There could not have been a better growth environment for Robinhood, the popular retail investment app, than the last two years.
The social media craze on the platform Reddit and stock picking, combined with the stay-at-home COVID-19 restrictions and perpetual unemployment benefits, all that fueled the Robinhood phenomenon and growth in the brokerage’s accounts.
Just recently, Robinhood publicly filed for an IPO and, according to its filing with the Securities and Exchange Commission, it plans to be listed on Nasdaq under the ticker HOOD. Robinhood had an increase in its funded accounts from $7.2 million to $18 million with the total clients’ assets of $81 billion, where over 50 percent of those clients are first-time investors, according to SEC filings. Also, Robinhood’s largest source of revenue is obtained through so-called payment for order flow, the payment that the market makers pay to Robinhood for obtaining the retail customers’ trades.
So, what can happen to the first-time inexperienced retail investors when you mix the craze of the social media, a trading app that looks more like a casino app and pay per flow? Nothing good.
Fueled by commission-free trading, leverage and recently abandoned confetti animations that would celebrate customers making their first deposit or first trade, the platform encouraged excessive trading by unsophisticated first-time traders.
It is a known fact that day traders, and especially inexperienced investors, lose money. A recent study, “Attention Induced Trading and Returns: Evidence from Robinhood Users,” found that “consistent with models of attention-induced trading, intense buying by Robinhood users forecast negative returns. Average 20-day abnormal returns are -4.7 percent (-19.6 percent) for the top stocks purchased each day (extreme herding events).”
A separate study, “Day Trading for a Living,” found that “it is virtually impossible for individuals to day trade for a living. We observe all individuals who began to day trade between 2013 and 2015 in the Brazilian equity futures market, the third in terms of volume in the world. We find that 97 percent of all individuals who persisted for more than 300 days lost money.”
The United Kingdom's Financial Conduct Authority has studied a sample of spread-betting customers and found that 82 percent lost money on products offered by the financial industry called contracts for difference, according to The Guardian.
If most retail investors lose, then payment for order flow by the few hedge funds that provide market making to Robinhood and paying for customers’ losses makes all the sense in the world. In essence, Robinhood is the aggregator that delivers unsophisticated traders to the hedge-fund slaughterhouses and market makers, so they lose all they have. What a change from Robin Hood of the 12th century, robbing the rich and giving to the poor, to Robinhood of the 21st century, taking it from the small retail investors and giving it to the hedge funds. If Robinhood has $81 billion in clients’ assets and those clients have a large propensity to lose, then the market makers who pay for order flow have a huge potential to gain, $81 billion to be precise.
The payment for order flow by Robinhood has not gone unnoticed. On June 9, SEC Chairman Gary Gensler announced an investigation of the payment for order flow to determine whether it conflicts with "best execution" for retail traders.
As if payment for order flow was the only problem plaguing Robinhood’s business model, according to CNBC, “Robinhood will pay roughly $70 million in penalties for its systemwide outages and misleading communication and trading practices,” the largest ever penalty from the Financial Industry Regulatory Authority. According to some lawmakers, this is not enough. According to online journal RIABIZ.com, “FINRA's action drew sharp criticism from Democrat Sen. Elizabeth Warren, who accused the regulator of not going far enough.”
"Robinhood won't clean up its act with slap-on-the-wrist settlements," she tweeted on Jun. 30.
Time will show if the craze of the Robinhood business model, paid for and profited by the hedge funds, will come to an end with the help of the financial regulators or whether the market pullback will wipe out the small inexperienced investors.
Paul Belogour is the founder of Vermont News and Media, which owns the Brattleboro Reformer, Bennington Banner and Manchester Journal. He is an expert on financial markets, technology and the intersection of the two. Nothing in this article should be construed as financial advice. To contact Belogour, email email@example.com.