For all its benefits, the “democratization” of the stock market can quickly devolve into recklessness.
Turns out, no-fee stock trades can exact a very high price after all.
Not only for the retail traders sitting on deep losses speculating on meme stocks, or for Robinhood, which faces recriminations for “gamifying” the frenzy that spun out of control and was forced to scramble for billions in fresh cash, but also for the stock market itself, which must reckon with the wild swings that have little bearing on fundamental value.
If the surreal events of the past week hold any lessons for investors, it’s this: that for all its benefits, the “democratization” of the stock market, powered by the no-commission model, is far from without risks. Things can quickly and recklessly devolve into mob rule.
By now, just about everyone is familiar with GameStop and its spectacular rise and fall. But in many ways, it’s merely the most prominent example of what can happen when short-term stock trading — in place of the tedious, long-term vision of passive investing — becomes free and accessible to all.
“It’s when friction decreases that you expect much more action, more trading, so going to zero in trading fees matters,” said Stephen Wendel, head of behavioral science at Morningstar. “The more frequently that people get price updates the more it warps, and changes their behavior.”
Of course, the race to zero commissions was meant to even the playing field that was all too often tilted toward the Wall Street establishment and help ordinary Americans take their financial futures into their own hands. Still, the recent episode lays bare troubling questions for not only Robinhood, which pioneered the idea that anyone, anywhere could trade the hottest, most volatile stocks and options for free, but for everyone else in the brokerage industry.
Online stalwarts like Charles Schwab, E*Trade and Interactive Brokers, which followed Robinhood in eliminating commissions, all faced disruptions or were forced to curb some transactions amid the retail trading crush.
“We’ve made gambling on the stock market cheaper than gambling on sports and gambling in Vegas,’’ said Larry Tabb, an analyst at Bloomberg Intelligence. “There’s no rake, there’s no vig.”
Today, Robinhood — which until this past week was having a banner year as cooped up millennials became addicted to its slick and game-like app — is at a crossroads. It’s had to borrow or raise billions of dollars to shore up its capital. Regulators and lawmakers plan to examine its decisions. And legions of users, feeling betrayed by Robinhood’s emergency decision to ban purchases of the popular, high-flying shares, have vowed to leave the platform as those same stocks now tumble.
Robinhood declined to comment.
‘Unintended Consequences’
Pandemic lockdowns set the stage for an explosion in high-risk, high-reward trades as millions of bored young people began betting on a range of fringe, oddball stocks for the rush of a big score. By one estimate, market value of all the niche stocks caught up in the frenzy amounted to just 0.1% of the total capitalization of the U.S. stock market. The saga has spurred debate over whether the current situation could have been avoided if users had to pay a price, however small, on each transaction.
“If there was not zero-fee online trading, the effect that we’ve seen the last several weeks would have been orders of magnitude lower,” said Julian Emanuel, chief equity and derivatives strategist at BTIG. “When you can engage in an activity that used to cost you something and no longer seemingly costs you anything, the inclination is particularly if you’re making money doing it, you’re likely to do it more often. It’s a perfect example of the law of unintended consequences.”
While a confluence of factors — like Redditors pumping up GameStop en masse to punish short sellers — helped to whip up the speculative frenzy, no platform was more successful at tapping into the no-fee craze than Robinhood.
Fun and Free?
The no-fee trading model fueled the speculative mania in GameStop
Last year, an average 10.9 billion shares changed hands across U.S. exchanges each day, the most on record in Bloomberg data going back to 2008. This year, daily average has increased to almost 15 billion shares. On Jan. 27, nearly 24 billion shares traded, the most on record by far.
Robinhood has been a prime beneficiary. Daily unique users have tripled since the start of 2021, according to data by SimilarWeb, a technology firm that analyzes web traffic data. Meanwhile, its traffic grew by about 1,200% in the week ending Jan. 29, nearly 6.5 times more than traditional brokers.
It’s not hard to see why. Robinhood’s app is designed to feel more like a game, with asset prices flashing in various colors of neon. And unlike rivals, it leverages its no-fee model by making deposited funds instantly available for trades. Bursts of confetti celebrate new transactions.
The brokerage also recruits financial influencers to promote the app across social media. Users can refer a friend to get free stock and screenshots of Robinhood’s interface celebrating gains or losses have become commonplace on apps like TikTok. Arguably, it’s all done to get its users, particularly millennials, hooked on trading.
Mixed Signals
Robinhood points to academic research published in September that shows its users increased their holdings during the March swoon, providing a stabilizing force to the market, and in aggregate tilted toward mostly large, highly liquid stocks. But in recent months, volume data for Robinhood also shows its users trading more and growing increasingly obsessed with smaller-cap names that don’t qualify as blue chips.
In December, about 13.6 billion shares of non-S&P 500 companies traded on the app — four times as many compared with the first month of the year, data pulled from the latest filings and compiled by Bloomberg show. There was a commensurate decline in the share of the biggest firms. Currently, of the 100 most-held stocks on Robinhood, 12 have a share price below $5. That’s double the number on the list back in early March.
The development has come with some negative consequences for investors. A study published this week by researchers at Oklahoma State University and Emory University showed that commission-free trading on Robinhood not only contributes to greater volatility in stocks bought by retail traders, but also lends no predictive value on returns. In other words, the no-fee model isn’t particularly beneficial and just adds more noise to the market.
This Is the Way
GameStop is case in point. At the end of December, it traded at $18.84. Then in January, the stock went haywire as Reddit’s WallStreetBets crowd took over. In the previous five days, the shares went from $347.51 to $193.60, then back up to $325 before slumping to $225 and then all the way down to close at $90 on Feb. 2. The rise of options trading — which effectively allows traders to supersize their bets on stocks — helped amplify the stomach-churning volatility.
A record amount of call options, which gain in value as the underlying shares rise, has traded in the past 20 days, data compiled by Bloomberg show. Much of the upswing came from small-time retail investors. These types of traders spent over $44 billion in premiums buying more than 87 million call options in the past four weeks alone, according to Sundial Capital Research.
Robinhood is often the primary gateway. It accounted for roughly a quarter of all options trading across retail brokerages last year, the most for any single platform, according to data compiled by Bloomberg.
Market watchers say the situation is unlikely to change any time soon. Brokerages have little incentive to keep vast amounts of cash sitting idle, and every reason to nudge customers to trade more and more. That’s because the no-fee business model relies on a practice known as “payment for order flow.” Market makers make enough money by processing trades that they’ll pay brokerages for sending orders their way. The more people trade, the greater the revenue collected.
“That’s something that we may need to figure out, ‘How do we make sure people understand there are limitations,’” said Shane Swanson, senior analyst at Greenwich Associates.