Robinhood: Evidently Too Good to be True

Keith Fitz-Gerald Mar 13, 2020
14 

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.

Evidently.

Robinhood’s vaunted app stopped working entirely during some of the worst market conditions on record… not once… not twice…

But THREE times in recent weeks, during some of the most critical moments in modern financial history.

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.

Translation?

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.

Interesting.

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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.

Including you.

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.”

Ouch!

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Remember Enron?

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.

Now what?

There are three things to think about:

  1. 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.
  2. “Free” stuff is usually what ends up of costing you the most; and,
  3. Dinosaurs like me may, in fact, understand perfectly well.

At least until the next meteor arrives, anyway.

Until next time,

Keith

14 Responses to Robinhood: Evidently Too Good to be True

  1. William Candelaria 9797998832 says:

    I smell a rat to, when you’re dealing with that much cash and access to it no matter how it is minutes hours can be outstanding when you have people’s cash in your hand or access to it. I started a business when I was young it wasn’t how much I was making per item. It was how many items I had to sell. As long as I had product which was endless, my profits we’re amazing. I also said the best money in the world to make. Is with other people’s money. I used to hold people’s money for 24 hours, in that 24- hours I could make almost $20,000. And nobody would ever know it because they didn’t know it I actually got away with it. Just think what happens when you have a large sum of cash or access to money. How much can you make just think about it she had access to $1000000 how much could you make in a 24-hour. Sky’s the limit. The old saying goes I’m mad too Eddie I smell a rat

    • Keith says:

      Interesting insight, William!

      Thanks for taking the time to chime in – OPM is Wall Street’s maxim! Hard to separate the heroes from the zeros the way the game is played – and Wall Street likes it that way.

      Best regards and thanks for being part of the Total Wealth Family, Keith ๐Ÿ™‚

  2. Jim Swain says:

    It’s a next company running and on you smartphone that you should mess with other E-trade

    • Keith says:

      Thanks, Jim. I think I get what you’re saying and agree.

      Best regards and thanks for being part of the Total Wealth Family, Keith ๐Ÿ™‚

  3. Richard Waldren says:

    When people sign up for brokerage service, you want to make sure the firm doesn’t go under????? You become SOL.

    • Keith says:

      Most definitely, Richard.

      Then SOL becomes AMF when the company founders get golden parachutes and ride off into the sunset as has been the case with other “failures” – yeesh!

      Best regards and thanks for being part of the Total Wealth Family, Keith ๐Ÿ™‚

  4. Mashund says:

    I had a $5 put on cron that was up to over $600 that I was trying to sell on Mar.9 but the app wouldn’t let me fill it cause it wasn’t working what can I do about it, Thanks I an also a lifetime SLP member

    • VAMPr1 says:

      I’m on Robinhood and for my orders to buy at a low price to not go through until after price goes up and sell before prices go down and my cancellation not happen at all untill I just LOST almost 1500.00 of a 1800.00 account IN 15MINUTES 2 MONDAYS IN A ROW because they processed my orders AFTER everything has caused me to not put anymore into Robinhood. It convientley Shutdown after orders were placed then waited until after people lost THOUSANDS of dollars to exacute so we can pay back thier maxed out credit limit. Biggest brokerage scam I’ve over seen. I’m done with them after I sell off the rest at price bought I’m switching. Please share law firm that’s running class action lawsuits with people because I find many a time the prices we pay for or get for are almost always not what’s being showed on the screen! #@_$#Robinhood is supposed to give the poor not steal from them! Even Bitcoin was delisted from thier site.. where’d all the money that people invested in Bitcoin go? ๐Ÿคฌ

      • Keith says:

        Howdy VAMPr1 and thanks for sharing. That’s terrible and I’m very sorry you experienced that. I’d be livid (and have been in the past with a broker years ago for a very similar situation).

        I will follow up and keep everyone posted!

        Best regards and thanks for being part of the Total Wealth Family, Keith ๐Ÿ™‚

    • Keith says:

      Thanks for writing in, Mashund!

      That’s definitely a YIKES moment. Sorry you had to go through that. Execution is everything and that, more than anything, is what I look for whenever a new player comes to town. Sounds like they blew it even worse than they’re letting on!

      Best regards and thanks for being part of the Total Wealth Family, Keith ๐Ÿ™‚

  5. eric says:

    Being a Robinhood customer myself I’m glad you gave some opinion and insight but my question or concerns are:

    Everyone has pretty much gone to free trades and faster and easier trading using apps or online, which means these types of companies or services will continue to open

    Companies like Robinhood and M1 Finance offer free trades and fractional shares which allows people with very little to invest to finally do so and with Robinhood offering crypto (though not enough of them) is like icing on the cake

    I’m not saying it’s the best but when more popular brokerage firms doesn’t allow fractional shares and most likely only switched to free trades because of companies like Robinhood your argument become null and void

    As more people realize the companies that offer fractional shares, crypto currencies and no minimum to start ,big brokerage companies will either have to follow or be put out of business

    • Keith says:

      HI Eric and you’re right – competition will prompt entirely new behavior.

      Where I get boiling mad is that stuff like this doesn’t have to happen. Companies can change entire industries when the execution matches up to the promise; something that clearly didn’t happen here.

      Best regards and thanks for being part of the Total Wealth Family, Keith ๐Ÿ™‚

  6. Jane says:

    It’s true that Robin hood is not perfect, especially with the events that have taken place lately. Neither are the big firms. The recent events have happened in extraordinary circumstances that Robin hood has not experienced or lived through before. I was affected by what happened, but that does not take away the pioneering role that Robin hood has played. I have more than one trading platform, like most people. but I like trading on robin hood. There is something liberating about the platform. Through their initiative and drive, they have made many young people to start thinking of investing as a way of life. A simplified and hassle free trading and investing. You don’t need to be big “monied” to fit in Robin hood. The restrictive nature of big firms has kept young people from this important life lesson. Through the ‘Robin-hoods’ of today, our nation will have better money managers tomorrow.
    This, however, does not exempt Robin hood from constructive criticism when they mess up. They have to up their game. They are in uncharted territory, just like we are struggling with corona virus. They are learning the hard way. We all fall short in one way or the other. Let us criticize constructively without an agenda.

    • Keith says:

      Hello Jane and thanks for such thoughtful commentary.

      You are correct and I agree entirely – Robinhood has played a pioneering role. I just wish it was not at the expense of those who put their faith in unproven systems that failed at a critical moment in their young company’s history. Helluva way to figure out something wrong when customers pay the consequences.

      Best regards and thanks for being part of the Total Wealth Family, Keith ๐Ÿ™‚

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