Retail Gamers Invade Equity Markets
A guest post by Sarah Cullinan, undergraduate student at the University of Notre Dame
Introduction
With a strong boost from Robinhood, retail investor participation in the U.S. equity market has increased dramatically over the past two years, forcing many to pay close attention. Robinhood is a retail focused broker that launched in 2013 and is leading the charge among online brokerage firms. Retail investors increasingly use the trading platforms of online brokerage firms, like Robinhood, for trade execution. Robinhood routes these trades to wholesalers, such as Citadel Securities, to complete the execution, often occurring off of market exchanges. Both Robinhood and Citadel profit nicely from this arrangement. While Robinhood benefits from payment for order flow (“PFOF”) and/or price improvement for customers, Citadel earns the difference between the PFOF cost and their estimates of what the traders are worth. This off-exchange process differs from the more traditional execution practiced by institutional investors, who trade more frequently at one of the 16 major stock exchanges or in dark pools.
Robinhood has transformed how online brokerages operate. The move to zero commission trading and a mobile-first design has encouraged young and inexperienced investors to enter markets, while the pandemic disruption further fueled the momentous introduction of new traders. Robinhood and other online brokerages have designed simple and clever interfaces incentivizing younger clients to trade more. This increased activity results in more interaction with wholesalers, profiting both parties. As a result the larger market is experiencing higher trading volumes with episodic spikes in volatility.
In early 2021 retail trading volumes jumped as new investors rallied into meme stocks, significantly elevating the volatility of such. In response to these events taking over news headlines and jolting markets, regulators responded by questioning and investigating these modern-era practices of online brokerage firms.
ROBINHOOD LEADING THE CHARGE
Retail investor trading has significantly transformed over the past half-century. Decades ago, the stock market was not accessible for everyone. Retail investing required some market knowledge and money. Trades often cost between $8 to $10 and had to be completed over the phone during market hours with a brokerage firm. Around 2008, online brokerages began to emerge and offered clients a new and cheaper way to invest, opening the market to a broader group of investors [4]. And then with the introduction of its app in 2015, Robinhood revolutionized and transformed the online brokerage business.
Robinhood launched in 2013 with the stated mission to democratize finance for all, while striving to make Robinhood the most trusted, lowest cost, and most culturally-relevant money app world wide. In the early years, Robinhood resembled other online brokerage firms in many ways. But in 2018, Robinhood became the first to introduce commission free trading. By October 2019, Charles Schwab, E-Trade, and TD Ameritrade were all forced to follow and make the switch. With no commissions and no account minimums, Robinhood made it easier than ever for first time investors to trade. Robinhood noted that over 50% of its new accounts opened from January 1, 2015 to March 31, 2021 were first-time investors [2]. The firm also made it more accessible for younger and lower-income investors to trade with the addition of fractional-shares. Again, other brokerages followed and introduced the same.
From the very beginning, Robinhood set out to build a product “so simple and elegant that it would revolutionize an entire industry” [6]. They developed an easy to use and informative app, while embedding a familiar look and feel for mobile-first customers. This appealed to young and inexperienced investors that are easily driven by the app’s unique features. Robinhood claimed that competitors followed by modernizing designs, adding color, notifications, and even some with similar features. The Robinhood interface emphasizes the fun of trading, thereby further influencing user engagement. These enticing features attracted a whole new group of investors to the stock market.
PANDEMIC TRADERS
When the pandemic hit in March 2020, the US was put on lockdown and people were largely isolated in their homes with no professional or college sporting activities to follow. All gambling and sports betting was cancelled. And on top of boredom, people were granted stimulus checks that could be used for anything. As a result, many young adults turned to a new outlet, easily accessible trading, with people like Dave Portnoy leading the charge and encouraging participation.
