Since the fuss of how a band of rogue Reddit investors managed to strike a huge established hedge fund where it hurts, there has been plenty of time to let the happenings settle. Enough time for it to ferment into ideas that are less noise. Underneath all the pan clanging and the sudden spike in stock market interest is the more boring truth. This was not a sudden explosion of rebellion against institutions. This was an expectant outcome enabled by technology that’s being built around finance for years.
But before I get to that, I will take some time to talk about the GMExRedditxRobinhood story. It’s certainly more fun, and there are interesting things to note about it.
The way I heard it, there are three actors: Redditors (more specifically, r/wallstreetbets), Melvin Capital, and Robinhood. To be clear, though, I’m not writing to give you a play by play of the event. This is more of a retrospective analysis. You can search that news item yourself in case you’re out of the loop. I’m not here either to explain what short selling is or what a short squeeze is. But if you’re already even faintly aware of that, then read on.
So anyway, there were three. One corner of the ring is r/wallstreetbets (WSB) and on the other is Melvin Capital. Squeezed in the middle is Robinhood. Frankly, Melvin Capital’s role here is the least interesting. One point I just want to mention related to this is about investing in a short position. As an economist, I know that this market feature is excellent for price discovery and a healthy system. Personally, however, I’m not a fan. It leaves a bad taste in my mouth when you’re involved in an activity that makes someone’s failure your best interest. So maybe I’m biased by my lack of interest in digging into Melvin Capital’s part in this whole affair. You shorted, but the lousy outcome you hoped for someone else bounced back to you instead. Sucks, I guess. You’ll be fine.
So now for the meat and potatoes. With each element of everything, I’ll attach a concept that will put things into greater context. So this is how I’ll structure this write up:
- I’ll talk about WSB and the idea of predatory trading.
- I’ll continue about Robinhood’s cash squeeze and the concept of Payment For Order Flow (PFOF) which is a part of their business model. As well as why Robinhood got in its controversial position.
- Finally, I’ll talk about the tech that made this possible. I’ll go on some more to explain how this can make the future of finance better through increased liquidity in various asset markets.
r/wallstreetbets and swarm predatory trading
What is Predatory Trading?
Let’s start broad and open with the abstract of a study from America’s National Bureau of Economic Research.
This paper studies predatory trading: trading that induces and/or exploits other investors’ need to reduce their positions. We show that if one trader needs to sell, others also sell and subsequently buyback the asset. This leads to price overshooting and a reduced liquidation value for the distressed trader. Hence, the market is illiquid when liquidity is most needed. Further, a trader profits from triggering another trader’s crisis, and the crisis can spill over across traders and across markets.(Brunnermeier & Pedersen, 2004)
Let me repeat that abstract with more context. As the term may imply, predatory trading requires prey; the predator profits from the prey’s misery. Say the prey owns a stock that is undergoing some volatility that’s higher than their risk appetite. The prey wants to sell a stock because its price went down, and they’re now making a loss. Now, the predator notices this bleeding prey, and he happens to own the same stock. The predator may have a higher risk appetite or a longer-term plan for the stock and has no selling intentions. In a well functioning and liquid market, the prey can limit its losses and sell its stock, no problem.
But if the stock happens to be illiquid, wherein the trade volume of that stock is so little than large trades can shift its price, then the prey is open for exploitation. The predator may make the price lower by selling some of his stock, making the prey’s losses bigger. Eventually, the predator will buy back the shares it sold and probably the shares that the prey was selling. So now, the predator managed to get more of the same stock for a lower price, profiting from the prey’s losses.
This template for predatory trading will not fit what WSB did to Melvin Capital perfectly. But predatory trading does have a couple of requirements that this event had. First, predatory trading must have illiquidity: more illiquidity, more profit.
