The Robinhood Earthquake

Estimated Reading Time: 5 minutes

We don’t have enough things on our plates. We needed this. We have a Congress trying to impeach a president who is no longer president.  We have a new president trying to set a world record for executive orders.  We have people calling everybody either racists or white supremacists.  Oh and then there is the pandemic.  The good news is we have vaccines.  The bad news is many of our state governments are too inept to get the vaccines into the arms of our citizens.  Then along comes this story out of nowhere that rocks our stock markets and will certainly redefine our markets going forward.

Let’s go back to the beginning.  Robinhood is a securities firm that was formed in 2013 and became active in March of 2015.  Its purpose was to redefine the ability to invest in the stock market without charging for trades.  In 1971, Charles Schwab redefined acquisitions in the stock market by becoming a discount brokerage house.  Slimmed-down services with substantially lower fees.  Forty-plus years later, two guys decided to redefine access to the markets.

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Their no-fee platform was immediately attractive to millennials. They were used to no fee platforms like Facebook and Twitter.  The difference was those platforms were not really providing a service.  What they offered really had not existed before.  Robinhood was competing with not just Charles Schwab, but the long-established houses such as Merrill Lynch.

It appealed to millennials who think they can learn something from the internet and become experts overnight.  Ask a doctor about their millennial patients who come into them having self-diagnosed. “Don’t let my medical degree get in the way of your internet search” thought many an experienced doctor. Robinhood became a great success with an estimated 13 million account holders.  There is just one thing here and I will state this as genteelly as possible: How stupid do you have to be to believe this service was being offered for free without some kind of catch?

Robinhood was in the business of making money.  They had three defined revenue streams.  Earnings on the float of the accounts they had which in itself is questionable.  Second, interest on any margin accounts on which they might make loans.  Third, they sold the trading information of the accounts they had to the hedge fund people who funded this startup.  If I knew that was from all appearances their major revenue stream I would never open an account. I never did. This third stream of revenue is highly questionable and should have been disclosed and not in small print.  In big bold print.

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What the hedge fund guys never expected was the Frankenstein they created would turn on them.  And turn on them it did.

Hedge fund guys sometimes invest differently than we do.  We put our money in a brokerage account whether it be with the Robinhood model, the Schwab model, or the Merrill Lynch model, with the idea that we will buy a stock or bond, and because of good management the value of that stock will go up and thus our portfolio will go up.

Hedge fund guys don’t always do that.  They frequently bet on a stock going down.  A company failing in our economy.  That happens.  Remember Woolworth’s and Blockbuster.  The COVID pandemic really helped some companies and some others were really hurt or at least their business model was exposed to being outdated.

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The hedge fund guys (and others) use a process called short selling.  They position themselves to make money as a stock goes down.  This has gone on for a long time and has provided some constructive elements to the markets.  The real problem I see here is that quite often these people take positions and then go pump the market to go down through either release of information or going on a business channel casting negativity on the stock or the market to drive down the stock and clean up. These people should be forced to disclose their positions in the stocks before they offer their opinions so that people will take their so-called advice with a grain of salt.

It is clear not all of Robinhood’s 13 million holders of accounts are stupid.  Either through leaks or other methods, they found out that some hedge funds were shorting some stocks in a big way.  One, for example, GameStop (others were Blackberry, AMC, and Bed Bath & Beyond) was shorted so much the shorts were 140% of the number of shares of the company.  That would be crazy in itself.  But if the stock started going up the short sellers would not be able to acquire enough shares to meet their contracts and the price they would pay would mean they would lose money.  The higher the stock went the more money they would lose.  It is called a short squeeze.

The people who figured this out disseminated the news on Reddit and people took their own money to buy the stocks and make money on the squeeze.  They made a lot of money on the squeeze as companies had to buy stock as it was going up to cover their short positions.  Some of these people will lose money if the stock starts to go down, but that is the risk they assumed.

Where the real problem came in is when Robinhood stopped trading on certain stocks –particularly GameStop.  Robinhood said their account holders can sell their stock, but not buy any.  This was a completely out of order position for Robinhood to take.  There is speculation that the hedge fund owners of Robinhood ordered them to do that.  Whether true or not the position was taken by Robinhood forced the stock down because there were only sellers and not buyers. 

For your edification, Robinhood has a 36-page small print agreement you need to sign before opening an account.  Buried in that agreement is a statement that says “I understand Robinhood may at any time, in its sole discretion and without prior notice to ME, prohibit or restrict my ability to trade securities.”  That is fair, but it did not say it would prohibit it on one side – selling not buying.  That is an irrational position to take.

My personal opinion is the hedge fund managers decided they would rather crash Robinhood than continue the losses on their short positions.  Even if that is not true, anyone who maintains an account at Robinhood after they pulled that stunt of cutting off buying must have their head examined.

The Leftists don’t need to step in here and make new governmental rules or as some have proposed to use this episode to impose a stock trading tax which is a Bernie Sanders knucklehead idea.   The small guys will have learned their lesson.  Free services are worth exactly what you are paying for them – nothing.  The media should make sure that anyone using their platforms disclose their positions — including the short sell positions — before they start spewing their supposed wisdom.

In this case, David put a major hurt on Goliath.  Some Davids will make a lot of money and some will have lost some money. But not nearly as much as the Goliaths and the Goliaths will have to be a little more cautious in the future in taking negative positions.  The market will work itself out.

 

This article first appeared in Flash Report on January 31, 2021 and is hereby reproduced with permission by the author.

 

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