Opinion: who gets richer from the actions of GameStop? Market makers and intermediaries, including Robinhood


I would love to talk about the mechanics of the central bank or index funds, but the only thing that matters in financial markets is GameStop.

1. Robin Hood or Robin Hood? The big story of the day is that Robinhood, the trading platform, has halted purchases from GameStop, a video game retailer. This essentially blocks potential new buyers and forces existing holders to sell. The stock fell 70% at one point on this news. A lot of people are outraged by this. They feel like Robinhood is protecting the big hedge funds against further losses and taking advantage of the little guy.

Well, where have you been all this time? This is literally the entire Robinhood business model. They don’t charge commissions for trading. But they attract and encourage trade. And they make money from this trade… by selling their order flow data to big hedge funds.

I often talk about how financial companies are so intertwined with so many complex businesses that they inevitably have some level of conflict of interest. And a company like Robinhood has conflicts in the wazoo. By necessity. Their biggest clients are actually large market makers and hedge funds. But they are selling a service to small retail investors posing as the business that takes the rich to give to the poor. When, in reality, they take the order flow from the poor and sell it to the rich.

Who do you think is actually getting richer? Basic market arithmetic tells us that active investors get lower returns than less active investors. It can not be otherwise. You may not see the costs. But they are there, whether they appear as spreads, commissions or taxes.

So while there are stories of Redditors getting fabulously rich, the average Redditor probably loses his shirt, or at least loses more of his shirt than less active investors.

But the ones who definitely make money along the way are the market makers and the middlemen. Robinhood acts as a middleman, gets rich along the way, and sells order flows to hedge funds while encouraging irrational behavior on the part of clients, which is guaranteed to generate lower average returns for these users.

A lot of people think this saga has somehow benefited the little guy because Melvin Capital, a large hedge fund with a short selling strategy, was crushed. Makes a nice headline when we see a hedge fund demolished by a retail investor-focused Reddit forum.

People who think that this is part of a process of moving money from the rich to the poor are missing out on long-term macro calculations. Overall, this activity harms Robinhood’s clients and benefits middlemen who make money through irrational activities. And if you think GameStop’s biggest individual beneficiaries are Reddit traders, you’re unfamiliar with GameStop’s executive suite and board.

Robin Hood? I think not.

2. Close. This. Down? People are outraged by the closure of the business in GameStop. This is a complex subject. A company like Robinhood has a lot of direct and indirect counterparty risk by allowing certain types of transactions on its platform. No one knows the specific amount of counterparty risk they have, but if Robinhood felt like this product could put their business at risk, then they don’t have to let you buy or sell it.

Robinhood is just a middleman, after all. The company doesn’t have to create a market for anything you want, and securities laws protect it from having discretion as to what it can give you access to.

This one is really messy because they obviously let people make deals on this product. And so closing it now looks like a bait and a switch. Again, Robinhood’s mission is to encourage reckless behavior. The whole platform is designed to encourage you to trade more and be more reckless. So we shouldn’t be surprised when a client’s reckless behavior creates a counterparty problem that forces the middleman to reconsider whether he really likes this reckless behavior.

Should Robinhood have closed access to trading? I do not know. I run a website called Pragmatic Capitalism, and I encourage people to treat their wallet like a literal savings wallet. I manage people’s money and eat my own cooking allocating people’s savings in super boring wallets. Intentionally.

The Robinhood model is the opposite of almost everything I believe in allocating savings. But I also run a website called Pragmatic Capitalism. And I know that capitalism needs liquid and free markets. So while I encourage people to be smart and mostly passive, I also know that smart / passive needs to be dumb / active to have a market. So, yes, I want people to have free access to freely tradable markets, but I also know that these companies need a certain degree of discretion to deal with how reckless their customers can be.

But there is a bigger problem here. GameStop has obviously become a pyramid scheme. That is, we know that GameStop’s intrinsic value has not increased by 1000% over the past few weeks. Maybe the intrinsic value was too low before that, but it certainly didn’t go up 1000%.

So you have a definitive pyramid-like aspect in trading. And the problem with pyramid schemes is that the bigger they get, the more money they make and the more they hurt the people who come later.

In the case of GameStop, you have a stock that was trading at $ 10 and rose to $ 100. The first investors are rich, and more investors buy later. By definition, the exposure is longer as the value increases. And then word gets around that people are going to drive it to $ 1,000. So people keep buying and pushing up the prices. More and more people are buying.

But who are they selling to? How are these people going to get by? They need more people to join the pyramid, of course. Except that’s not how it is. Eventually people realize that this is a pyramid scheme, and when they try to sell to someone else the pyramid collapses and the people who are hurt the most are the ones who joined late. In a sense, Robinhood is acting responsibly by ending the pyramid scheme even before Following people stick and get hurt.

Either way, this is a difficult question. Robinhood is a private company, and they can control what they give their clients access to. But they are now at a dead end of potential legal exposure.

3. Bitcoiner FOMO and counterparties, counterparties, counterparties. This story is really about counterparty risk. In fact, the whole historical history of finance is about counterparty risk. For each buyer, there is a seller. For every borrower, there is a lender. There are two sides to these transactions in a money economy.

There have been tons of bad takes on this issue. But nothing worse than BTCUSD bitcoin,
+ 0.43%
advocate talking about how this means we now need “decentralized finance“.

Decentralized Finance (DeFi) is a unicorn. It is not a thing. The second you create a debt contract or act as an intermediary in a financial transaction, you have immediate counterparty risk. For example, cryptocurrencies like Tether are not DeFi. Tether is a cryptocurrency that is inherently backed by Tether’s ability to maintain its peg to the dollar. They are as decentralized as Belize’s central bank is with its dollar peg. In other words, there is absolutely nothing decentralized about it. It’s mostly just a story to get some naïve people, just like, um, “Robinhood.”

Of course, you can create a trading platform that gives people access to financial products without much centralized intervention. But an entity is going to be regulated and will necessarily oversee much of the counterparty risk inherent in trading on that platform.

Or consider the reality of the world when bitcoins realize that their scarce money supply is actually a problem for bitcoin because, well, people need money for stuff and bitcoin is mostly held by a few people. . Well, credit markets will form from this centerpiece. And what happens when someone starts creating credit? By definition, they assume the counterparty risk. And, suddenly, people are going to create bitcoin credit contracts, which are contracts that are not decentralized. This is how all money works in the long run. We can try to reduce our counterparty risk, but we cannot eliminate it.

Look, I have nothing against bitcoin. I keep saying that bitcoin is one of the coolest things happening in finance. And yes, bitcoin itself is actually decentralized. But if bitcoin is the center of the crypto ecosystem and you want to create a financial system that derives from it and gives people access to things like credit and the stock markets, you will end up creating a largely centralized system. . This fairy tale about a fully decentralized financial system is therefore just that.

What we have, at the end of the day, is a whole bunch of tales of how bad “Wall Street” is and how we need Robinhood or bitcoin to save us from it, but these are just tales. based on misunderstandings, or, more likely, accounts of people trying to sell you a new centralized platform that will replace the old centralized platform through which they or they will become rich.

Anyway, I’m very busy watching the paint dry in my portfolio, so I have to come back to it. I recommend that you try it every now and then.

Cullen Roche is the author of the blog Pragmatic Capitalism, where this column first appeared. Follow him on twitter @cullenroche.


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