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Discount Brokerage Weekly Roundup – February 22, 2021

Even though this past week was technically a short one in both Canada and the US, Friday couldn’t come fast enough for several online brokerages (and one Texas senator).

In this edition of the Roundup, we take a detailed look into what is sure to be yet another chapter in the history-making story of GameStop (and other meme stocks) and the impact on the superstar US online brokerage, Robinhood. Though we normally have two big stories to report on, this is a gargantuan story that is worth giving the whole spotlight to. We’ll check back in on some additional developments around the Canadian online brokerage market in our next edition. To maintain some semblance of tradition, we’ll also include highlights of activity on Twitter and chatter from DIY investor forums.

Errors of Commission and Errors of Omission: Robinhood Grilled Over GameStop

After a very big storm, you can expect a very big cleanup. And, after the very big storm that hit the online investing space in the US, there’s a lot to be cleaned up, especially in Sherwood Forest, aka Menlo Park, aka Robinhood headquarters.

The conversation about what exactly happened with GameStop, shorting, hedge funds, Robinhood, and payment for order flow continued this past week. Curious eyes were treated to a virtual gathering of members of the US House Financial Services Committee as they sought an audience with characters from the recent trading saga, to hear testimony and air some grievances about the events that unfolded for retail investors at the end of January.

Though this was not a formal trial, it did put a lot of actions “on the record” that would otherwise be able to be swept under the financial rug. On that note, it was a win for transparency relating to these events to at least have several of the key players involved answer for their part in “what happened.”

For Canadian DIY investors and online brokerages, it might be easy to dismiss this event as American political theatre rather than a consequential event; however, points that were raised in this inquiry could have serious implications for online investing in Canada.

Suffice it to say, there’s a lot to unpack from the five-hour-plus back-and-forth session. But to (ironically) paraphrase a Robinhood catchphrase, to keep things “digestible” for readers, we’ll narrow this story down to the most important points from the GameStop hearing.

Key Point #1: Who Was There and Who Was Not

By now, there are a couple of emerging celebrities in the GameStop stock story, and many of them were present at this hearing.

Top billing, of course, goes to Keith Gill, aka “Roaring Kitty,” who is a person of interest in this story given his role in being the “face” of the “squeezer” Reddit army who, through the power of online communities, were able to narrate their interest and point of view on why going long on GameStop was an awesome opportunity to make money.

Of greater interest to the world of DIY investing and online brokerages is the CEO of Robinhood, Vlad Tenev, who is now the face and name associated with the zero-commission online brokerage and who sits at the heart of so much controversy.

Also called to testify were Reddit Co-Founder Steve Huffman, Citadel CEO Kenneth Griffin, and “squeezee”/Melvin Capital Management Founder and CIO Gabriel Plotkin.

Of the many fascinating developments around “hauling in” individuals to testify before a congressional committee, it is noteworthy that senior executives from other online brokerages were omitted. These companies benefitted from the trading activities taking place during the GameStop run-up (many of them also make money via payment for order flow) and also implemented restrictions of various degrees for retail investors to be able to buy or trade meme stocks such as GameStop in late January. But, for better or for worse, Robinhood was in the hot seat on this one.

Certainly, important players were brought before the House Committee on Financial Services to elaborate on “what happened,” but placing Robinhood alone under the “online brokerage” microscope put the focus on their business practices and not on those of the industry they are part of, a move that misses a lot of valuable context.

That said, there is no denying that Robinhood has a significant retail investor client base, and many of those investors have smaller balances and are not as sophisticated or as experienced as the investors at some rival online brokerages.

In looking at the “big picture” of this particular hearing (and apparently there will be more hearings to come), one of the central figures in this fiasco was Robinhood. The business practices that are synonymous with Robinhood, which happen to be very important in their ascension, were also very much under scrutiny. Practices or features like payment for order flow, “gamification” techniques, zero-commission trading, and “democratizing” financial markets all came under fire – surprisingly – by the panel of committee members.

As troubling and perplexing as the testimony was, it seems like the biggest danger did not get any airtime. The most frightening portrait of events and systemic vulnerabilities that could impact many more stakeholders than just Robinhood customers came from the Founder of Interactive Brokers, Thomas Peterffy, who was not one of those providing testimony but who did appear in a TV interview to provide some food for thought. We’ll dive into that in just a moment.  

Key Point #2: Ducking Details Makes You Look Either Incapable or Guilty

Just to put it out there, getting grilled by a congressional panel about major mishaps in business practices isn’t going to be high on many people’s bucket lists (except for maybe a certain pharma-bro).

The unenviable position that Robinhood CEO Vlad Tenev found himself in seemed, upon final analysis, to be a crisis of his own making and potentially the result of not doing the requisite preparation. Either way, it wasn’t Tenev’s finest (four) hour(s).  

