March 30, 2022
The Ethical Pitfalls in Robinhood Markets, Inc Business Model
In 2021, a ground-breaking case stopped the stock market in its tracks. It came to be known as “The GameStop Incident”, and Dr. Rosemarie Monge of the University of St. Thomas Opus College of Business, who had been closely watching this case develop, discussed her perspectives on some of the ethical aspects of this event with Haskayne students.
The GameStop Incident rose to its height in January of 2021; it was a stock market upheaval that was only possible due to hedge funds that had been shorting GameStop (GME) since 2019. The investment activities that caused the incident were due to hedge funds borrowing funds from those who owned the stock and then selling it on an open market. This would be successful If the price of that stock depreciated, allowing the hedge funds to easily give the money back to its original owner. As these shorting activities had been happening for a couple of years with GME, many began to speculate that the stock price was too low and had become over shorted. This was when users of the online platform Reddit began speaking on the forum “WallStreetBets” and discussed how they could impede hedge funds by buying as many shares and short-dated call options as possible, ultimately driving up the price of the shares and initiating a short squeeze on those shorting the stock. This forced short sellers to “cover their shorts” by buying back the GME share and returning it to its lender, further driving up the price. This led to immense volatility in GME and other meme stocks and caused interactive brokers like Robinhood Markets, Inc (Robinhood) to suspend trading in GME, a decision that caused further outrage as will be explained further. This finally allowed for a break in the upward price momentum of GME and enabled hedge funds to close out short positions but undermined the interests of retail customers.
Monge illustrated that while the outrage was directed at Robinhood for stopping trading in meme stocks, it was necessitated by Robinhood’s business model which had been in operation before the incident. As it was a major player in the timeline of events relating to The GameStop Incident, Dr. Monge outlined that this company would be the main firm discussed, despite there being other major players who also contributed to the meme stock mania.
According to Dr. Monge, there were four set practices of Robinhood’s business model that not only allowed but encouraged this kind of behaviour. The first being novel account features standard for beginner accounts, with the most prevalent being risky margin accounts which allowed for an investor to have access to their funds from a sale as soon as it happened. Typically, with a cash account – which in other brokerages is the default upon signing up – an individual must wait up to two days to access funds after a sale.
The second practice was the gamification of trading and removed friction by adapting the app interface to be designed for a phone and not a desktop. This allowed for more frequent trades by users, meaning that Robinhood was able to get a larger profit as it was paid almost four to 15 times more per trade than other brokerages. This hurt both users of the app and society as research has repeatedly shown that increased trading is inversely correlated with positive returns.
The third practice was in how it made options trading more accessible for its users by displaying an oversimplified version of the app that led to overconfidence by investors. Dr. Monge explained that the risk in accessibility is that options trading is riskier and more complicated, meaning that an individual should have a better understanding of options trading before taking part. Finally, the increase in user trades and Robinhood’s reliance on the payment for order flow model, allowed them to gain increased revenues per stock and option trade.
Going into specifics of Robinhood’s actions in The GameStop Incident, the main ethical problems according to Dr. Monge were that Robinhood acted in its own interest. Other brokerages halted trading in meme stocks when The GameStop Incident started gaining traction, however Robinhood decided that it would continue as it was making money by having its users engage in trading meme stocks. Dr. Monge explained that as it continued to allow trades, it backed itself into a corner by increasing the volatility of the 13 meme stocks and was hit with a margin call. Dr. Monge explained that this margin call occurred due to the use of margin accounts and the fact that the user does not actually own the money they receive through this account. Users of margin accounts essentially owned the rights to the money and are owed a promise by the broker. As customers of Robinhood continued to buy into meme stocks, they became a bigger part of Robinhood’s assets and skyrocketed the volatility, ultimately resulting in Robinhood being held liable for more collateral to offset the risk. At this point Robinhood decided to halt the trading of meme stocks in order to avoid paying extra collateral to the Depository Trust and Clearing Corporation as well as to its own customers due to the use of margin accounts.
Dr. Monge summarized that Robinhood’s actions prior to The GameStop Incident were reckless and were problematic because of the way they regarded the risk of an outcome like this one. It’s actions during the incident only further proved that Robinhood was only trying to make more profits from its customers as it created chaos, benefited from it, and did not proportionally share the burden with investors. Dr. Monge interpreted the actions of Robinhood’s as controversial as it acted to democratize trading yet held itself to a different standard once it was challenged.
Dr. Monge’s Ethical Speaker Series session shed light onto the complexities associated with risk in the stock market. Especially when brokers with questionable ethics push users to make trades without being fully aware of their actions in the name of accessibility.