Critics say Robinhood more aligned with the wealthy than average investors

For one shining moment in January, it looked as if the stock trading app and retail brokerage Robinhood had lived up to its namesake – the rabble-rousing outlaw of English folklore.

In the hands of a merry band of Reddit traders, Robinhood helped to bring a group of short-selling hedge funds to their knees and many people cheered – delighted to see wealth stripped from a few members of the billionaire class after decades in which wealth has been increasingly consolidated in the hands of the very few.

"Our customers have shown the world that investing is for everyone," Robinhood said on its website, "not just institutional investors and hedge funds."

But the reckoning came quickly.

On January 28, Robinhood halted trading in GameStop, a gaming retailer whose best days appeared behind it, temporarily prohibiting Robinhood's accountholders from harvesting profits. The traders were furious, accusing the brokerage of selling out to the billionaires.

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That wasn't true.

The reason was purely practical, Robinhood says.

The Depository Trust & Clearing Corp., the clearinghouse that ensures there's enough money to cover sales and purchases of stock, demanded Robinhood put up $1.4 billion of margin to cover its outstanding trades, according to Robinhood CEO Vlad Tenev. But the company only had half that much on hand. So it had to restrict trading until it could raise the rest.

Reputation damaged

It didn't take long for Tenev to come up with the money, but the damage to company's reputation already had been done: A theory spread that Robinhood had somehow sold out to the uber-wealthy, and it resonated with the app's customers, who were sick and tired of Wall Street's most powerful making the lion's share of profits.

It was a notion that was only reinforced by the speed with which Robinhood was able to raise $3.4 billion in fresh capital from some of the wealthiest individuals and investment funds in the country. The idea was also bolstered by the fact that Google, one of the world's most powerful companies and an early-stage investor in Robinhood,removed at least 100,000 negative reviews of the Robinhood app from the Google Play app store, according to gizmodo.com.

Why all the support from the rich and powerful?

Because Robinhood has grown extraordinarily quickly since its launch in 2013, it offers its early investors an opportunity to get even richer when it goes public later this year. And contrary to all the company's hype, critics say Robinhood is not about leveling the playing field for the little guys. Rather, it's about finding a better, faster way to separate them from their money.

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Critics say the simple and intuitive trading app that Robinhood created steers customers into risky investments that make the company and its trading partners the most money. Robinhood also has made misleading statements about how its makes its money and the true risk of its products, including a high-interest-rate checking account that had to be withdrawn from the market a day after its launch. Robinhood has been sued more than once by regulators for failing to ensure that customers get the best prices for their trades.

"This whole machine is designed to attract an underserved, young and unsophisticated investor demographic – the epitome of so-called dumb money – and I say that with some affection," said Paul Rowady, founder and director of research for Alphacution, which studies quantitative and derivatives trading. "They've specifically designed a frictionless, highly gamified platform that's heavily weighted toward trading options, and they've grown so quickly and aggressively that their business model borders on the abuse of their own clients for the enrichment of themselves and their shareholders."

Robinhood's website says that it “has always sought to put you – our customers– first."

Investing that feels familiar, intuitive

In a statement to USA TODAY, it said: “We designed Robinhood to be mobile-first and intuitive, with the goal of making investing feel more familiar and less daunting for an entire generation of people previously cut out of the financial system. Our focus has always been on breaking down systemic barriers to investing to help more people take control of their finances.”

Tom McGlade, a former Wall Street bond trader and hedge fund manager who now lives in Los Angeles, used a scene from the "Bonfire of the Vanities" in conversations and email messages with USA TODAY to explain how brokerages like Robinhood make money.

"Just imagine that a bond (or a stock trade) is a slice of cake. Now you didn’t bake the cake. But every time you hand a slice of that cake to somebody else ... a tine piece comes off. Little crumbs fall off … And you are allowed to keep those crumbs," the main character's wife explained to her daughter. "And many a man has sold his soul for those little crumbs."

Robinhood lives on golden crumbs

That's what Robinhood and its business partners do, McGlade said. They collect golden crumbs from every stock and option their customers trade. And because of the way Robinhood designed their app and their target market, "they have created the most fertile ground for picking up crumbs that the equity trading business has seen in ages."

The app itself makes it extraordinarily easy for investors to buy and sell stocks. Within minutes, users can be online and trading up to $1,000. And like video gamers, they are rewarded and encouraged with virtual confetti after each transaction.