The first interesting takeaway is that Tenev always seemed to be in “commercial” mode – taking as many opportunities as he could to try to bring the focus of his answers to the mission of Robinhood. It often sounded more like a commercial for Robinhood than like he was directly addressing the questions he was being asked. His opening remarks are perhaps the clearest example of that.

Why that matters, however, is that during the course of the inquiry, there were some very (important) direct questions that didn’t seem to have been properly addressed. Too much time was spent – perhaps on purpose – talking about mission or esoteric elements instead of directly addressing the questions. This left many of the responses from Tenev sounding hollow or superficial. Here are some examples.

In an exchange with Rep. Cindy Axne from Iowa, the topic of user experience and design of the Robinhood platform garnered some informed scrutiny. With a background in digital design, Rep. Axne asked why design elements on Robinhood’s platform were intentionally built to look like or simulate a casino.

This is at the heart of “gamification,” which is a big part of what observers of Robinhood characterize as one of their most appealing features. Arguably, Tenev would be well versed in what has clearly been a huge differentiator for their platform since inception. For a firm to have worked so long and so hard at making the experience of investing seem “fun” – it raises the question of why there wasn’t a better response as to whether or not it is appropriate for an online investing platform to embellish user behaviour with elements to celebrate actions.

Tenev, who acknowledged using behavioural research as part of the standard course of business for designing refinements, stated flatly that Robinhood is against supporting “gamification.” Nevertheless, his statement that “we want to give people what they want in a responsible, accessible way” rings hollow against the features cited by Rep. Axne.

It seemed unclear that the majority of users, who Tenev cited as longer-term investors, would want the kind of features intended to generate the “excitement” that active traders crave.

Another important interaction (and arguably the most damning) took place between Tenev and Rep. Madeleine Dean of Pennsylvania. The basic crux of Dean’s line of inquiry tore a page from the classic “what did they know and when did they know it?” playbook.

Not surprisingly, it was the simplest yet most elegant way to piece together what happened when Tenev was first notified that Robinhood effectively got margin called and the subsequent decision to restrict trading in select securities.  

The full exchange is worth watching on C-SPAN, but as the clip below shows, when asked directly what mistakes were made by Robinhood – something that Tenev stated on several occasions that took place – he was at a loss to specify what those mistakes were.

Rep. Dean asked, “You admitted to making mistakes. Specifically, what mistakes did you make?” The silence leading into the response was deafening.

Further, another series of damaging “non-answers” came in the specifics of recounting what customers were told and when they were told it.

There was a concerning absence of awareness about exactly when and what communications were relayed to Robinhood clients in the days leading up to the restrictions as well as on the day of those trading restrictions being imposed. Tenev cited a blog post and social media posts being made but could not recount specifics on timelines for those or other client communications. Also, the shifting narrative on why stocks were being restricted from trading also made it seem like Tenev did not have a clear answer for users, which further adds to the uncertainty surrounding these events.

Finally, we would be remiss if we didn’t also point out the interaction with Rep. Alexandria Ocasio-Cortez of New York. It came well into the session, and while it seemed like most of the time was spent getting to a lead-up, the journey to the punchline read like a laundry list of Robinhood’s missteps. As for the punchline itself, Rep. Ocasio-Cortez pointed out the obvious conclusion that commission-free trading does not equate to free trading: There is clearly a cost to Robinhood users, which comes in the form of poorer execution.

Ever since that testimony, Robinhood and Tenev have been on a full-court press of PR moves. Since late January, the Robinhood blog has been busier than it has been in many months. The latest post appearing on the blog features a video of Tenev tackling some of the questions and sentiment coming at him/Robinhood. He is, interestingly, also more active on Twitter.

Key Point #3: We Didn’t Hear How Bad Things Really Were

While there are still more hearings ahead, the most troubling statement came from someone not at the hearing but who is also deeply familiar with market function.

Founder, and now retired CEO, of Interactive Brokers Thomas Peterffy appeared on CNBC to provide his take on the GameStop fiasco. And, true to form, he did not mince his words.

Peterffy stated that “we have come dangerously close to the collapse of the entire system” and that the general public, the US Congress, and financial regulators are unaware of just how bad things could have become.

To make his point crystal clear, he walked through the math on the outstanding shares of GME and how it would have been (almost) impossible, and likely catastrophic, for many counterparties to attempt to purchase GME stocks – which they would have been required to do by law – had GME stocks continued to climb in price. For further clarity, had options buyers collectively exercised their call options, they would have had to receive 270 million shares, but there are only 50 million shares outstanding.

In this nightmare scenario, clearinghouses would likely have collapsed or defaulted. Brokerages would then have been the counterparties responsible, and they too could have collapsed. It would have been nearly impossible to untangle the ensuing mess.

If it sounds alarmist, consider for a moment what would have happened if Robinhood did have the capital on hand to meet the 10x margin requirement handed to it by the clearing firm.

What would likely have happened then?

