Robinhood is not about democratizing markets

Robinhood Markets Inc. has been at the forefront of democratizing finance, which is the idea that an average Joe can play on the stock market alongside the professionals. And in January, they did, by defeating a group of hedge funds betting against GameStop Corp. in one of the greatest short compressions of all time. Hollywood is full of stories of the average outsider Joe, but is it true in real life? Not, at least, in the markets, where the retailing of “memes stocks” is, on the whole, a massive transfer of wealth from the simple to the sophisticated.

What is at issue is the long-standing practice in the stock market known as payment for order flow. Brokerage firms no longer execute orders to buy and sell stocks; they send them to market making companies for execution in exchange for a small payment. This allows brokers to offer commission free trades. Market making firms like this arrangement, especially when it involves orders for retail investors, because they are generally wrong and are profitable. Thus, market makers will pay brokers the privilege of receiving these orders, with the idea that while they are small individually, overall they are profitable. Robinhood made about 75% of its $ 958.8 million in order flow payment revenue in 2020.

A foreigner might consider this practice, which has been going on for several decades, as a conflict of interest. The broker does not guarantee that their clients will get the best price on a trade, but rather sends orders to the market making company that pays them the most, where the quality of execution may not be the best. (1) Robinhood says all market makers he has a relationship with pay him discounts at the same rate, which means he has no incentive to send orders to a particular market maker. The real problem is how Robinhood’s message on democratization is inconsistent with its enforcement practices. In addition, under the current arrangement, trading costs are hidden. With zero commission, the brokerage firm’s client does not pay commissions directly, but does so indirectly through payment of order flow arrangements. The new chairman of the Securities and Exchange Commission, Gary Gensler, has identified payment for order flow as a potential conflict.

To be fair, other than a few insiders, no one really knows how market makers work. In the old days, when stocks were quoted in fractions, it was as easy as creating a bid-offer spread on a stock, buying on the offer, and selling on the offer. Then 2002 brought decimalization, and things got a little tricky. The math behind market making today is incredibly sophisticated, and I imagine it takes into account correlations with different stocks and sectors, and I suspect that the quants programmed the algorithms to take into account the informational value of ‘a transaction and whether the transaction is probable. be right or wrong in the short term.

That’s even before taking into account the explosion in options trading, from two million contracts a day on the stock exchanges 20 years ago to tens of millions of contracts today. Some of the memes stocks have seen wild option trading, with option prices warping and warping in ways never seen before. Of course, this happened with Robinhood’s own stock – as soon as the options were listed, retail traders clawed back short-term call options, driving the stock up. It turns out that many quants who started their careers in complex and exotic options are turning to listed options in an attempt to mathematically model the volatility under the explosion of retail options trading.

The outlook for this business is terrible. The average Joe opens an account at Robinhood, deposits $ 250, buys an options contract that’s engulfed by a computer leviathan programmed by some of the world’s smartest mathematicians. I can tell you who wins here, and it’s not the Average Joe. I’m not saying Robinhood’s order flow should go to stupid market makers; I say their populist appeal is slightly misplaced.

This should not be interpreted as an attack on market making activities. It has become much more efficient and sophisticated over the years, translating into billions of dollars in savings for retail investors in terms of quality of execution. Increased mathematical sophistication allows market making firms to maintain tight bid / ask spreads on stocks experiencing an explosion of volatility. I haven’t seen full investigations into the losses of retail investors in memes stocks, but we can see the profits from market making companies, and they are huge. Bloomberg Intelligence said in May that wholesale order flow payments jumped 39% in the first quarter to $ 1.16 billion from the last three months of 2020, which it expects the total for the year increases 61% to $ 4.6 billion.

I’m not against paying for order flow arrangements in principle. Arrangements have evolved from natural market forces and it is difficult to say that investors are being harmed in terms of speed of execution or price. The problem is, the costs aren’t explicit, and since online trading is seen as free, it pushes retail investors to overconsume the product – in this case, trading. If execution costs were made explicit and investors could see the cost of their executions, they could be incentivized to trade less frequently, which would likely result in better returns. But the more investors negotiate, the more money Robinhood makes. It is not really about democratizing investment.

(1) To be fair, advancements in technology now mean that the differences in the quality of workmanship are so small that they are imperceptible.

Jared Dillian is editor and publisher of The Daily Dirtnap, investment strategist at Mauldin Economics and author of “Street Freak” and “All the Evil of This World”. He may have an interest in the areas he writes about.

This story was posted from an agency feed with no text editing.

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