- [Michael] This video is brought to you by Keeps.
(upbeat music)
- What's up, WiseCrack?
Michael here.
The Gamestonks debacle captivated the world
because it showed that apps like Robinhood
have given us normies a collective
and unprecedented power and influence
over the stock market, until it didn't.
- Robinhood interactive brokers,
and I believe E-trade came out
and were limiting the ability to buy stocks
through their app.
So limiting going after Gamestop.
- Amongst the chaos, and to the outrage of its users,
Robinhood and other apps like WeBull, and TD Ameritrade
temporarily stopped people from being able to buy
shares of certain companies.
After this happened,
sub-Reddit, wall street bets,
tweeted in outrage that individual investors
are being stripped of their ability to trade
on the Robinhood app,
meanwhile hedge funds and institutional investors
can continue to trade as normal.
A lawsuit was filed accusing Robinhood
of, "Purposefully, willfully, and knowingly
"removing the stock GME from its trading platform
"in the midst of an unprecedented stock rise,
"thereby deprived retail investors
"of the ability to invest in the open market."
This all raises some pretty cool questions.
Robinhood promises to democratize finance.
To put power in the hands of the people,
but does it really?
Let's find out in this Wisecrack edition on Robinhood.
What went wrong?
And before we continue,
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Now back to the show.
Scholars, journalists, and finance nerds alike
argue that trading apps like Robinhood
make investing money accessible to everyone.
It's even in Robinhood's mission statement
to "Democratize finance," and to do it for free.
In the pre-app days, it wasn't possible to go to war
with a hedge fund from the comfort of their home.
Before the popularity of creating apps
and online brokerages like E-trade,
the small percentage of people who wanted to invest
and buy individual stocks would have to go to a library,
read up on finance, and research company financial reports
to help them decide what stocks to buy.
Day traders would call a voice brokers
who were either on the floor of the stock exchange,
or had access to expensive stock paper machines
called quotrons, and ask them to
execute the trades for a fee.
In some places, like the New York Stock Exchange,
you can still shout such requests at your broker,
but most people don't have time for that.
In short, the ability to buy a stock for four dollars
and sell it for five dollars on the same day
was pretty rare for the normal population
and often reserved for the pros.
Most normal people who invested in the market
went through an institutional investor,
an organization specializing in investing
other peoples money.
They would manage a diversified stock portfolio for you.
If you're lucky enough to have 401 K,
it probably works like this.
But most institutional investors
require you to put in a minimum amount of money,
usually in the thousands,
rendering them inaccessible to lots of people.
Basically if you wanted to go to the moon
with an individual stock, at this point,
you needed a solid stack of cash.
No offense, but you wouldn't have been,
and still aren't, of interest to many traditional brokers
as a client because small investments
usually don't bring in big commissions,
and of course, there are people like Jordan Bellfort
running around taking your money to invest in penny stocks.
- You mailed in my company a postcard a few weeks back
requesting information on penny stocks
that had huge upside potential,
with very little downside risk, does that ring a bell?
- But with the advent of apps like Robinhood,
people are suddenly able to build their own portfolios
and invest in whatever they want with a tap on a screen.
Want to buy one 18th of a share of Amazon
and see what happens?
Go ahead!
Want to spend your last five dollars and 52 cents
on your friend's buddy's uncle's weed company
that just went public?
Just swipe up to confirm.
With trades like this being so easy,
the number of individual investors,
also called retail investors,
increased dramatically.
In the past 10 years alone,
the percent of equity trading value
by retail investors nearly doubled
from 10.1% to 19.5%,
and with trading commissions going out the window
on places like Fidelity, E-trade, and Robinhood,
it's easier than ever to take a shot at day trading
or dump your spare change into the Clever Crevice stock.
This is all well and good,
but you may have wondered
how exactly does Robinhood make money
when it's letting you trade for free?
The answer lies in something called payment for order flow,
and an explanation that can help us understand
that in spite of democratizing finance,
Robinhood's primary customers
are the exact same big financial players
they are quote, unquote disrupting.
Payment for order flow is when big financial institutions,
also called market makers,
pay Robinhood for the privilege
of handling your transaction.
Basically for a fee,
Robinhood routes your order information
through a hedge fund to execute the trade,
instead of sending it directly to a stock exchange.
Think of order flow as a bunch of moving traffic.
Your order leaves the Robinhood app
and heads toward its final destination, the stock market.
In an ideal world, we all want to get to the destination
in the quickest way possible.
But instead of doing that,
a big trading firm or hedge fund
will pay to have the traffic diverted through them, first.
