The Lure of "Democratizing" Finance

“The sense of responsibility in the financial community for the community as a whole is not small. It is nearly nil.”—John Kenneth Galbraith, The Great Crash: 1929

The idea of "democratizing" finance--that is, leveling the Wall Street playing field--has an appealing ring to it. After all, the world of finance is notoriously run by highly remunerated financial elites who possess key advantages that many believe make the game rigged against the small guy. This egalitarian and anti-establishment message--perhaps better called a "brand"--is what made the long-haired, hipster founders of the online brokerage company Robinhood Financial look unique, and even appear to be revolutionaries, especially given the firm's legendary namesake.

This article is from the
January/February 2022 issue.

With the rise of the internet, we got the "day trading" craze of the 1990s. Now firms like Robinhood have created what amounts to day trading 2.0, with zero-commission, "gamified" smartphone apps (apps that provide incentives for trading by introducing elements of games into investment) that encourage do-it-yourself retail investors (and traders)--mostly amateurs--to actively trade stocks and options. "Fractional investing," meanwhile, lets investors buy smaller portions of stocks, compared to the old days, when investors needed to buy a minimum of 100 shares; this opens the stock market up to small-money investors on trading apps like Robinhood (whose average account size is $3,500). Unlike traditional brokerages in the pre-internet days, where you might have received investment advice from a full-service broker, Robinhood traders largely get their investment advice from social media hype that can quickly go viral creating a copy-cat effect that can turn into a tsunami of buying, as was seen with the GameStop price bubble and collapse.

What is a "Meme Stock"?

Meme stocks are stocks that acquire a cult-like adherence by denizens of the internet when they are hyped and promoted via memes--those provocative little images that go viral on social media platforms like Facebook, Twitter, TikTok, and especially Reddit, through the "subreddit" message board WallStreetBets. GameStop is one of many so-called meme stocks that made headlines in January 2021 with their meteoric share price leaps driven by young (many new) traders with accounts at online brokerages like Robinhood, egged on by hustlers and promoters who stood to gain.

Given that momentum to buy meme stocks can be driven by a quasi-religious devotion, partly out of "solidarity" with others who claim to share an anti-Wall Street sentiment, stocks can develop into bubbles that are disconnected from valuations based on a stock's fundamental value. This overvaluation is driven by a social media frenzy, fueled by the passion of buyers of meme stocks who have been fed a narrative cultivated on social media that the small guys in large numbers can beat the Goliaths of Wall Street. The bullish sentiment of these investors is partly informed by the idea of ganging up on hedge funds who had "shorted" GameStop and other meme stocks (that is, made bets on the GameStop price falling).

Some have described this as nothing more than a social media "pump-and-dump" operation that exploited the gullible retail investor crowd to move meme stock prices higher before dumping shares to this meme stock crowd ahead of the crash. Savvy watchers of Wall Street insider behavior see the hand of bigger players at work, shrewd insiders who stood to benefit from the bullish sentiment of the new crowd of meme-stock traders. Pam Martens of Wall Street on Parade describes it like this: "At the time of this news, GameStop had lots of big [bullish] players standing to make billions of dollars if the share price took off. That effort would be enhanced greatly if the hedge funds who had taken short positions (bets on the share price declining) could be forced to buy back the shares they had borrowed as part of their shorting maneuvers." When a stock price goes up, short traders lose money, and if the price goes up too much, shorts are forced to buy shares to close their positions, which drives the price even higher (this is known as a "short squeeze"). Whether the GameStop frenzy was a pump-and-dump operation or an attempt to squeeze hedge funds who were shorting GameStop, the facts remain clear that prices of meme stocks became unhinged from reality and took on a life of their own. Price determination had little to do with present or future earnings of meme stocks and instead became solely a function of the madness of the meme crowd and those attempting to capitalize on their buying power.

Who benefits from the wave of new investors drawn in by these "democratizing" trends? Surprise, surprise, the "revolution" benefits Wall Street. Findings contained in a report from the Securities and Exchange Commission (SEC) on the January 2021 GameStop stock-price bubble suggest that Robinhood is profiting from ensnaring individual ("retail") investors on behalf of, and as an accomplice to, some of Wall Street's shrewdest insider firms.

