Robinhood: Evidently Too Good to be True
I smell a rat.
Robinhood Markets Inc. burst onto the scene in 2013 promising unlimited commission free trading in stocks, funds, options, and cryptocurrencies via a slick smartphone based app. Even “fractional shares” for as little as $1.
Millions of new traders – millennials in particular – signed on, drawn like moths to a flame by the premise of “democratizing finance” and crowdsourcing investment advice… whatever that means.
Old farts like me, who’ve been trading since dinosaurs roamed the earth and who cautioned against the risks associated with using an unproven app, were told bluntly that we didn’t understand.
Robinhood’s vaunted app stopped working entirely during some of the worst market conditions on record… not once… not twice…
Here’s Why You Should Care Even If You’re Not a Robinhood Customer
Robinhood’s a great idea – I’ll give founders Vladimir Tenev and Baiju Bhatt that. However, the company has had all sorts of problems and NONE of ’em are good for investors.
For instance, FINRA fined Robinhood $1.25 million on December 19, 2019 for selling customer orders to high frequency trading firms between October 2016 and November 2017.
Why is this a big deal?
Because doing so violates rules stipulating that customers get the most favorable prices possible.
Robinhood sold out its customers in exchange for information that guaranteed Robinhood a profit whether the customer got a good price or not.
This is a dirty little secret on Wall Street known as “payment for order flow” which makes it impossible for customers to know if they got a good price on the stocks, bonds, and other investments they buy and sell.
Professional trading firms usually buy retail order flow from the brokers then execute those orders on their behalf. They make their profit by splitting the bid and offer. Some of that money is then given as a “rebate” to the brokerage that provided the flow.
I hate to sound like my grandfather but know I will… you didn’t really think “free” meant free did you??!!
The problem with this little arrangement is that brokers are tempted to send trades to the market makers that give them the best rebates rather than placing the priority on which ones will give their customers the best prices like they’re supposed to.
In fact, SEC filings – called SEC Rule 206 disclosures – suggest that high frequency trading firms may have paid Robinhood 10X what they’d pay other discount brokers for the same information.
Naturally, the company neither admitted nor denied FINRA’s claims when it settled saying simply in a statement that the situation didn’t reflect current business practices.
Then there’s this little ditty.
Customers made highly leveraged trades in November 2018, by exploiting a flaw in the app that didn’t ensure they had enough cash on hand to back it up – a potential violation of SEC Rule 15c3-5 which stipulates appropriate “pre-set credit or capital thresholds” as a means of protecting the broker from systemic risk.
The reason you should care about this little nugget is that every broker-dealer including Robinhood is required to control the risks associated with market access — and this is key – “so as not to jeopardize their own financial condition, that of other market participants, the integrity of trading on the securities markets, and the stability of the financial system” as a whole.
Every time you buy or sell a stock there’s somebody else on the other side of the trade. A Robinhood failure would be like trying to play catch with a catcher who isn’t there.
A brokerage failure would negatively impact the broader markets, including your portfolio if you own any of the same stocks that Robinhood’s customers do because it could interfere with price discovery and normal trading patterns.
Then there was Robinhood’s botched cash management launch.
The company created a new cash management service in 2018 paying 3% interest and said that it would be SIPC insured. Only to have the SIPC’s CEO note a day later that he didn’t believe that would be the case.
Senators John Kennedy, Jerry Moran, Doug Jones, Brian Schatz, Jack Reed, Robert Menendez and Mark Warner were so concerned that they sent an unusually harsh letter to Robinhood’s management expressing concerns that the company was making changes as “a way to circumvent regulatory scrutiny without offering full transparency to its customers.”
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CFO Andrew Fastow used financial wizardry to mask the company’s true performance, while at the same time committing one of the single largest cases of fraud in corporate history.
He’s back, and, in a very telling interview, he told CFO Magazine’s Russ Banham that “virtually all the safeguards that have been built [into the system] are built to catch rulebreakers,” when the far more “insidious and dangerous problem is the rule users,” who find the loopholes.
Fastow went on to point out in comments to Banham, using an analogy about Bill Belichick using obscure rules to obtain a competitive advantage and ensure the New England Patriots win.
Banham concludes – and I agree – “that human nature leads some people to do whatever they can to win, including bending the rules. The easier that is, the greater the chance of doing it.”
I have to wonder if that’s what is happening at Robinhood; the desire to create something so innovative is so strong that it’s hurting millions of otherwise unsuspecting clients who don’t know any better.
Fast forward to the week of February 24th when Robinhood maxed out a $200 million credit line from Barclays Plc (NYSE:BCS), Citigroup (NYSE:C), and JPMorgan Chase & Co. (NYSE:JPM) as coronavirus-related fears triggered unprecedented market volatility.
The company claims that decision was already baked in as a precaution and “unrelated,” but I have a hard time believing that. And, evidently, I’m not alone.
David Ritter, a Bloomberg Intelligence analyst, observed that “companies only use their credit line when they need it.” I agree, this is not something you usually see in the normal course of operations because it makes creditors and presumably regulators nervous.
Which brings me full circle.
Robinhood’s much bally-hoo’d trading application has crashed at least three times since the credit line was drawn including a session long outage on March 2nd when the S&P 500 rose 6.92% and the Dow tacked on 1,838.13 points. Then, it failed again on March 9th when futures cratered, leading to a gut wrenching 2,475.2 point drop on open.
Robinhood clients couldn’t do squat during one of the most violent market moves in recorded financial history. No buying, no selling, no managing risk… bupkis.
The company has chalked up the failure to excessively high load on the Domain Name System – DNS for short – which is like a digital phone book computers and smartphones use to convert domain names into IP addresses that, in turn, allow them to access websites from around the world.
That’s just a little too convenient for my taste.
I don’t think it’s illogical to wonder given the pattern of behavior and circumstances at work if the company really did have a malfunction. Further – and to be very clear – there’s absolutely no evidence to support this, but the chatroom bandits are also suggesting the possibility of a deliberate shutdown because Robinhood couldn’t handle the situation… or simply didn’t want to fill the orders.
There’s at least one class action lawsuit pending over what’s happened and I’m sure the SEC will be keenly interested when it looks into the situation as I trust they will.
There are three things to think about:
- I’d urge every Robinhood customer – millennial or not – to think about alternative brokerage arrangements, if for no other reason than where there’s smoke, there’s often fire.
- “Free” stuff is usually what ends up of costing you the most; and,
- Dinosaurs like me may, in fact, understand perfectly well.
At least until the next meteor arrives, anyway.
Until next time,