The Barstool Sports’ President said “With the volatility, it is kind of like watching a sports game” [7]. He created a live stream, “Davey Day Trader Global” where he infused investing with entertainment. The primary audience of Portnoy and Barstool are Millenials and Gen Z’s. Viewers watched the thrill of Davey Day Trader and were inspired to get involved. As more individuals joined the community, it took over news headlines and social media. Robinhood and other online brokerage firms saw a dramatic increase in total retail participation in the markets. Below, the red lines show the date COVID-19 was declared a national emergency (March 13, 2020).
Robinhood gained 3 million new users in the first four months of 2020 alone. [4] And many of these users were individuals the stock market had never seen before.
A FINRA survey found that New Investors in 2020 earned lower incomes than Experienced Entrants, who opened a new investment account during 2020, but also owned one prior, and Holdover Account Owners, who maintained an account that was opened before 2020 but did not open a new one. Of note, 33% of New Investors had account balances less than $500 [5].
Additionally, New Investors during 2020 were younger than both Experienced Entrants and Holdover Account Owners, with 62% of New Investors under the age of 45.
One can certainly make a strong case that Robinhood has removed institutional barriers and contributed to a more diverse investing public. However, it is not just their services that have attracted these new investors, but also behavioral triggers in the app. Their sleek design makes it not only possible to invest, but also very easy for less-experienced individuals, who lack deep investing knowledge, to start trading. As a result, the average Robinhood customer is 31, while the average Schwab customer is around 50 [4].
GAMIFICATION
The Robinhood app differs from other brokerages by only providing the most relevant information and focusing on simplicity. For example, its app only offers 5 charting indicators while TD Ameritrade provides 489. An individual stock performance over time is displayed as a simple line graph and can be bought with just 2 clicks on the ticker page. Features like this make it easier for new investors to both understand and trade.
Robinhood states, “we have replaced confusing jargon with simplicity and slang. Our tools are delightful and engaging” [2]. But, these tools also contain behavioral triggers that prompt use and gamify trading. This begins immediately after a customer downloads the app. Robinhood offers a free stock with every new account, encouraging people to start trading. The app also sends push notifications, enticing user engagement. It previously rewarded users with confetti after completing a trade, incentivizing them to trade more frequently. Robinhood has removed this feature after accusations that it gamifies the app. Yet it continues to update its interface. In 2020 Robinhood completed a large remodeling with fresh colors and typography [6].
Trading apps lead to more frequent use and trading. FINRA found that 60% of people who reported monitoring their account multiple times a day did so using a mobile app [5]. Because Robinhood is ushering users to such high activity, the company now has more interaction with wholesalers.
THE GROWTH OF ROBINHOOD
Robinhood has grown rapidly. Its clients have accelerated to 18 million net cumulative funded accounts in just 8 years [2].
As a result, Robinhood’s revenues have increased dramatically, with total revenues jumping to $959 mm in 2020 as compared to $278 mm in 2019 [2].
The revenue growth is primarily driven by Robinhood’s Transaction-Based Revenues, which contributed 80.5% of total revenue in March 2021[3].
This Transaction-Based revenue is driven by PFOF largely from its options and equities trading. Remarkably, in 2020 these two sources combined for 72% of Robinhood’s total net revenue [2].
Robinhood’s payment for order flow is dominated by wholesalers such as Citadel Securities [3].
These pronounced trends in retail client growth and the related PFOF volumes correlated strongly with the growth of the wholesalers engaged in these transactions.
TRANSFORMING MARKETS
In January 2021, only five major wholesale brokerage firms generated internalized flow as a percentage of total US equity volumes of 30.6% out of the 37.2% total for inaccessible liquidity (volume traded off-exchange, but not at an ATS/dark pool. Most institutional orders primarily go to exchanges and dark pools, so this volume is “inaccessible” to them [4].) This 30.6% has more than doubled the same internalized flow from as recent as September 2019 [1].