This might seem fine and good,
like a traffic conductor
merely directing some cars to wear they need to go.
But it's maybe more accurate to think of it as
said conductor diverting cars to a parking garage
where their buddies can properly ripoff the drivers.
Okay, maybe a little extreme,
but it's important to remember
that every transaction in the stock market
has some theoretical winner, and a loser.
That is to say, the buyer either bought the stock
for what it's actually worth,
or the seller should've gotten more money.
When hedge funds go against hedge funds,
it's like a complicated math war
to find information nobody has,
and buy stocks that are undervalued,
or at least sell overvalued stock
to some sucker who doesn't know any better,
and that sucker is probably you.
As the Wall Street Journal notes of companies
that use payment for order flow,
"They are willing to pay for order flow
"from online brokerages because they are
"less likely to lose money trading
"against individual investors
"than on an exchange where traders
"tend to be larger and more sophisticated."
That is, you are less sophisticated, AKA, money-dumb.
It is quite literally like when your older brother
told you your foil Pokemon card was worth one dollar,
bought it from you, and flipped it for $50.
While you might've cried and said it wasn't fair,
you also learned a timeless lesson
about the inner workings of capitalism.
Congratulations.
In the case of Robinhood,
they direct your order to someone like Citadel Capital,
who knows they can get the stocks you want
for a few cents cheaper and sell it to you,
splitting the profit with Robinhood.
A few cents off every order might not seem like a big deal,
and when compared to a six or seven dollar trading fee,
it might even seem like good deal,
but the ethics of it are still pretty sus.
- So you're stealing.
- No, no you don't understand.
It's, uh, it's very complicated.
- Payment for order flow was pioneered by one Bernie Madoff.
You know, the Ponzi scheme guy.
It's literally how he made his fortune
before the aforementioned Ponzi stuff.
Madoff made his name through
Bernard Madoff Investment Securities,
which bond sold stocks on behalf of brokerage firms.
To encourage orders to come his way,
his firm would pay brokers a fee.
Usually brokers with,
"Large bases of relatively unsophisticated retail clients."
Now if stock trading is sophisticated three D chess,
payment for order flow lets your opponent know
what your move is ahead of time.
The key to the stock market for hedge fund managers
is knowing things other people don't.
Specifically, by getting in a stock
when it's still priced low
before everyone else figures out how valuable it is,
thus driving up the price.
In the case of payment for order flow,
the orders of you or the wall street bets crowd
are known to market makers literally before they happen.
That right there is valuable information to big hedge funds,
who can know what large groups of people
are investing in before they actually do.
A Harvard law revue article from 1994 notes concerns
that the practice distorts incentives for brokers
to serve the best interest of you, the investor.
There were also concerns
that it perverted the basic logic of the market,
specifically that the practice might foster
oligopolistic concentration
within the market of brokers and dealers.
During a senate hearing about our boy Bernie,
one professor testified
that the way Madoff used payment for order
really wasn't all that different
from the way he lured feeder funds into his Ponzi scheme.
- It would not have been beyond him
to pay the feeder funds under the table
because for decades he had paid brokers
to direct order flow to him,
and the two are not that functionally different.
In a letter about the Robinhood, Gamestop fiasco,
Elizabeth Warren notes that regulators
have criticized the behavior as a, "Conflict of interest,"
While another called it legalized bribery.
And as Warren notes, Citadel invested two billion dollars
in Melvin Capital,
which famously lost over four billion dollars
in shorting Gamestop, providing a very clear
conflict of interest between Citadel
and it's business partner Robinhood.
The chairman of the SEC talked openly about
his disdain for the practice as far back as 2001,
but admitted it would be seemingly impossible to ban.
- I am not a great proponent of payment for order flow.
It's always trouble made.
- The imperfect solution, he thought,
was to openly disclose the practice to customers.
- There is no possible way, really,
that we could effectively ban that kind of reciprocity.
I don't like it, and I think the best way to respond to it
is by saying to it that it is disclosed.
- Anyway, in December,
the SEC fined Robinhood 65 million dollars
for not disclosing this to customers between 2015 and 2018.
Because even though payment for order flow is legal,
it's regulated, so it's only legal
to accept payment if the third party brokers
are buying and selling at rates
better than or the same as the stock exchange,
and it must inform its clients in writing.
Robinhood had really high order flow rates,
and never informed its users it was doing this,
and that information is still buried
in the fine print of the thing you hit agree on.
The SEC said it found that Robinhood deprived customers
of $34.1 million dollars
through it's payment for order flow practices.
