Last week GameStop was all over the news. Not because of a new product release or a great Q1 earnings report. It made headlines because users on Reddit, a social media platform where communities share posts, content, ideas, etc, banded together to rock Wall Street’s world. Hedge funds were leveraging themselves to short sell certain stocks. Investors noticed a structural inefficiency in this marketplace and seized the opportunity.
Short selling is where an investor borrows a stock, sells it, then buys the stock back (at hopefully a lower price than it was sold for), and returns it to the lender. It’s no secret hedge funds do this regularly: short selling companies with wobbly financials. When Reddit users saw hedge funds going after GameStop, they saw a risky opportunity to make money.
For many individual investors, the tool for battle was Robinhood, a commission-free trading platform that was built with the mission to “democratize finance for all.” The creators of Robinhood were inspired by the 2011 Occupy Wall Street movement where people were protesting Wall Street corruption and wealth inequality. They wanted to create a platform where everyone could access the financial markets and participate in long-term investing, thus Robinhood was born.
However, most of its customers are not “long-term investors,” rather, they are individuals enjoying a gamified experience of investing. When you make a trade on Robinhood, the screen lights up with confetti, celebrating your transaction. Robinhood’s commission-free trading and gamified experience encourages consistent trading, but not at the frenzy we just witnessed. The company was not prepared for the influx in trades on a risky stock. In response, they restricted the trading of some highly volatile stocks, claiming their actions were due to “significant market volatility.”
This response did not bode well with Robinhood’s users, the public, and even politicians who never agree on anything. All were especially peeved to know hedge funds were free to keep trading the stocks without restrictions.
So, why did Robinhood cease trading? To answer this, you need to understand the plumbing of our financial system. Robinhood is a brokerage firm. On its platform, it offers stock trading, options trading, and margin loans. When an investor places an order to buy or sell a stock, the broker accepts the trade and sends the order to an exchange (ie: NASDAQ or New York Stock Exchange). As an investor, you think the job is complete, but behind the scenes, the clearinghouse is making sure the trades are processed and completed and all parties follow through on their end of the deal. This is why, when you place a trade, the funds are not immediately made available to you. Trades take two days to settle, and on settlement day, the seller’s broker must deliver the stock and the buyer’s broker must deliver the cash. As more buyers entered the market and the stock’s volatility increased, the clearinghouse required more collateral from Robinhood and other brokers to cover the risk of settling both sides of the trade.
Robinhood users can also purchase stocks on margin, meaning they borrow money to purchase more shares of stock and Robinhood collects interest on the loan. So, the combination of a bunch of people buying stocks on margin and a clearinghouse requiring more collateral, put the broker (Robinhood) in a tight position. They needed more cash to complete the trades. To stall, they restricted trading on volatile stocks and went looking for cash. They had to draw down credit lines at several banks and quickly ran to their business investors to raise capital.
Robinhood did not effectively inform their users why they restricted trading. Most users found out trading was restricted when they went to try and purchase a stock. This was a huge blow to the user base, who joined the company based on their mission to “democratize finance for all”; their democracy was threatened the day they couldn’t buy the stock they wanted.
This whole occurrence has demonstrated the concerns with commission-free trading and uninformed investors. A gamified investing experience with easy access to complex investment products, makes us feel like we can all be winners. But if we don’t understand the fundamentals of market risk and investment products, the risk can lead to a significant loss.
I think the key takeaway for this short squeeze is that social media is powerful, and FOMO (fear of missing out) is real. A phone app has made investing easy and fun; it’s allowed inexperienced investors to participate in the financial marketplace and play the stock market like a game. And when we hear the success stories, we quickly follow suit hoping to make it, too (aka FOMO). However, where there are winners, there are losers, and in this game, there are significantly more losers who can’t afford the loss.
And, really, should investing be a game? Most would agree, no, for the average investor, it shouldn’t be a game. Investing should be boring. Typically, the biggest losers are those who attempt to time the market and trade frequently. The winners are often those who buy and hold, but this is not mentioned on the app. A company that makes most of its money from high-frequency trading (even though it’s free to you) isn’t educating its investors about the difference between investing for retirement and stock picking.
You can argue this app is not intended for retirement saving, so why would they educate their users in this regard? That’s a valid point, but regardless of the platform’s purpose, when it comes to money and investing, we want everyone to be fully informed. This is how we will democratize finance for all, how individuals will build wealth, and how one day (hopefully) the wealth inequality gap will shrink. Educating people on how to save and the power of “boring” investing, will create more winners than losers in our financial system. Accessibility to options trading and buying on margin won’t turn all individuals into millionaires. Because let’s face it, we the people aren’t Wall Street, and do we even want to be?~ Rachel Bubb
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This material was created for educational and informational purposes only and is not intended as ERISA, tax, legal or investment advice. If you are seeking investment advice specific to your needs, such advice services must be obtained on your own separate from this educational material.