Looking more deeply into this off-exchange volume uncovers divergent trends in the composition of the alternative trading system (“ATS”) / dark pool cohorts versus the inaccessible liquidity. (ATS’s /dark pools are trading venues that are less regulated than exchanges, and often run by large banks. For more information see Proof’s market structure primer). Over the past five years, ATS’s have been consistently losing share to non ATS volumes. In 2020 31.4% of volume in US equities was off-exchange at non-ATS firms, and this subsequently increased further to 37.2% in early 2021 [1].
2020 generated historically high volatility and trading volumes. But this increased volatility did not move trades back to the exchanges, as had been the case historically (see https://www.sifma.org/wp-content/uploads/2021/02/SIFMA-Insights-Market-Structure-Recap-2020-FOR-WEB.pdf, page 11). In fact, since 2020 over 40% of overall U.S. equity volume has been executed away from the 16 stock exchanges [1].
The material increase in off-exchange/non-ATS trading volume largely explains these pronounced trends and momentous shifts.
THE ROBINHOOD COMMUNITY
Over the past two years, this new investment community of retail gamers has piled into particular themes and moved markets. During the Spring of 2020 these amateur investors focused on airlines and cruise ships, in hopes that quarantine would break, and they would make money. Portnoy was a large part of this as he influenced his followers’ investment decisions. When he tweeted a video questioning Warren Buffett’s decision to get out of airlines, the 30-day average volume in the ETF JETS, an exchange-traded fund tracking airlines, skyrocketed from about $45 million to $200 million [7]. These new investors subsequently migrated to technology stocks such as Apple, and electric vehicle stocks like Tesla[8]. But the most profound impact these traders have had on markets was their investments in memestocks.
As this community of inexperienced investors rallied on social media groups, specifically WallStreetBets on Reddit, select shares skyrocketed. The news took over headlines and sites as more and more people joined this community. Other traders did not want to miss out on the fun. Seasoned institutional investors who had shorted names such as GameStop and AMC experienced sizable losses in early 2021. This was a new and impactful force for the markets. Amateur retail investors rallied together and generated strong momentum which ultimately led to significant losses for certain highly regarded institutional investors. In the most intense period, volumes and volatility were so elevated that Robinhood was forced to halt trading in order to raise more capital to satisfy the clearinghouses’ margin calls.
While it is illegal for institutional investors to secretly collude, this new group of retail traders rallied around their collective influence and the associated press coverage. WallStreetBets on Reddit has increased to 10.7m members, or “degenerates” as they call themselves, who post daily and influence the decisions of others. FINRA found that New Investors they surveyed were greatly influenced by the decisions of others. They tended to seek investment information from friends, colleagues, or family members [5].
The evolution of this new investor group proved to be an impactful force in select segments of the markets.
BEHAVIORAL OUTCOMES
The behaviors and outcomes of these retail gamers were not only driven by their community, but also prompted by Robinhood. One key feature of the Robinhood app is its watchlists. The “Most Popular” and “Top Mover” lists are presented to all users. While “Most Popular” is long and basically static, “Top Movers” is short and constantly changing as it lists stocks with the day’s largest percent gains and losses since the market close of the previous day. The sorting of this feature differs from most competitor lists, as Top Movers uniquely mixes the top gainers and top losers together and sorts them based on the absolute value of their return. Researchers analyzed both Robintrack data and TAQ data for general retail investors, from May 2, 2018 to August 13, 2020, and sorted Top Mover rankings based upon overnight return. (Robintrack’s dataset contains repeated cross-sectional snapshots of user counts for individual securities https://robintrack.net/, and the Boehmer, Jones, Zhang, & Zhang algorithm was used for TAQ data. Retail trades are identified as trades reported to FINRA with fraction penny prices between $0.006 and $0.02 for buys and between $0.00 and $0.004 for sells.)
With the hypothesis that the Robinhood app is driving user’s trading, they expected to see Robinhood traders buy both gainers and losers, while other retail investors would buy gainers. The results show just that; Robinhood users responded similarly to top gainers and losers, while other retail investors bought top gainers much more frequently [9]. This evidence suggests that the attention of Robinhood users is directed to both top gainers and top losers because both appear on the Top Movers list, while the attention of other investors is more directed to stocks that appear on the Top Gainers list.