It stands to reason that GameStop would, or at least could, have continued higher. What is not yet clear is the price that GameStop could have risen to before the financial system would have headed into an uncontrolled meltdown.

Would circuit breakers kick in? Could they even prevent the swell of interest that could have come at Robinhood if the online brokerage did have the requisite capital to manage the surge in settlement requirements?

In that light, it seems to be clear that it was a direct result of Robinhood’s failure to be properly capitalized for this scenario that probably helped save the financial markets from significant ruin. A happy accident in not being prepared ended up saving the day.

Peterffy positioned the current scenario and regulatory environment as needing repair to resolve this particular oversight. He called specifically for better tracking and reporting of short selling and changing the margin requirements.

Whether this is a “bug” in the system, which the new reality of social media enables users to exploit when trading, or this is a case of financial elites changing the rules of the game after being caught offside, it’s clear the rules of trading online have changed and are still too opaque to be considered “fair” for all.

Why Is This Relevant to Canadian Online Investing?

While it is still unclear what the repercussions will be in the US, the testimony shared thus far and the series of events experienced at the end of January can provide a few clues as to what Canadian online brokerages and DIY investors will be paying closer attention to going forward.

The first item that we’ve discussed a few times before comes back to user experience, and specifically how investor behaviour intersects with design features.

Robinhood’s mission was to “democratize finance” by making the experience of investing as accessible as possible. As their CEO pointed out to Rep. Ocasio-Cortez, they are also a private business with a fiduciary duty to act in the best interest of their corporation, which means they have to consider how to maximize revenues and, by extension, profits. At what point do those interests conflict?

User experience features that Robinhood is now facing increased scrutiny and legal action over relate to the idea of “gamification” – the kind of user interaction moments that might misrepresent important financial decisions for something like gameplay. Being encouraged to tap an app up to 1,000 times and getting confetti when placing a trade don’t sound like the kind of enhancements that make trading accessible. They do sound like things that make trading fun.

This hearing and testimony will almost undoubtedly be a topic of conversation among senior executives at Canadian online brokerages who know they have to make their platforms more appealing to a shifting demographic but who now will have to seriously reconsider putting in certain features (like confetti) and even talking about investing in a way that might communicate that investing can be too enjoyable.

With financial literacy about online investing being nowhere near where it ought to be for the general public, the conversation about investing responsibly is one that will need to balance being engaging while at the same time not crossing a line that makes it resemble a video game lacking real-world consequences.

Another important consequence for Canadian online investors, in particular, is where and how they communicate about investing in specific securities.

One of the key factors in the GME stock surge was the rapid and widespread dissemination of information – true or not – on social media and forums. These are areas that we at Sparx are continuously monitoring. Some recent statements by Canadian securities regulators suggest that they will be watching the chatter on securities and, most importantly, observing whether or not individuals who are talking up or down a particular security have disclosed whether or not they have a position in said security.

Finally, one other area Canadian online brokerages might want to pay closer attention to based on the activity taking place in the US relates to communications to clients. Rep. Dean from Pennsylvania had a simple but powerful test to subject Robinhood to that is equally relevant to Canadian online brokerages: What did they know and when did they know it?

The crushing phone wait times, the ongoing system interruptions, and even the errors in data reporting that arise are all systemically risky situations that are neither new nor immaterial to investors. Although they do not impact a specific set of stocks, these actions ultimately impede the ability of self-directed investors to fairly and efficiently trade the markets. And, if held to account, Canadian online brokerages will have to be able to answer those two simple questions when it comes to explaining why they have yet to fully resolve these issues.

There is already data showing even greater investor interest in trading markets this year than there was during March and April of 2020, which suggests even further stress on the systems of Canadian online brokerages that are already struggling.

The GameStop story is unique in that it focused on one specific stock, but it is already clear that huge retail investor surges can happen again. Whether it is for blockchain or cannabis or any stock whatsoever, any online brokerage that cannot meet the sudden spike in demand or, worse, cannot fulfill the basic requirement to provide efficient access to trade the stock market should be prepared to face scrutiny in two places: financial regulators and the court of public investor opinion.

Discount Brokerage Tweets of the Week

From the Forums

The FOMO Is Real

In this post and this post, investors ask about the wisdom of buying cryptocurrency. Their fellow Redditors express very strong opinions about whether buying crypto is smart, or just harmless fun, or the equivalent of wasting money at a casino.

(Im)Balancing Act

A Redditor with $40,000 in a TFSA invested it all in a healthcare company. That lucky decision paid off – to the tune of about $343,000. Now they don’t know how to invest this much larger amount. In this post, Redditors weigh in with their advice (and to express their envy).

Into the Close

Don’t be fooled by fewer days on the calendar. There was a lot of news for such a short week and much that we didn’t get to highlight. The events surrounding the GameStop saga are as fascinating as they are frightening. So, as a little bit of levity, here are puppies. Have a great week!