Everyone's Making It Big But Me
Who is really manipulating investors? Hint: It's not hedge funds.
It seems every financial website, tv show, newsletter, twitter feed, and podcast has been fixated on GameStop for the past two weeks. It’s understandable - the company’s stock rose from $17 on January 1 to an unfathomable $483 on January 28 before falling back to earth and the mid $60s where it currently trades. But most of the coverage is missing the real message - hedge funds are not taking advantage of individual investors’ lack of knowledge (or at least not anymore than they usually are), stock brokers are! Just as Facebook or Google only value users to the extent they can sell ads, brokerage firms are only using investors to sell their data and orders to their real clients and revenue sources.
Much of the outrage about the situation came when Robinhood, along with other so-called retail brokers including eTrade, TD Ameritrade, and Fidelity, halted buy orders for GameStop. A simple answer might be that they were overwhelmed by the activity and their systems were incapable of handling the order volume. While partially true, this does not seem to be the root issue. The conventional theory is that the brokers were acting at the behest of large hedge funds and protecting the entrenched interests on Wall Street. But why? Is it that hedge funds and larger financial institutions hold a sufficient ownership stake in these companies to influence their operations? It’s possible, but ultimately these are companies whose revenue and whose future depends on individual investors, right?
Think again. In late 2019, retail brokers including eTrade, TD Ameritrade, and Charles Schwab drew headlines when they dropped commission rates on most stock orders to $0. So how can a stock broker make money if they don’t charge a commission for trading stock? Simple - they’re making their money on the other side of the trade where the customer does not see it. When an individual enters an order, rather than simply seeking the best price to buy or sell an individual’s stock, the broker is collecting a fee from a middleman to process the order (known as a market maker.) Different middlemen offer the brokers different fees. This is known as a payment for order flow. And who is the king of payment for order flow? Robinhood.
In fact, in December 2020 the Securities and Exchange Commission and Robinhood agreed to a $65 million settlement that Robinhood failed to disclose their source of fees to investors. While Robinhood is a private company and is not required to disclose the financial information in the same manner a public company would, it’s widely believed that order flow is the main source of revenue for the company. Up until two weeks ago they were widely expected to go public later this year, which would have yielded additional insight to their business model.
What’s going on here was perhaps best articulated by Venture Capitalist Roger McNamee in a CNBC appearance last week - Robinhood is following the path of Facebook and other tech companies and creating a world where the user is not the customer. The benefit to the company does not come from serving the user but in generating activity for the real customer - in the case of Facebook it’s about generating activity on the social platform for the benefit of advertisers; in the case of Robinhood it’s about generating trades for the benefit of market makers. They don’t particularly care if anyone is making or losing money, so long as they’re trading. And the more they’re trading, the better.
The fervent trading in GameStop and the actions by the brokers such as Robinhood to limit trading has little to do with picking sides in a battle of big versus small investors, but it has everything to do with brokers looking out for themselves in a new world where users are being told they can get something for nothing. If investors are going to expect free trading, there is going to be a cost somewhere else - the GameStop saga demonstrated that part of that cost may be an inability to trade certain stocks when it is most advantageous. Remember, there’s no such thing as a free lunch on Wall Street.