The SEC staff report, which was released in October, identified Robinhood's off-exchange order routing practices (diverting investor orders, made via Robinhood's app, away from public stock exchanges, i.e., "off exchange")--known as "payment for order flow" (PFOF)--as a major source of concern. This controversial non-competitive, off-exchange routing by Robinhood of retail investor trades to wholesalers (known in the world of finance as "market makers," who execute trades from their own inventories) in exchange for fees creates a misalignment of interests that works against the average investor. So when customers use the Robinhood app to trade stocks, instead of delivering them to the public stock exchange, Robinhood directs them to wholesalers who may not be giving the customers a fair price.

Over 50% of all U.S. stock trading volume is now being routed away from "lit" (public and transparent) market exchanges--like the New York Stock Exchange (NYSE)--to a few off-exchange wholesalers. When trades are routed to wholesaler inventories that constitute "dark pools" (with less transparency than the public exchanges), this can mean investors get less-than-optimal pricing when buying and selling shares of stock. Dominated by a few wholesalers, off-exchange pools enable the extraction of monopoly profits, critics contend, since investors are charged more than competitive conditions would provide. For this reason, PFOF has already been banned in other countries.

Robinhood made headlines in January 2021 when it restricted trading for individual investors in shares of the money-losing, brick-and-mortar firm GameStop, a so-called "meme stock" driven by aggressive hype on social media platforms to millions of users, most notably on WallStreetBets, a user-created forum (or "subreddit") on the social-media discussion website Reddit (see sidebar "What Is a 'Meme-Stock'?"). Most of Robinhood's more than 20 million customers purchased shares and became part of a Reddit-driven hyping of GameStop and other meme stocks with the hopes of driving share prices higher and crushing hedge funds that were betting the other way. Media reports dubbed this the "Reddit Rebellion'" against Wall Street.

Many retail investors who bought into GameStop and other meme stocks hyped by Redditors got burned, and conspiracy theories swirled after they learned that hedge funds were not restricted from trading. As the stock promptly fell from over $400 per share to just over $100 per share in one day following these actions, it looked like Robinhood had taken the side of some of Wall Street's biggest players, hedge funds who appeared to benefit from their actions. But this distracted attention from a more systemic problem.

Details from the SEC Report: Hidden Costs, Conflicts of Interest,and a Distorted Market Structure

The SEC report on GameStop did not contain any evidence of collusion between hedge funds and Robinhood (although the SEC does not seem to have looked very hard). The commission's report on the mania and crash did, however, describe how PFOF helped create what amounts to a gamed market structure. The SEC report noted that "the execution of retail orders [of Robinhood customers] by off-exchange market makers" such as Citadel LLC and Virtu Financial "raises questions about whether individual investors may still be subject to other less conspicuous costs and conflicts of interest."

While PFOF did not cause the sharp run-up in GameStop's stock price (and subsequent collapse), the stampede into this meme stock helped swell PFOF payments and profits for the parties involved. The SEC warns that investors need to be "mindful of how their orders are handled, including the difference between 'free' and 'no commissions.'" The SEC is alluding to what others have pointed out--that Robinhood's real clients are not its millions of individual account holders but the likes of Citadel, which is Robinhood's main source of revenue in the form of payments received for noncompetitively routing to Citadel its retail investor orders and not seeking best prices through public and competitive exchanges like the NYSE and Nasdaq.

In effect, when we read between the lines of the SEC report, it becomes clear that this questionable relationship (Citadel as wholesaler paying Robinhood for trades from individual investors) amounts to turning average investors into the "product." By producing more investor orders to sell to Citadel for fees, Robinhood maximizes its revenue. Despite claims by interested parties that PFOF helps retail traders get better prices and permits "zero commission" trading (not having to pay the broker for buying and selling shares of stock), more savvy experts see it quite differently.

