By Jim Campbell, author of Madoff Talks: Uncovering the Untold Story Behind the Most Notorious Ponzi Scheme in History
According to some media conjecture, Robinhood, which ostensibly offers “free” trading to retail investors, has ignited a populist movement democratizing the stock market and beating down the big bad hedge funds.
The reality is darker.
As the author of Madoff Talks – the first complete account of the Madoff story from one man’s Ponzi scheme to systemic failure of the regulators charged with protecting investors – even Madoff never abused his customers in the way Robinhood does.
It is no doubt little understood by its customers, but Robinhood makes its money, not through charging commissions to its investors – touting so-called “free trading” – but by receiving “payment for order flow” whereby they direct their customers’ trading volume primarily to appropriately named “dark pools” – non-transparent, private exchanges, consisting of high-frequency trading firms like Citadel Securities instead of a transparent stock exchange like the NYSE.
Essentially, Robinhood’s business model is in conflict with its customers.
Robinhood has a regulatory requirement to execute its customer trades at the best buy and sell prices available. In actuality, the SEC found Robinhood ran its customers’ trades to get the best payment for itself by directing order flow. Robinhood did this to such an extent its customers paid $34 million more than if they’d paid commissions because of inferior price execution. In other words, “free” commissions were anything but free. Rather it’s a marketing gimmick luring investors into excessive trading without regard to the quality of the stocks.
This investing approach can only lead to a bad ending. Robinhood earned $440 million in payment for order flow in options and $120 million in equities in the timeframe that the SEC investigated, which slapped Robinhood on the wrist, levying a $65 million fine along with the typical “no admission of guilt” by the guilty firm.
Madoff built his firm from nothing into the third-largest market maker, executing trades for brokers, like Schwab, in behalf of their retail customers. Madoff practically invented payment for order flow, but he never deprived his investors of best price execution. He specifically designed his automated stock execution systems in a way that blocked anything but best pricing for his customers. Bernie would have been disgusted, and he was the undisputed master of running circles around the regulators. The SEC having cleared Madoff in five separate investigations. Along with real penalties, the regulators – SEC and FINRA – should force firms to disclose fundamental conflicts of interests with its customers, such as payment for order flow.
Rather than a new-age business democratizing the market, Robinhood is a vehicle for age-old “pump and dump” schemes. It is driving stock prices of bad companies to ludicrous levels via social media to unsuspecting investors who are entirely ignorant of, nor interested in, the fundamentals of stocks, like GameStop.
This inevitably results in run-ups for the stock to the benefit of the few who pump up the hype, leaving the investors getting in late to the dumping and parabolic decline of stock prices back to lousy fundamentals.
If Robinhood were genuinely interested in democratizing the markets, they would listen to Warren Buffett and educate its retail clients. The way to get rich in the markets is through long-term investing and letting the power of compounding increase the value of investments. The best way, as Buffett recommends, is regularly buying low-cost index funds and holding them. The market has averaged 9% compound growth for over a century. That’s how to get rich safely. It’s not sexy, but you can sleep at night and make sound investments, not reckless gambling bets.
As to the hedge funds, when they are grossly over-leveraged and can be brought down overnight by a social media-driven short squeeze, they should fail, not be bailed out. Recently, the Archegos hedge fund, run by someone the SEC had previously sanctioned for insider trading, using excessive dependence on derivatives, or as Buffett calls them “financial weapons of mass destruction,” self-destructed after rumored leveraging of $5-10 Billon into over $50 billion. This begat a cascading fallout of potentially de-stabilizing risk: from margin calls forcing liquidation of positions at distressed prices; capital losses at Wall Street firms lending money to the hedge fund, and partially contributing to a sudden loss of 50% of the value of ViacomCBS that Archegos held an outsized position in.
Madoff’s version of Robin Hood lore involved stealing money from his moderate net worth investors and siphoning it to his richest investors – what I label in “Madoff Talks” a “reverse Robin Hood.” Robinhood’s business model hoodwinks its average investors as well. Bernie Madoff and Warren Buffett admittedly make for strange bedfellows, but neither would approve of the likes of Robinhood; nor under-regulated, over-leveraged hedge fund ticking time bombs.