(Just in case you’re not super sure of what liquidity means, let me give a quick and dirty explanation. Basically, it’s the ease of transforming an asset into cold hard cash—the more liquid, the easier. So in the context of stocks, if a lot of people are trading a stock, then it’s more liquid since more trading means more buyers and sellers. If you want to sell your Apple stock to get your cash back, I’m sure there are many people out there who want to buy an Apple stock. So it’s liquid. To reverse that, an illiquid stock is one you want to sell, but no one is buying. So it’s harder to turn your stock back to cash.)
Second, predatory trading must have prey. Prey is someone who has a limited capacity for sustained losses. The more pain for the prey, the more profit for the predator. (But also, the more predators, the less profit.)
What WSB did fits this template to a degree. I mean, they preyed on Melvin Capital, which they knew was shorting GameStop’s stock (GME). The predator is WSB, the prey is Melvin. Now the specifics will get muddy since the formal definition of predatory trading assumes a long position. In this case, it’s a short position. But the requirement is for a “prey with a limited capacity for a sustained loss.” Well, if you short a stock, you lose money if its price goes up. And as far as stock prices go, the sky is the limit. In a way, the potential loss is hypothetically unlimited. And so, Melvin can be and has been a prey.
What about illiquidity? Was GME illiquid? To be honest, I don’t know. What I do know is that the point of that requirement is that an illiquid market makes the price more sensitive to trade. WSB rallied its members into some sort of swarm that shoots the trading of GME to such an extent that it yeeted its stock price to the ceiling. And so with that, Redditors, using predatory swarm trading, were able to fell a giant and make a profit.
I’ll be honest; initially, my first reaction was to worry about the precedent this sets. It smelled of market manipulation. And while making short-sellers suffer through predatory trading may be poetic justice to some, for me, it’s becoming the very people you’re against. Some argue that there are good reasons for GME’s stock to rise; the spike was just too much.
But seeing that the price deflated back to its usual, I’d say it’s growing pains for our financial world. But I’ll get back to that in the final section. First, we have to talk about Robinhood and how they operate. Perhaps this will illuminate some as to why they had to do what they did. This is not to give them absolution for their part in this, however.
Why did Robinhood suspend the option to buy GME, and why was that suspicious?
To understand this, we have to get acquainted with how Robinhood earns money and how stock orders flow in general. The actual transactions that occur when trading stocks are rather complicated, so we’ll only focus on a few key actors here: the broker, the marketmaker, and the clearing-house.
The broker in this play is Robinhood. Robinhood is a retail broker whose main selling point is that you can trade for free. For free! Ain’t that dandy. Now fees whenever you trade stocks (i.e. buying or selling) wasn’t always like that. It all started around 1975 when Charles Schwab removed massive commissions. Then by 2019, a price war broke out among brokers. Thanks to technology, trading fees were pushed down due to automatic trading, robo-advisors, and the share prices’ decimalisation. And then there’s Robinhood that pushed it to the limit: trades are free.
While that’s nice, we should be at a point wherein we should be wary of anything free. Facebook is free and look at what that ended up costing us. Nothing is free. So how was Robinhood earning money? The answer is in the little thing called “payment for order flow” or PFOF.
What is a Payment For Order Flow (PFOF)?
While Robinhood does earn money from other ways (like from the premium version of their services), PFOF does make a massive bulk of their earnings. Additionally, they earn the most from PFOF compared to other brokers. PFOF isn’t bad by nature, but it is banned in some countries, and it was pioneered by Bernie Madoff, who also happen to pioneer Ponzi schemes. Additionally, they do incentivise brokers not to offer clients the best price possible for a stock. As icing, the SEC has once given Robinhood a fine for not doing its duty to execute its customers’ trades at the best possible price. So, all in all, PFOF is quite controversial, and Robinhood’s reliance on it gives it a bit of a reputation.
