facilitated people with little to no knowledge, “It is only a wild speculation, and I believe we are crazy to allow it,” said to the Wall Street Journal in February (6).

Robinhood is successful in Silicon Valley. It has followed the same trajectory as other tech companies: behave aggressively to gain fast growth. In the initial four months of 2020, over three million people opened accounts on Robinhood, bringing the total number of users to over thirteen million. Robinhood is not only taking market share from traditional brokers; it is also growing the market. Notably, the mean age of Robinhood’s users is thirty-one, and more than half of them are first-time investors.

While Robinhood has declined to say whether most of its users profit or lose, Tenevl revealed in February this year that the value of all its consumers’ accounts was 35 billion USD, more than the total amount of money users had deposited. However, the distribution of the profit is unknown (7).

Robinhood Vision: “The Amazon of Financial Services”

Tenev and Bhatt aimed to trade on Robinhood to be free. To make money, Robinhood planned to engage in PFOF. Unsophisticated but predictable trade orders present prominent opportunities for the high-frequency trading companies to make money. In return for access to the orders, companies pay rebates to the brokerage firm that routed the orders to them. Such rebates and skimming are not visible to users placing the trade order.

While payment for order flow is common among brokers, it is controversial since it seems to build an incentive for them to send their user orders to whichever market maker is willing to pay the most. The SEC needs brokers to disclose to their users that they are engaged in PFOF and ensure that their users get the best value for their trades.

Robinhood argues that PFOF results in customers getting faster execution at better prices. However, some market experts disagree. According to them, small investors would be better off without it. An attorney representing Citadel Investment Group wrote in a 2004 letter to the SEC during a discussion about legalizing PFOF in the options market (8), “The practice of payment for order flow has serious conflicts of interests and should be banned.”

Tenev and Bhatt mostly likely knew that removing commissions and making it easy for people to trade like crazy would potentially make a lot of money. As per Tenev, about 75 potential investors had rejected them. Some were concerned about investing in a startup that had not yet rolled out its primary product, while others believed that millennials would not be interested in trading stocks.

Some of Robinhood’s prospective investors also had ethical concerns about the platform. As per Bill Gurley, a general partner at Benchmark Capital (9), “when Tenev pitched the idea and stated that Robinhood would rely on PFOF, it made me feel emotionally bad because it is misleading to people.”

According to Gurley, “other brokerage companies following the same practice don’t pretend to be doing good; my issue with Robinhood is that I believe their mission and what they say they stand for is not true.”

On the other hand, as per Howard Lindzon, Social Leverage’s founder (10), an investment fund, and one of Robinhood’s seed investors believes it is a public-relations issue.

“First of all, almost every broker follows the payment for order flow practice.” Although, he also acknowledges that “people can argue about their communication for it, and whether they were tricking people.”

As per Lindzon, traditional brokers have been lazy about offering their consumers the flexibility they want. It is because of the mistakes they have made that platforms like Robinhood even exist.

Making Users Hit Buy or Sell

It takes a few minutes to open a Robinhood account and start trading. The app asks for name, phone number, level of investment experience. If you say you have a little experience, it will ask if you would like to enable options trading. Options are contracts called “calls” and “puts” to purchase or sell a hundred shares of a company at a predetermined price and date. Notably, on Robinhood, they are also commission-free.

The app also asks for employment status and the source of your investment funds. Then, it directs users to log in to their bank account details to link it. Lastly, it asks how much users would like to transfer to Robinhood, a 100 dollar, 500 dollar, or 5k dollar or a “custom” amount.

According to Adam Alter, a professor of marketing at NYU’s Stern School of Business and the author of “Irresistible: The Rise of Addictive Technology and the Business of Keeping Us Hooked” (11), In a case of Robinhood, it is not enough for them to have users on board, they have to get them to hit Buy or Sell button. You have got to make it feel like there is no consequence. You have got to lower all resistant barriers, so they stop thinking about money at all.“

In March, Vicki Bogan, a behavioral finance expert (12), stated that “the bigger game is the one that online brokers play with the retail investors. How much can they get the investors to trade even though it may not be beneficial for the investors to do so?” A spokesperson from Robinhood stated that attracting users who had been excluded from the financial system previously is “a profound positive change” and “indicating otherwise is an elitist, old way of thinking.”

In March, Gary Gensler, the head of SEC (13), stated that the digital confetti that Robinhood users saw after placing their first trade might serve as a “behavioral prompt” to encourage more trading. Notably, Tenev had denied it and described it as a “moment of delight.” Nonetheless, during the same month, Robinhood announced that it had removed the confetti.

According to Tenev, who is wary of Robinhood’s charge of making investing seem like a game. “I believe people need an explanation for Robinhood’s success.” After the site launched, he added, Robinhood was the only broker offering commission-free trades. When it emerged as a profitable company, some critics credited all of its success to PFOF.

As per Tenev, “Robinhood is an idea and product in one that no one else has claimed. The idea is that the financial system is a robust tool and has been available only to the wealthy until now.”