"It's great for introducing people to the concept of investing in the stock market and hopefully, to get them thinking about long-term financial goals," says Christopher Smith in Clark.com blog. "Robinhood makes it easy to invest even in the most expensive stocks without much capital."

More than 20 million people now use the app, some of whom might have never thought of walking into a brick-and-mortar brokerage firm. The average age of Robinhood's customers is 31, and according to the company, twice the percentage of Hispanics and six times the percentage of African Americans have signed up to use its services as traditional brokerage firms.

The app also makes it easy for customers to graduate from buying and selling stocks to buying and selling options, which have much greater upside and downside risk. But while riskier for the investor, these trades are also much more profitable for Robinhood, earning the company 58 cents per 100 shares, compared with 17 cents per 100 shares for equities. That's because the spreads between the bid and offer prices for options are wider.

Turning risk into a game

"The way the app is set up, gamification is used to nudge investors into those practices that are most profitable to Robinhood – frequent trading, trading on margin and trading options," said Barbara Roper, director of investor protection at the Consumer Federation of America, a consumer advocacy group. "This is not remotely appropriate for unsophisticated, new investors."

Roper said that if a brokerage were really designing a system with the interest of the investor in mind, traders would face hurdles before being able to trade options or trade on margin, which means trading with borrowed money. They would have to pass tests to make sure they understood the risks.

"Instead of that, they make it as easy as possible," she said.

In December, regulators in Massachusetts filed suit against Robinhood, claiming the stock trading app treats investing like a video game and lures young and inexperienced investors into taking on excessive risk.

The suit also accuses Robinhood of not being prepared for its own explosive growth, with the site going down about 70 times in 2020, often on days when stock prices sharply rose or fell and investors needed to act quickly.

Robinhood lawsuits

"As a broker-dealer, Robinhood has a duty to protect its customers and their money," Secretary of the Commonwealth William Galvin said in a statement when the suit was filed."Treating this like a game and luring young and inexperienced customers to make more and more trades is not only unethical, but also falls far short of the standards we require in Massachusetts."

Robinhood has never charged its customers commissions.

It makes money by selling its customer trading orders to market makers – high-tech trading firms like Citadel Securities, Virtu, G1 Execution Services, Wolverine and Two Sigma. They buy and sell stocks and other securities through computer algorithms and make money on the spread between the bid and offer prices.

But unlike other brokerage firms, Robinhood doesn't sell its customers' orders to market makers for a flat fee. It charges them a percentage of the spread on each trade. So the more market makers make from their trades, the more Robinhood makes.

The perfect customers

With a stock like Apple, which is highly liquid and has thousands of market makers, the spread between the bid and the offer price might be a small fraction of one cent, McGlade said, So trading is very efficient and a market maker can't make much money. But with a stock like GameStop, which is illiquid and whose price might fluctuate from $250 to $350 in a single day, the difference between the bid and the offer can be as much as 10 cents.

Illiquid stocks with high volatility and large bid/offer spreads are fertile ground for Robinhood and its market-making partners, and they pay Robinhood handsomely for access to those trades.

"The small investors are completely insensitive to the bid-offer spread. They don't see it," McGlade said. "If they pay $250 or $250.10 for a stock, it doesn't matter. But to Robinhood and Citadel, capturing those pennies tens of millions of times represents a fortune."

During the first half of 2020, Robinhood collected $271 million from selling its order flow, according to SEC disclosure reports, and Citadel Securities handled half of all of Robinhood's trades.

Across all its businesses, which include processing 40 out of every 100 shares traded by U.S. investors and running a series of other trading operations, Citadel Securities logged profits of $4.1 billion on revenues of $6.7 billion in 2019, according to Bloomberg.

But while market makers like Citadel Securities have benefited handsomely from buying customer trading orders, customer advocates have long warned about the dangers inherent in this model.

Jumping ahead on trades

The worry about how market makers might use the order information obtained from customers seconds before they are executed to design their own trading strategies.

"Front running (jumping ahead of clients to buy stock before they do) is illegal," said Robert Weissman, president of Public Citizen, a nonprofit consumer advocacy organization. "But that doesn't mean companies don't do some form of it. There's been a long history of Wall Street entities engaging in that sort of practice."

Market makers can also benefit from other types of information from Robinhood customers such as stop-loss orders that customers put in place to protect themselves from adverse price swings. These orders tell market makers to sell a stock at a predetermined price to protect against further loss of capital or to lock in profits.