Who's Who in Online Stock Trading

A review of some of the cast of characters and terms in the world of online stock trading:

Retail investors (or traders), such as Robinhood's individual account holders, purchase and sell stocks (and options) through a broker-dealer (like Robinhood) who send the trades to market makers for execution (i.e., to carry out the transaction).
Broker-dealers, like Robinhood, facilitate retail customer's buy and sell orders for stocks (and options), trades that are executed (or filled) by market makers. (Brokers act on behalf of their customers; dealers do their own trading; broker-dealers can act in both capacities.) "Discount" brokers like Robinhood don't charge commissions, but they also don't provide the investment advice that traditional, "full-service" brokers do.
Market makers, like Citadel or Virtu, act as wholesalers (analogous to wholesalers for a grocery store chain), buying lots of different stocks for their inventory and then selling them with a slight markup (or buying them with a slight markdown) known as a bid-ask spread to retail investors (or traders). Market makers are required to "make" a market by standing ready to buy and sell stock shares at all times.
The bid-ask spread in stocks can be understood using the example of auto trade-ins and the resale of used cars. The price an auto dealer is willing to pay you for your trade-in--the bid price--is always lower than the price for which the same dealer is willing to sell you the same car. The latter--the ask price--is always higher than what the dealer is willing to pay. This difference allows for a profit for the dealer much as the bid-ask spread in stocks does for market-makers who need to make a profit in exchange for facilitating buy and sell orders. If perceived trading risk grows for the market-maker, the spread will widen to compensate for that risk.

As the SEC noted in the conclusion to its staff report regarding "trading in dark pools and through wholesalers" like Citadel:

Much of the retail order flow in GME [GameStop] was purchased by wholesalers and executed off exchange. Such trading interest is less visible to the wider market--and payments to broker-dealers [i.e., Robinhood] may raise questions about the execution quality investors receive. Further, though wholesalers increasingly handle individual investor order flow, they face fewer requirements concerning their operational transparency and resiliency as compared to exchanges [e.g., NASDAQ or NYSE] or ATSs [automated computerized matching systems for buying and selling orders in the market]. [Emphasis added].

Citadel's Market Power and Concentration

This split-market structure (off-exchange versus public markets like the NYSE) provides wholesalers like Citadel with "asymmetric information among liquidity providers," writes Hitesh Mittal, an industry professional who conducted research into PFOF and its claims of offering better pricing, and Kathryn Berkow, an assistant professor at the University of Delaware. Wholesalers get to see the big picture and can take advantage of it in many ways.

In a research report prepared by Mittal and Berkow for BestEx Research ("The Good, the Bad & the Ugly of Payment for Order Flow"), the authors show that PFOF actually "reduces competition in public markets and leads to higher NBBO [national best bid and offer] spreads, [thus] increasing costs for all."

Mittal and Berkow's thorough analysis undermines much of the hype in favor of PFOF. Based on meticulous analysis of aggregate trading data recorded on the public NYSE's "trade and quote" system during a one-month period, they convincingly show that any purported price improvement in trade execution is simply an illusion created by the structure of today's bifurcated (off- and non-off) exchange structure itself. (See sidebar "Debunking PFOF's 'Price Improvement' Claims.")

Debunking PFOF's "Price Improvement" Claims

Defenders of payment for order flow (PFOF) point to evidence of better prices for stocks provided by routing retail customers to market makers paying for order flow versus prices available on "lit" (i.e., public and transparent) market exchanges like the Nasdaq and New York Stock Exchange (NYSE). But critics contend that this is really just smoke and mirrors. Some industry insiders maintain that this is a false comparison, because the two pricing structures are functions of one another—the latter made worse by the former (PFOF). Claiming PFOF provides "price improvement" is based on comparing purported "better" pricing to distorted (worse) pricing brought about by the practice itself. A simple analogy using the trading of cars will help make this abstract idea understandable.

Suppose that a large metropolitan Honda auto dealership decides to route all its traded-in used cars to a used car dealer for executing (purchasing and reselling) who has offered to pay the Honda car dealer for this flow of trade-ins (and orders to buy the trade-ins). Now assume that the Honda dealership only routes the low-risk (higher quality) cars to this used car dealer in exchange for payment for the flow of traded-in cars. Meanwhile, the Honda dealership sends the high-risk (low quality) cars to a public auto auction for resale. Given this bifurcated market structure (where adverse selection, or getting stuck with a bad trade, in the high-risk pool is greater), it is not too difficult to understand how an off-exchange vs. public auction market structure will produce different prices—the latter producing worse prices to compensate for adverse selection risk associated with low quality/high risk cars.