Market Manipulation

In late January, Robinhood had decided to restrict transactions for multiple securities. And much of that seems to have stemmed from the GameStop frenzy. It was stocked by users of r/wallstreetbets, a Reddit forum with more than 7.4 million followers.

At that time, The Economist (14) stated that GameStop was a target of short-sellers, and retail investors wanted the shorts to lose money, and they did.

Bullish retail traders ginned up when the market makers who sold them their bets we’re forced to hedge against the surging prices by purchasing shares. Short-sellers were also forced to purchase shares after incurring several billion dollars worth of loss.

The wall-to-wall stock coverage prompted even more investors to pile in. On January 26th, GameStop was the single most traded stock in the USA; the volume had matched the five most prominent tech giants combined.

Retail investors were fiercely critical of short-sellers, portraying hedge funds as companies who make money off of manipulating and exploiting markets and media to their advantage.

In a blog post, justifying their decision to restrict transactions on GameStop and other securities that had been hyped up on r/wallstreetbets, including AMC Theatres, BlackBerry, and Nokia, Robinhood reiterated its mission while contravening it.

While deciding to restrict securities, Robinhood had to strike a balance between its massive liabilities and fiduciary responsibility to its users. However, it didn’t mention how the market volatility came, which resulted in significant profits for retail investors and huge losses for funds such as Melvin.

Tenev had also denied allegations that the company’s relationship with Citadel, a financial securities giant to which Robinhood routes more than half of its customer orders, had anything to do with the decision.

While other brokers, including TD Ameritrade and Charles Schwab, imposed more restrictions, the public outcry had been focused on Robinhood because of its mission to empower the general public to invest.

Democratizing Finance: Core Issues With Robinhood’s Claim

There are two core issues with Robinhood’s democratizing finance claim. First, the internet transformation of day trading also allowed a greater share of the public to speculate on a minute basis. In his 1978 book, Manias, Panics, and Crashes, the economic historian Charles Kindleberger (15) wrote that “at a late stage speculation detaches itself from valuable objects and turn into delusive ones.” However, all trading involves some extent of speculations. Robinhood’s targeted restrictions had raised serious questions about the arbitrary mechanics for deliberation.

Another issue is what role brokerages should have in financial literacy. One of Robinhood’s blog posts stated that users were making uninformed decisions and that “amid the high market volatility, it is important to help consumers stay informed.” The decision to restrict trading seems to have come from a perceived inability to keep people educated. It is unclear why Robinhood felt that this particular volatility went over the line.

Moreover, the gamification of trades can quickly offset any education headway no matter how well-informed the public becomes. Features such as emoji-filled push notifications or falling confetti upon completing transactions don’t seem to remove the complexity of investing.

As per Erik Olin Wright’s definition of democracy (16), “it is a system in which people should collectively decide over matters which affect their collective fate.”

Robinhood has overlooked the collective consequences of its actions on the generation public. It is not because it decides to restrict trading on some securities but because of its persistent inability to protect and inform the users on its platform. Remember Alexander Kearns?

Additionally, as per a recent The Verge report (17), Tenev and Bhatt are not quite serious about their big talk about democratizing finance.

What’s Next?

There is no denying that in online trading platforms, ordinary people are investing in ETFs and stocks. The pandemic further accelerated it.

However, the bigger question is whether the trend would outlast the pandemic. According to Timmerman, a Professor of Finance at California State University, Northbridge, it will.

“I see it as a long-term pattern because of the accessibility that websites like Robinhood offer retail investors. The volume will go down as it does when things in the market don’t go up, but the overall increase in the volume of retail trading is here to stay.”

From one perspective, platforms such as Robinhood have helped democratize investing, as they have empowered young and less affluent traders to build wealth. However, they have also left these traders exposed. The gamification of options trading and equity poses risks to uninformed investors.

However, there is also another real-world benefit to the increased trading accessibility. In the short space of time, millennial investors have made a big impact on Wall Street and the way its companies operate. They have driven brokerage companies to cut the commission and upend their business models. They have also pushed them to invest more heavily in online platforms.

Millennials may have also convinced these companies to offer more socially and environmentally sustainable investments. As per Morgan Stanley, people under 35 are twice as likely to sell a holding if they behave unsustainably.

Millennial investors are changing Wall Street, and in some way, it may be for the better.

Robinhood IPO Details: As of writing this article, Robinhood has gone public on the New York Stock Exchange after securing 1.89 billion USD in its IPO. Despite its conflicts, it has become synonymous with no-fee trading, mobile, options, cryptocurrencies, and a booming business.

The company has sold over 53.37 million shares at 38 dollars each, at the lower end of its proposed price range of 38 to 42 USD. It has started trading under the ticker symbol “HOOD.” As per Robinhood, it has set aside up to 35% of shares for its users. However, we don’t know the ultimate percentage yet (18, 19).

2021 has been the year of the retail investors; stay tuned to know more about the market’s reaction to that reality.