So what is PFOF? These are payments sent to brokers by another entity that does the trade’s actual execution for directing trade orders their way. In this case, that entity is the marketmaker. The marketmaker that Robinhood deals with is Citadel Securities. So Robinhood users can trade for free thanks to Citadel, who even pays Robinhood for the service. What’s the catch? First, we have to answer the next question.
What is a marketmaker?
As their name suggests, they create markets for various assets (in this case, stocks). Their main goal and benefit in the financial world is that they provide more liquidity. Imagine this, you want to sell your GME stock, but nobody is buying. It’s illiquid. To fix that, a marketmaker will find sellers of GME and will buy all of their shares. Now the marketmaker will have stocks of GME that are always ready to be sold to anyone who wants to buy a GME share. The marketmaker enhances liquidity by ensuring that there will always be someone who will buy the stock you want to sell and you can always get the stock you want to buy.
How does a marketmaker earn money, though? Through the bid-ask spread. In simple terms, they will try to sell the stocks they just bought just a wee bit more expensive (in the region of cents). So since the profits are meagre, they can only earn plenty if they have plenty of orders. This is why some marketmakers would pay for more orders (hence PFOF).
But while technically they control how much they price a stock, they cannot deviate too far from the stock’s actual market price. Why would a buyer buy from them if it’s cheaper elsewhere? There’s still a risk for them if they buy a stock, then the price goes down. This is also where the incentive to not offer clients the best price for a stock comes in. When you pay a broker for executing their clients’ trades, you will benefit from pressuring them to sell a stock for a higher price.
In addition to why marketmakers would pay for more order flows, marketmakers also regard retail investors (like Robinhood) as “friendly.” To understand this, it’s better to know what’s “unfriendly.” Some massive institutions order in such a way that’s not great for marketmakers. For example, some may do iceberg orders. Iceberg orders are orders that are bigger than they appear. It’s done in a way that breaks a particular institution’s large order into smaller ones. They do this to avoid rising the price of a specific stock, which can happen if a large order (on a scale that’s only possible for huge institutional investors) is placed. This can make it harder for a marketmaker to profit since they benefit from rising prices. So basically, institutions have plenty of tricks to make it harder for marketmakers to earn. Retail investors, less so.
Now, let’s try to answer why Robinhood suspended the buying of GME shares in its platform, which prompted anger from users and attention from lawmakers.
What is a clearing-house?
We need to talk about clearing-houses first though. A clearing-house is an intermediary between buyers and sellers of stocks. They’re the people that will make sure transactions are recorded, and each party will deliver the promised stock and payment. Clearing-houses are the ones that actually send money to the seller’s bank accounts. They’re also the ones that match the buyers and the sellers, making the financial world more efficient since thousands of orders each day flow in. The buyers and sellers do not have to meet themselves; the clearing-house can just match them.
Now here’s the thing. These trades have a lag of usually about two days. There’s also a risk that the buyer won’t pay. So it’s standard practice for clearing-houses to require members to have a minimum amount to their account balances. DTCC, the clearing-house that deals with Robinhood, is no different.
The flood of GME buy orders has pushed the requirement for Robinhood to post collateral for its users’ trades. DTCC asked Robinhood to have 3 billion dollars collateral, scrambling Robinhood to raise its capital through credit lines.
While it’s a norm to halt trading when volatility goes crazy, what angry Robinhood users point out is that Robinhood only stopped buying orders. However, the option to sell was still possible. Now, the situation may be more intricate than what I know. Even so, I can understand it if it’s their way of maximising the ease of pressure for them to raise massive collateral. The risk for clearing-houses comes mainly from the buyers. So closing just buying seems to make sense.
But zoom out a bit, and you can see that the picture from an outsider is not pretty.
Why were people suspicious?
Remember that marketmaker that Robinhood is dealing with? Citadel Securities? Well, its parent company was Citadel, which also happens to own Melvin Capital. That’s right. Melvin Capital, the hedge fund that shorted GME. The same hedge fund that risks losing massive money from the surge in GME’s stock price. Through Melvin Capital, through Citadel, through Robinhood, one can trace a line of incentive for Robinhood to close the tap on GME buy orders.
