Robinhood is in the hot seat. Should retail investors be worried?

Allegations that Robinhood might be selling users’ data to hedge funds has struck a chord with nonprofessional investors throughout the nation.

In the wake of the digital era, users are beginning to realize the extent to which companies are willing to go in order to obtain users’ online data.

Earlier this year, tensions between Apple and some of the larger social media platforms ratcheted up after the company rolled out new privacy features that require companies to extract explicit permission from users in order to track their data.

As a result, the recent allegation that Robinhood Markets Inc., a popular stock and cryptocurrency trading company, might be selling its users’ data to hedge funds struck a particular chord with nonprofessional investors throughout the nation. This came after the company famously imposed restrictions on popular stocks, like those of GameStop Corp., where users were deliberately betting against larger hedge funds.

Yet, while some remain grounded against this “order flow process” – the process by which a company is paid by market makers to enact trades for their users – some analysts argue that it actually benefits nonprofessional (retail) investors utilizing the trading platform.

Who’s Robinhood looking out for?

In January, retail investors took to Reddit, a popular online forum, encouraging other users to purchase shares in a few major companies, the most notable of which was GameStop.

The users noticed that several hedge funds and large investors were allocating quite large sums of capital into “short-selling” these stocks, meaning they were betting on – and profiting from – a decline in the stock’s value. Thus, the worse a stock performs in the market, the more of a profit the entity with the shorted position earns.

So, in an attempt to counter these short-sellers, these retail investors bet against them en masse. This drove up the price of the stock (with GameStop, for instance, reaching nearly US$500 per share) and caused some of these short-sellers to incur losses in the billions of dollars.

Shortly after this, Robinhood opted to restrict trade on some of these stocks, citing “significant market volatility,” while hedge funds were able to continue to trade in these stocks on the market.

The company later released a letter to users stating that the restrictions were necessary to comply with clearinghouse deposit requirements that support customer trades. Still, the backlash from users was extraordinary, with many suggesting that the company restricted trade in an attempt to protect its hedge fund investors.

Such users pointed to the more than US$600 million in revenue that Robinhood received for this order flow process, which accounts for the majority of Robinhood’s quarterly earnings as the company is commission-free for users to trade.

They also cited a US$65 million fine from the Securities and Exchange Commission (SEC) that Robinhood incurred for “misleading statements and omissions” regarding this payment for order flow process, concluding that Robinhood “deprived” users of US$34.1 million after providing their order flow to clients that prioritized higher revenue over providing the best price for customers.

Indeed, the company’s primary customers for order flow are hedge funds and other institutional investors, according to an SEC filing from 2020.

What’s more, the users noted that over half of the company’s market orders were purchased by Citadel Securities, an affiliate of the hedge fund Citadel LLC, which extended a US$2.75 billion investment to Melvin Capital, after its GameStop short cost the company billions of dollars, according to The Wall Street Journal.

Insider information

TMS spoke with Adriaen Morse and Cory Kirchert, two attorneys and former Senior Counsels at the Division of Enforcement of the US Securities and Exchange Commission (SEC).

“The issue here is that certain introducing brokers like Robinhood have deals with certain clearing brokers that do the other side of the transaction and matching, so these introducing brokers are sometimes (or often) paid for the services they provide on the back-end,” says Morse.

“It’s a process people don’t see,” Kirchert adds. “So, let’s say you’re buying an IBM stock. That IBM is typically at the Depository Trust Company (DTC), where there are certain brokerage firms that have accounts; and it’s kind of like a bank account: you’re moving money from one account to another. These are the clearing brokers, the ones who actually move the securities from the account of Company One to Company Two. They’re the ones who bring in the orders.”

“So,” says Kirchert, “the clearing brokers and introducing brokers need to be compensated for their effort. The issue is just how they are compensated.”

As for the penalty Robinhood paid to the SEC, Morse suggests that this may have simply been due to disclosures.

“Basically, Robinhood’s disclosures on its website where it interfaces with its customers didn’t fully disclose the terms of payments they were receiving for the flow of various transactions,” he says.

“There are different ways of paying for it, and essentially what the SEC found is that Robinhood was claiming they were able to match the best execution you can get out there in the market, and that turned out to be incorrect. So, it was a disclosure issue.”