McGlade, the former bond trader and hedge fund manager, said stop-loss orders in the hands of market insiders are golden nuggets of information. They let them know exactly when a forced buy or sale of a stock will occur.

"If a market maker has visibility into a big stop-loss order at $300, as the price nears the stop from below, the market maker may start buying aggressively to bid the price all the way up to $300 in order to trigger the stop," McGlade said. "When the stop is triggered, the market maker will have placed offers to sell the recently purchased stock just above the stop price because he knows the stop-loss buyer will be forced to purchase a large block of his stock and will most likely take the market maker out of his position at a profit."

These maneuvers are called "stop hunts" and McGlade said he's seen them all the time when he was a trader.

Providing misleading information

There is no evidence that Citadel Securities or other market makers have engaged in front running or used customer information improperly.

Citadel Securities states in its client disclosures that it doesn't use customer stop-order information to assist its trading, It also says the reason it executes more trades than any other market maker in the country is that it is focused on providing the best service to its clients.

“Citadel Securities has been a driving force in reducing the costs of trading for retail investors,” said a Citadel Securities spokeswoman. “We receive a meaningful portion of volume based on retail brokers’ obligation to route orders to the source of best execution and last year alone, we provided $1.5 billion in price improvement that went directly into the pockets of retail investors."

By price improvement, she means purchases and sales of stocks that save retail investors money.

Citadel Securities was fined over $22 million by the Securities and Exchange Commission in 2017 because the algorithms it used to buy and sell stocks did not try to get the best price for the retail investors, the agency said. But the company says that action was taken based on trades made from 2007 through 2010 and they represented less than 1% of its order flow.

Robinhood faced sanctions more recently.

In December 2019, the Financial Industry Regulatory Authority, Wall Street's Self-regulatory arm, fined Robinhood $1.25 million for failing to make sure customer trades were executed at the best prices.

A year later, Robinhood paid the SEC $65 million to settle charges that it made misleading statements on its website between 2015 and 2018 about how it made its money and for selling order flows to market makers at excessive prices, purportedly depriving customers of $34 million.

During those years, Robinhood's website never mentioned the fact that it made its money by selling order flows to companies like Citadel Securitie, SEC documents show, and company training documents instructed customer service reps to avoid discussing the subject.

“Robinhood provided misleading information to customers about the true costs of choosing to trade with the firm,” Stephanie Avakian, director of the SEC’s Enforcement Division, said when the company settled. “Brokerage firms cannot mislead customers about order execution quality.”

Questions about Robinhood's transparency extended to its launch of a high-interest checking account in 2018. The company initially said that cash balances would be insured by the Securities Investor Protection Corp. But that was only true under certain conditions. Robinhood had to abandon the launch, according to USA TODAY.

"Robinhood has grown so quickly that it's been caught up by weak links in its platform that normally would have been scrubbed out by slower maturation," said Rowady of Alphacution. "They've done all these things to maximize profitability and to grow as fast as possible – exactly what you would expect from a company backed by a bloodthirsty venture capital consortium."

But it's not wise, Rowady added.

"Robinhood is a tool that can be used for good," he said. "It can be used to buy shares of Apple and other more traditional investments. But it is also a tool that can be used to gamble and be irresponsible. In a highly gamified environment. with the lightest of guard rails, there is a significant probability that people's worst instincts will take over."

'A rigged system'

Robinhood investors, especially those who invested in GameStop aren't happy with the company at the moment.

Robinhood’s trading limitations threw a wrench into Adam Bixler’s plans to cash in on his hefty GameStop profits, which at one point peaked at nearly $200,000 during the trading frenzy.

The Boonton, New Jersey, resident was frustrated when he ran into issues trying to sell his position after the online brokerage placed restrictions on trading the stock in late January, he says.

“A lot of people were going to make a big payday, but someone pulled the plug and now many of them lost a bunch of money,” says Bixler, 28, an active user on the WallStreetBets Reddit forum, whose members led the charge against hedge funds. “The frustration I have is the lack of responsibility that Robinhood has in running a company and not providing the base service they usually do.”

“It creates an idea that you’re playing in a rigged system,” added Bixler, who works as a product manager for a company that makes software and tools for the advertising industry. “There’s a distrust and distaste for Wall Street. Now Robinhood is starting to fall into that, too.”

This article originally appeared on USA TODAY: Robinhood IPO: Trading app more aligned with wealthy