While all parties deny this (of course they would), and while all of the lines make sense, I must remind everyone that there’s no concrete evidence for this.
But I’ll leave at that. That’s the complete story with sufficient context and explanation. I hope. I leave the judging to you. Now we talk about the real message here. What WSB did to Melvin was made possible by technology’s positive impact on finance.
How is tech reshaping the world of finance for the better?
To answer in one short paragraph: tech has enabled normal people to invest and affect the market, shifting the power away from big institutional investors and into a more level playing field. Thanks to more information flow, low-cost trading, and frictionless transactions, the possibilities to invest in more assets are increasing. The finance world can benefit from this by introducing a flood of liquidity into otherwise dry markets. This makes price discovery faster and markets more efficient.
You can stop reading here if you want, but I want to explain it a bit more.
Consider the internet, dubbed the superhighway of information since I was a child. Before the internet was ubiquitous, most information come from reports governed by laws against insider trading and market manipulation. These days, however, we have social media, which is ripe for any form of sentiment analysis on various assets and companies. We have web scrapers that can scour endless information on the web. All these information are up for grabs to anyone willing to cobble them together into an industry sensor.
As with all things, however, this free flow of information has some downsides. While the old ways of a report can lead to insights generated by a few people who may be prone to groupthink, they benefit from being bound by rules and a certain standard. We may be too familiar with this problem with social media by now. Still, the superhighway of information can easily be uno-reverse-carded into a superhighway of misinformation. The risk is that the inherent irrationality of human behaviour can now have a real financial cost.
Nonetheless, it opens up a wealth of knowledge that will enable more people to participate in financial markets as well as the possibility of making their own decisions given the information they consume.
The more significant impact of technology is enabling a new breed of business models to open up some asset markets. Let’s take Robinhood. Though a bit stained by controversy, this app has successfully democratise retail investing by offering almost anybody to buy stocks in an easy and frictionless manner. Another enabler that led to the GME kerfuffle are the conditions concocted by the COVID-19 pandemic. Combine frictionless trading with a whole bunch of people (in this case, Americans in particular) with more free time to finally get into stock trading. Plus a dash of extra cash thanks to the stimulus checks, then it’s no wonder how retail investing went from 10% of the trading volume to 25%.
This increased participation led to more trading volume, which is beneficial in keeping the market efficient through more rapid price discovery and increased liquidity. This also means that the power of substantial institutional investors is a bit diminished. While their scale is still much more significant, competition from apps like Robinhood will only apply more pressure on their profits via commissions and fees. This is already the case for years with stocks, but the other apps that open up the market beyond stocks are the real trouble for them.
This is the exciting part.
What’s the deal with liquidity?
To keep it short: liquidity is excellent for the financial market as a whole. However, liquidity may be undesirable for some big investors. See, they earn through “illiquidity premiums”, which is a bump in fees they get for investing in assets that are not liquid. So the picture is quite straightforward so far: thanks to technology, we can inject liquidity into markets. Stocks have been conquered. What’s next? In this write-up, I highlight the bond market and the property markets.
Let’s start with an understanding of what affects liquidity. I already mentioned it but let me put it in a nutshell: more trading activity leads to more price discovery. More trading activity leads to more liquidity. So we can see three variables that move in the same direction. The fourth variable that is inverse to all of those is fragmentation.
What is fragmentation, and how does it lower liquidity?
Fragmentation is the number of types a particular asset has. We’ll go about it in descending order of liquidity. The most liquid so far are stocks. Besides the reason I gave earlier, another factor for stocks’ liquidity is low fragmentation. A stock for GME is precisely the same as another GME stock and is pretty interchangeable. This makes trading easier. An apple is an apple, no matter what.