Now imagine that, in order to attract trade-ins, the Honda dealership advertises that it will get you better prices for your trade-in than what's available in the public auctions—the auctions where the low-quality cars are unloaded. This would be false advertising. There is no difference when Robinhood makes such claims to attract more retail investors. Wall Street insiders and PFOF experts Hitesh Mittal and Kathryn Berkow put it this way using a different analogy: "We liken price improvement on retail market orders is akin to getting a 30% discount on an item after the shopkeeper raises the price by 40%. Retail investors end up paying 10% more for their market orders."

PFOF critics point to this PFOF-induced bifurcated market structure to undermine Robinhood's claims of "better" pricing obtained for retail customers. The firm does not let its customers know that this is due to the draining of the low-risk retail orders by the likes of Citadel from the public markets (NYSE, Nasdaq), which leads to poorer pricing (wider bid-ask spreads) in those same public markets.

The practice of PFOF actually began decades ago and was first pushed on Wall Street by Bernie Madoff—hardly a figure that instills confidence in this controversial practice. But perhaps there is nothing more revealing of its toxic side effects for retail investors than the words uttered 15 years ago by Citadel general counsel, Adam Cooper. Long before Citadel became PFOF king of the hill, Cooper argued in favor of banning PFOF because the practice "distorts order routing decisions, is anti-competitive, and creates an obvious and substantial conflict of interest between broker-dealers and their customers."

Citadel—which handles 50% of all retail order flow and dominates in PFOF—no doubt now sees things differently.

A wholesaler like Citadel, Mittal and Berkow show, has "the most power in the existing structure," and has "no incentive to opt for a more competitive marketplace with reduced profits." In the absence of a change in regulation, the authors add, "competitive pricing for retail order flow is unlikely."

If all retail volume were moved to public markets, Mittal and Berkow conclude, trade-execution costs for retail investors (basically the markup on stock purchases and markdown on stock sales, known as the "bid-ask spread") in retail stock trading would decrease by at least 25%. But costs could fall by more than 25%, because the authors' calculation does not take into account informational advantages firms like Citadel have, which lead to even greater market concentration among market makers--and more room for abuse.

Robinhood's pitch of standing up for small investors against Wall Street big shots is, it turns out, merely a clever advertising hook, as the broker is aligned with the interests of unsavory inside operators. Most of its revenue (over 80%) now comes from the noncompetitive, off-exchange routing of retail investor buy and sell orders in exchange for fees from firms like Citadel who pay for the order flow. When an investor submits an order for purchase of shares of a stock like GameStop, the order is routed to Citadel for execution by Robinhood in exchange for a fee instead of seeing if better pricing is available elsewhere. Citadel then executes the orders from inside its own inventory at prices it determines itself.

According to the same SEC staff report cited above, over 80% of GameStop's off-exchange trading volume was "internalized" (this means that buy and sell orders are not subject to price discovery--producing the best market-determined price--on the stock exchanges and are executed instead from internal wholesaler inventories of stocks) and highly concentrated. For example, internalized stock trading dollar volume for January 2021 was executed by only three wholesalers, accounting for 88% of all off-exchange trading volume. According to the SEC, while Citadel, the largest of the three, "internalized an average of just under $37 million of GME [GameStop] per day in December 2020," this number exploded during the month of January 2021. By January 27, for just one of the more than 100 meme stocks exploding in volume, the SEC found that "Citadel internalized nearly $4.2 billion of GME." The second largest of the three market makers that dominated the order flow purchasing, Virtu, took an average of $23.4 million of GameStop stocks each day in December 2020, but this jumped to $2.2 billion of GameStop stocks on January 26. On January 29, meanwhile, Citadel acquired approximately $2.2 billion of GameStop stock, while Virtu took $1.4 billion.

Clearly, the GameStop mania had benefits for these wholesalers and for Robinhood, since a higher volume of trading means more revenue for both parties. Not surprisingly, Robinhood's first quarter revenues exploded to record levels as a result--going from $128 million in the first quarter of 2020 to $522 million in the first quarter of 2021.