And just for the record, plenty of people
think it should be flat out illegal,
and have been fighting against this
since Madoff started doing it.
This all gets us to the basic truth.
Robinhoods real customers aren't its users,
its real customers are hedge funds, like Citadel.
The investors like you are simply the product,
which brings us to the second sad reality of Robinhood.
You're just not as smart as you think you are.
And neither am I.
Part two, you suck! (bell chiming)
I'm just kidding, we love you.
Study after study shows that
even the savviest investor
can't perform better than the stock market average.
About 6.8 adjusted for inflation.
And sure, people do better than that some years,
but they also do a lot worse during other years.
Warren Buffett famously wagered
a million dollars that no hedge fund
could out perform the market, and he won.
To put your dreams of getting wildly rich from day trading
in context, Bernie Madoff drew suspicion
for consistently paying out returns
of 10% or above every year.
Which, before the Ponzi scheme unraveled,
some people thought was too good to be true.
- We've identified numerous red flags.
Returns that were too good to be true,
consistent gains over 10% every year,
in bull and bear markets alike.
Which is to say, remember that magical number
when some friend tells you about some totally legit
opportunity that will double your money.
- They're coming to hear Kyle talk about
how he turned 50,000 into over three million.
- The point is, picking individual stocks
is totally your personal prerogative,
and might even work out for you.
But statistically, it's a very bad idea,
no matter how many YouTube ads you see
of dudes in Ferrari's.
But Robinhood plays on these dreams
by making a user interface
that treats investing like a very fun game.
Sociologist Adam Hayes, and a host of other scholars,
argue that this user interface is intentional.
It's designed to encourage trading rather than discipline,
because that's how these apps make money.
Robinhood doesn't care if you win or lose
your stimulus check, because it makes bank
by skimming a few pennies off every trade you make.
Hayes suggests that these apps
purposefully exploit human propensity to over-trade,
playing upon emotions like fear and greed
and the thrill of gambling.
One study found that active customers on average
checked the Robinhood app 10 times per day,
often because they're spammed with push notifications,
and for the average user,
the more you trade, the worse you'll probably do.
As we're beholding
to so many psychological traps while making trades
that just aren't smart financial decisions.
Robinhood's designed to keep you pouring money in
so that it can keep profiting off of your trades.
You get congratulated with confetti every time you invest.
You get free stocks when you sign up and refer friends.
Every time you buy or sell anything
you get notifications with fun emojis
and exclamation points.
Actually, this sounds awesome, give me a second.
Daddy's gonna be rich.
Robinhood founder, Baiju Bhatt defends it pretty bluntly,
saying, "It shares some of the mechanics
"with gambling activities,
"but the reason it's different
"is because on average,
"you will make money through investments
"in the stock market," while if you go to the casino,
on average, you'll lose money.
And that makes sense if I'm using Robinhood
to buy safe index funds.
But not so much when I learn what options trading is,
and lose tens of thousands of dollars.
Which, if wall street bets is any indication,
happens all the time.
In one case, a Reddit user
managed to turn $5,000 into a negative $58,000 balance,
thanks to something called a box spread,
which he thought was a sure thing.
20 year old Alex Kearns took his life
after Robinhoods easy access to options trading went south.
He mistakenly believed he owed the company
$730,000 after making some bad trades.
But it's still better
than not being able to invest at all, right?
Right?
Can we pause, I'm gonna,
I need to delete that app immediately.
Fraud, fraud alert, I didn't, my kid did it.
(beep) kids.
You could make that case, but the apps that give-ith,
can easily take-ith away, and they do.
Even though better alternatives might not seem obvious,
it's at least important to see through the bullshit
that this well financed start-up company
really has your interest in mind,
or cares about anything resembling democratic finance.
Aside from a maybe once in a lifetime victory
for the Gamestonk crowd,
what's clear is that game is rigged.
Individual investors still need to rely on these platforms
to execute their trades,
but these platforms are beholding to the market makers
and the system itself.
Until we figure something else out,
it seems like the hedge funds will always win.
But what do you guys think?
Do the pros of Robinhood outweigh the cons?
Or are we all destined to be suckers?
Let us know in the comments.
Big thanks to our patrons for all your support.
Hit that subscribe button
like you're hitting delete on your Robinhood account,
and don't forget to ring that bell
And as always, thanks for watching, later.
(upbeat music)
- Okay, username, Santa Claus of dat skrilla 420?
That works, I'm gonna be so (beep) rich.
I'll never come back to this studio again.