Let’s move to something more illiquid: bonds. The trade volume of bonds is much lower, and one reason is that it has a higher level of fragmentation. To make that concept concrete, it’s because a corporate bond from Wells Fargo is not necessarily the same as another corporate bond from Wells Fargo. There are different kinds of bonds from Wells Fargo with varying maturity dates, different amounts, different coupons, etc. A block of cheese is not going to be the same as another since there are many kinds of cheese. To add another metaphor, I’ll borrow this from The Economist. They say that stocks are like trading identical marbles. Doesn’t matter what you get; a marble is a marble. Bonds, however, is like smashing that marble into many pieces.
Another thing that may lessen trading activity with bonds is that they are less likely to be actively traded. They are more of a buy-and-hold type of investment.
Now let’s get more illiquid: investing in real estate. As The Economist continues, this is like grinding the marble into sand. Now it’s even more fragmented. You’d be hard-pressed to see two properties with the exact kind of characteristics, let alone with the same value. And like bonds, nobody actively trades real estate, save for flippers, which still takes quite some time.
This is where tech comes in.
As you may have guessed, new apps are bringing in some liquidity into these asset markets. Let’s start with bonds. Bonds can now be traded as ETFs making investing in them so much easier. Just buy one ETF and BOOM. The $100 you just invested is automatically divided and diversified into a multitude of bonds within the ETF. Since bonds are more fragmented, creating ETFs out of them are more complex. But of course, thanks to better computers, this is now more manageable, which helps it be more commonplace these days.
Take a look at how BlackRock designs the creation of their bond ETFs. Like Robinhood, BlackRock, the biggest wealth manager globally, works with marketmakers in creating their funds. If a bond ETF gets more in demand, its price will go up, and so the bonds are above their fair value and are at a premium relative to the market. Marketmakers would be incentivised to buy some bonds at a market prize then offer it to the fund manager at the implied premium prize. This will expand the fund and bring the value back to normal. This works vice versa. This makes pricing the asset correctly much more efficient.
Bond ETFs make trading bonds much easier. This increases trading volume and hence price discovery as well.
The final way tech is improving price discovery is by using machine learning. Of course, data science finds its way here as well. Take Overbond, a fintech company that employs machine learning to aid price discovery. They leverage data into predicting the worth of a bond. No doubt, they can also look into the price of ETFs and price other similar bonds using the ETF components as a benchmark.
In summary, it really boils down to better pricing of bonds. This keeps the market efficient and has the perk of increased trade volume and liquidity.
As you might’ve guessed, a similar trend is happening for property assets. In this sector, we have Cadre. It’s almost like how a stock is for companies but for properties. Usually, a retail investor wouldn’t have enough cash to invest in expensive real estate. What Cadre does is it takes a property then allows multiple people to buy a bit of it. Rental income is paid out, much like a dividend would. This would yield all the same benefits mentioned above. By making it easier to participate in the market for properties, the trading volume goes up and so does liquidity.
Overall, the hot story over Reddit versus Wall Street underlies a more critical message that headlines often miss. Technology is reshaping the financial world’s landscape for the better, giving everyday investors more participation and say in the market.
However, I’m in no way saying that what WSB did to Melvin Capital is something I approve of. Sticking it to a man is an admirable motivation most of the time. Still, I can’t say that’s the right spirit to participate in our free markets. But I see the whole fiasco as some sort of growing pain to tech’s change to finance. As with new things, the process can be chaotic. Some retail investors might get misinformed, some may lose real money, and some assets may get mispriced (like GME). Volatility may ripple and threaten financial stability.
With this, governments should probably act carefully in a way that ensures guardrails without choking innovation. Rules against insider trading and market manipulation may be updated to the digital age. Regulation is starting to stray from my area of expertise though, so I won’t say more than that.
And that’s it. These are my thoughts on the whole thing, mixed in with some scholarly research about the matter. Hope you found it as fascinating as I did. And I hope you found some bit of optimism for the future of finance.