Stocks on “Top Movers’’ grab users’ attention and encourage them to trade. Immediately upon opening the “New/Popular Lists” tab, users see that a stock is popular and want to join in. The design of the Robinhood app influences the actions of users. Its simplicity and tailored features make it easy for investors to focus and generate coordinated attention-induced responses, resulting in the increased gamification of trading. Regulators are taking notice of the impact Robinhood is having on investors while evaluating if new regulations might be needed.
CHANGES IN REGULATION
The new SEC Chairman, Gary Gensler, addressed the changing market structure in his remarks at the Global Exchange and Fintech conference in early June 2021. He spoke about how rules adopted 16 years ago do not address the influence of today’s technology on the markets. There is “greater access, innovation, and competition to our markets spurring economic growth” [11]. Recently, PFOF has been a largely investigated topic. While 38% of transactions are executed by off-exchange wholesalers, these wholesalers price their segmented order flow simply by referencing the National Best Bid and Offer (“NBBO”), which is a quote that represents the tightest composite bid-ask spread. Additionally, “higher trading volume generates increased PFOF”[11]. On its website, Citadel publicly states that it executes nearly half of all retail volume. Certain market makers have more data than others and this could give them an advantage. Chairman Gensler is questioning whether “broker-dealers have inherent conflicts of interest” and if they are “incentivized to encourage customers to trade more frequently than is in those customers’ best interest”[11]. For instance, “Robinhood explicitly offered to accept less price improvement for its customers in exchange for receiving higher PFOF for itself”[11]. Chair Gensler acknowledges that Robinhood features encourage investors to trade more, leading to more PFOF for the company.
One of Chair Gensler’s other major concerns is that the NBBO is not a complete enough representation of the market. In January 2021, one-third of the trading interest in the equity market was either in dark pools or wholesalers [11]. This means it was not reflected in the NBBO. Odd lots and non-displayed orders are also not included.
Away from the SEC, Massachusetts Regulators filed a complaint against Robinhood in December 2020. They alleged “the company aggressively marketed to inexperienced investors and failed to implement controls to protect them”[12]. They also investigated gamification, Robinhood outages, the cash management feature, and the company allowing customers to trade options who were not qualified.
Robinhood is not just being investigated but also fined record amounts. In December 2020 the SEC charged Robinhood with a $65 million fine for its actions between 2015 and late 2018. The SEC found that Robinhood made “repeated misstatements that failed to disclose the firm’s receipt of payments from trading firms for routing customer orders to them and failed to satisfy their duty to seek the best reasonably available terms to execute customer orders”[10].
Another substantial fine was levelled recently in June 2021 when FINRA fined Robinhood a record $70M for misleading customers, approving ineligible traders, and not supervising technology. Robinhood was forced to pay a $57M fee and $12.6M in compensation for harmed investors. “Many allegations involved problems with technology that automated the opening of new accounts or trading strategies and updated clients about their balances or borrowed funds”[13]. Although these are record fines, Robinhood has set record revenues of $959 mm in 2020.
As online brokerage firms continue to grow and modernize the market structure, ongoing regulatory investigations and potential new rules may be introduced in the future.
Resources
[2] Robinhood’s S-1 (Securities and Exchange Commission 2021)
[3] Capital Robinhood IPO | S-1 Breakdown (Maritech Capital 2021)
[4] How Robinhood Makes Money (CB Insights 2021)
[5] Investing 2020: New Accounts and the People Who Opened Them (FINRA 2021)
[6] The top secret Robinhood design story (Robinhood 2021)
[7] Barstool Sports’ Portnoy Is Leading an Army of Day Traders (Bloomberg 2020)
[8] Rise of the retail army: the amateur traders transforming markets (Financial Times 2021)
[12] Massachusetts Regulators File Complaint Against Robinhood (The Wall Street Journal 2020)