But as for Robinhood’s decision to suspend trading, Morse says, “I don’t think we really know what happened, yet, but I suspect that a lot of this is probably something the SEC is investigating. Really, the question to be answered is whether or not there was a legitimate reason for Robinhood to cease processing trades, and I don’t think we fully know the answer to that.”

Are trading halts common?

While trading halts by stock exchanges happen fairly regularly, it’s quite rare for brokers to suspend trading in a specific stock.

“Basically,” says Morse, “there’s an agreement between Robinhood and its customers that when they place orders, Robinhood will execute those orders, if possible. So, those customers in this situation may have been thinking, ‘Wait a minute, I have a contract with you as an entity, I placed an order, and it didn’t get executed.’ So, whether or not there is liability depends on the reason why Robinhood did not fulfill its obligation.”

“A broker doesn’t have discretion on whether or not an order is placed,” he says, “but there can be extenuating circumstances. So, it all depends on: what was the reason?”

Would a significant stock increase from retail investors constitute an extenuating circumstance?

“All this is what they call a ‘short squeeze’. You squeeze the short by driving the price up,” says Kirchert. “Quite frankly, unless there’s market manipulation — like lying to the market or creating illusory market activity that isn’t genuine — there is no rule to prevent people from paying what they want to pay for a given asset, in this case, a stock.”

“And this goes on all the time,” he insists. “It makes zillions of dollars for people — but they’re usually big players because it’s a risky trading strategy.”

“You’re selling something you don’t own at $10, you’re driving the price down because you’re putting more supply at a given demand, so you’re hoping that price stays down so that you can cover your sale and pay back the borrower at a cheaper price.”

Morse adds that “if you go in and say ‘I’m going to buy a stock, let’s all go in and buy this stock’, and you buy the stock, you’ve made no false statement.”

“If you have a significant number of people buying a stock,” he goes on, “the demand is high and the supply is low. That’s just standard movements of a stock market. The market perceives buying activity — which is real people buying shares — so there’s nothing wrong with that particular action.”

“You know, if you look at analysts for large brokerage firms or dealers, you have all sorts of people and companies that follow stocks and write analyst reports, and, at the end of the report, make recommendations. If professionals can do it, why can’t an investor on Reddit?” says Morse.

The pair suggest that this draws the line between trading and investing.

“Traders are trying to take advantage of each other in guessing which way things are going to go, and this is more short-term. Investing is more long-term, saying ‘I perceive the value of a company is actually greater than what you say it is, so I’m making a bet that over time, the market will come to realize the [true] value of this company,’” Morse explains.

“If you think about it,” adds Kirchert, “usually the value of a company depends on some change in the state of affairs, and if you’re day-trading on a stock, you’re just gambling. So, it’s just a game, and not one necessarily of valuation.”

What do experts anticipate for the future of Robinhood?

“My own view is that in some ways, it’s a really great thing for retail investors to have access to the ability to trade in the market and participate, and there’s no reason to think that that’s a negative thing overall,” says Morse.

Still, he insists that “people need to understand that they are swimming in a very complex and very sophisticated market with a lot of sophisticated players, and individual investors tend to have day-jobs and are competing with those whose job it is to understand the markets and these stocks.”

This doesn’t mean retail investors cannot be successful in the stock market. Simply put, these investors “just need to be aware that there’s no guarantee you’re going to make money in investing,” he shares.

But “[Robinhood’s] model is certainly viable. They’re registered with the SEC, of course, and as long as they follow the law, there’s no reason they couldn’t continue to participate as they have been,” Morse asserts.

“I think the model is ingenious,” contends Kirchert. “When you see a business model that’s more efficient for the customer, it’s difficult to believe that it’s not going to continue. Yes, there are arguable drawbacks in the sense that people may not be getting the best price possible, but these things can be fixed.”

“And whether it’s Robinhood or another company,” adds Morse, “once you see the model, it can be replicated. So, even if Robinhood has problems, I have to believe another entity would come along, choose what’s good about the model, and discard what doesn’t work.”

At any rate, whether or not Robinhood remains a chief platform in the world of fast-and-easy investing, it’s clear that the future for retail investors looks bright.

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