What do these numbers tell us? Brokers (like Robinhood) and wholesalers (like Citadel) make their money from trading volume and bid-ask spreads (the wider the spread, the greater the profit), whether or not average traders are making or losing money.

As Pam Martens of the finance blog Wall Street on Parade reports, this behind-the-scenes "pay to play in the trading world has worked out very well" for Citadel founder and head, Ken Griffin. Martens cites a Forbes report that Griffin's net worth had reached $15 billion as of December 2021, nearly doubling from just five years earlier. According to a report on the finance blog Zero Hedge, Citadel's exploding revenues and profits are due partly to surging retail equity trading volumes "sparked by the pandemic and an explosion in stock-market trading by people cooped up at home on apps such as Robinhood, with Citadel pocketing a huge portion of the order flow unleashed by millions of newly hatched Gen Z traders." Even before the GameStop mania of January 2021, the firm's 2020 revenue had soared to $6.7 billion, more than double its previous record set in 2018.

Forbes India described it this way: "By hooking disillusioned millennials on its zero-commission, gamified trading app, Robinhood has forever changed the retail brokerage business." While the founders of Robinhood have become billionaires, adds Forbes India, they are "leading a new generation of rubes right into the jaws of Wall Street's most notorious sharks." Sharks like Citadel.

Monopoly Profits Exposed Prior to GameStop

The SEC had exposed the monopoly profits extracted by wholesalers like Citadel (and shared with brokers like Robinhood) before GameStop grabbed headlines. On December 17, 2020, the SEC charged Robinhood Financial with failing to "disclose the firm's receipt of payments from trading firms for [exclusively and automatically] routing customer orders to them, and with failing to satisfy its duty to seek the best reasonably available terms to execute customer orders [emphasis added]." In other words, Robinhood was charged for exactly what the October 2021 SEC staff report was warning investors about. The firm paid $65 million to settle the SEC's charge of breach of fiduciary responsibility.

Better Markets, a nonpartisan advocacy organization focused on financial reform, described Robinhood's routing process the following way:

Imagine if you shopped at Amazon all along believing that the rules of the market required Amazon to automatically route you to the seller with the best priced widget only to find out later that it routed you not to the best available price but instead to a worse price. Furthermore, imagine if Amazon gave you this worse price with little or no explanation of what it was doing and even accepted hundreds of millions of dollars from the retailers selling you the widgets in exchange for sending your orders to be filled at the worse price ... rather than a lower best price. Finally, to add insult to injury, imagine that Amazon repeatedly asserted in an almost Orwellian fashion that it was doing you a favor--providing you "price improvement"--by sending you to sellers paying Amazon to provide you with worse prices. Everyone would correctly see that practice as wrong, but that is in effect how the PFOF practices work.

Will U.S. Regulators Ban “Payment for Order Flow”?

It did not take long for the new Securities and Exchange Commission (SEC) head, Gary Gensler, to weigh in on the controversy surrounding Robinhood’s use of payment for order flow (PFOF) to provide its retail customers with the ability to do zero-commission app trading. “These are not free apps,” he stated at hearings held by the House Financial Services Committee last spring following the extreme volatility of GameStop and other meme-stocks, adding that, “they’re just zero-commission apps.” He made clear that there is a hidden cost “inside the order execution.”

Already banned in the United Kingdom, Canada, Australia, and other countries, swelling off-exchange (noncompetitive) routing of stock market trading volume associated with meme-stocks and zero-commission trading in the last several years has again put PFOF on the front burner of U.S. regulators. Gensler expressed his concern over what he described as an “inherent” conflict of interest between firms like Robinhood (although he did not mention the broker by name), which is required to get the best prices for its retail customers, and its dependence on PFOF for its revenue. Gensler was not persuaded by claims from PFOF defenders that the practice provides retail investors with better prices.

Gensler indicated that the SEC would be looking at PFOF in the context of the overall equity market structure to determine what steps need to be taken to reduce risks and costs to investors. The SEC may move to ban PFOF, but many observers believe the next step for the SEC will be requiring more disclosures to increase the transparency of off-exchange transitions—which now represent over half of all stock market volume. Meanwhile, Robinhood is already gearing up for a major lobbying fight to protect its cash cow (PFOF) from being banned, according to Better Markets. The SEC is unlikely to ban PFOF, they note, “because there is so much money at stake.” In 2020 alone, $2.6 billion dollars in PFOF went to brokers like Robinhood from firms like Citadel and Virtu who, after these payments were made, still made record profits from operations.

In the SEC case cited above, the agency found that Robinhood's programmed (noncompetitive) routing of customer trades to firms like Citadel, which paid for that order flow, cost investors an extra $34 million dollars due to poorly priced trades (after accounting for zero commissions). This was before the spike in trading volume during January 2021, during which such potential for the same abuse certainly would have increased as there are no prohibitions against this behavior.

The SEC's findings, and the conclusions from Mittal and Berkow's structural analysis of retail trading markets, suggest that the so-called "free" trading pitch is deceptive, since it disguises a transformation from a competitive process of price discovery in public markets into an extractive, wealth-sucking form of financialized capitalism.

With a company named Robinhood pushing a "democratizing finance" message to the unwary, it is perhaps ironic that this implied "stealing from the rich to give to the poor" brand has produced just the opposite, namely more wealth for the biggest players on Wall Street. Far from undermining the Wall Street establishment by leveling the playing field, zero-commission trading--now the new normal among retail brokers--has instead provided today's biggest financial capitalists with a new way to siphon wealth from average Americans, without them even knowing.

SOURCES: John Kenneth Galbraith, A Short History of Financial Euphoria (Viking Press, 1990); John Kenneth Galbraith, The Great Crash: 1929 (Houghton, Mifflin, Harcourt, 1954); Security and Exchange Commission, “Staff Report on Equity and Options Market Structure Conditions in Early 2021,” October 14, 2021 (sec.gov); Imani Moise and Medha Singh, “Young, confident, digitally connected—meet America’s new day traders,” Reuters, February 2, 2021 (reuters.com); Security and Exchange Commission, “SEC Charges Robinhood Financial With Misleading Customers About Revenue Sources and Failing to Satisfy Duty of Best Execution,” Dec. 17, 2020 (sec.gov); Jeff Kauflin, Antoine Gara, and Sergei Guarei, “The Barons Of Casino Capitalism,” Forbes India, October 21, 2020 (forbesindia.com); “Gen Z has the lowest financial literacy, study reveals,” Yahoo Finance, October 19, 2021 (finance.yahoo.com); Simone Foxman, et al., “Robinhood Gets Almost Half Its Revenue in Controversial Bargain with High-Speed Traders,” Bloomberg Businessweek, October 18, 2018 (bloomberg.com); Pam Martens and Russ Martens, “Citadel Is Paying for Order Flow from Nine OnLine Brokerage Firms—Not Just Robinhood,” Wall Street on Parade, Feb. 4, 2021 (wallstreetonparade.com); Tomio Geron, “A Wall Street insider debunks Robinhood’s payment for order flow myths,” Protocol, May 27, 2021 (protocol.com); “Citadel Securities Posts Record $6.7BN Revenue In Year It Dominated Retail Order Flow,” Zero Hedge, Jan. 22, 2021 (zerohedge.com); Hitesh Mittal and Kathryn Berkow, “The Good, the Bad, & the Ugly of Payment for Order Flow,” May 3, 2021 (BestExResearch.com); “Payment for Order Flow: How Wall Street Costs Main Street Investors Billions of Dollars through Kickbacks and Preferential Routing of Customer Orders,” Better Markets, Feb. 16, 2021 (bettermarkets.org); Doug Henwood, “The GameStop Bubble Is a Lesson in the Absurdity and Uselessness of the Stock Market,” Jacobin, Jan. 27, 2021 (jacobinmag.com); Sheelah Kolhatkar, “Robinhood’s Big Gamble,” New Yorker, May 17, 2021 (newyorker.com); Maggie Fitzgerald, “GameStop mania may not have been the retail trader rebellion it was perceived to be, data shows,” CNBC, Feb. 5, 2021 (cnbc.com).

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