What’s Behind the GameStop Squeeze

By Dr. Richard Smith

With all the ink spilled on the GameStop saga, there’s one question that no one has yet been able to answer: in the end, who’s really making money on this?

To anyone outside of investing, it looks like David vs. Goliath: retail investors on one side, fed up with chronic losses and no respect; and hulking hedge funds on the other, winning relentlessly at the expense of the retail public.

It’s a compelling story, but it’s not the whole picture.  There’s a part of the story that is not being adequately told.  It’s the story of retail brokerage Robinhood and its partnership with prominent market makers like Citadel Securities.  When the dust settles on this episode, what will be undoubtedly clear is that while some won and some lost, Robinhood and Citadel made money coming and going.

Robinhood, despite its populist positioning, is not incentivized to protect its users, which makes sense, because its users aren’t the ones paying for the service. Robinhood makes a lot of its money by selling users’ trade data to market makers like Citadel. They actually state it openly on a page on their site titled “Stock Order Routing”:

When you buy or sell stocks on Robinhood, we send your orders to market makers that typically offer better prices than public exchanges… We earn a percentage of the bid-ask spread, or the difference between the highest price to buy (bid) and the lowest price to sell (ask) of the equity, at the time of execution.

Let’s unpack this paragraph.

The most important point to note is that Robinhood earns their rebates from the market makers as a “percentage of the bid-ask spread.”  Wow.  What that means in layman’s terms is that Robinhood is highly incentivized to drive its users into trades with the widest possible bid-ask spreads and to do so as frequently as possible.

Let that sink in, please.  In what universe is such a business revenue incentive for a retail broker aligned with the best possible outcomes for its retail clients?

What are the best possible outcomes for its clients?  Great question.  Robinhood and Citadel would argue that it is execution costs on individual transactions.  I beg to differ.  While average execution cost may be a key component of success for a small fraction of very active traders that use Robinhood, it is the last possible measure of success for the vast majority of its 10 million plus users.

Users that bought call options on GameStop when GameStop was $400 a share may be able to say that they saved a buck on their transaction cost but what about the loss of 100% of the options premium they paid by getting drawn into a transaction that had such a miniscule chance of success in the first place?  Meanwhile, such an order from a Robinhood user would have produced the maximum possible revenue for Robinhood, not to mention the pocketing of hefty option premiums by hedge funds, which could include the very market makers that Robinhood partners with.

What has not yet been widely discussed in this “meme-stock” episode is what a perfect storm of profits this event was for Robinhood, not to mention a giant valuation boost in a business that is valued on engagement and growth.

There could be no better setup for Robinhood’s current business model than what we saw with the meme-stock frenzy.  We saw unprecedented levels of transactions around the meme-stocks all taking place at unprecedentedly wide spreads.

Additionally, many of Robinhood’s users held GameStop shares which also means that Robinhood was able to make money loaning out those shares at hefty interest rates to hedge funds that wanted to sell the shares short.  Here’s how Robinhood explains that on its page entitled “How Robinhood Makes Money”:

Robinhood Securities earns income from lending margin securities to counterparties.

The moral hazard implicit in Robinhood’s business model truly boggles the mind.

I’m all for letting the public decide who they want to transact their business with but in order to make informed decisions, the public needs to have transparency about the real profit motives of the businesses that they transact with.  Lofty sentiments about “democratizing investing” make for good PR but they don’t say much about whether or not the public is likely to increase their wealth by doing business with Robinhood.

It is theoretically possible that Robinhood knows exactly what it is doing here and they are indeed going to “steal from the rich and give to the poor” in the sense that they are going to facilitate a transfer of wealth to the public from the hedge funds and institutions.  If we could be privy to the sum total of wealth transferred during this meme-stock episode, however, I don’t believe that it is what we would find.

Maybe this episode was just the first skirmish in a longer war where Robinhood is, in the end, going to lead a band of merry users to the promised land of a seat at the Wall Street table.  As long as Robinhood’s revenue generation model incentivizes it to drive users into illiquid trades with wide spreads, I won’t be holding my breath.

About the Author

Dr. Richard Smith – Berkeley Mathematician and PhD in System Science – is a fintech entrepreneur and the CEO of The Foundation of the Study of Cycles. Dr. Smith has built a reputation as “The Doctor of Uncertainty” amongst his academic peers and has helped government agencies and Fortune 500 companies (including Pfizer and Johnson & Johnson) alike make sense of complex sets of data. With his background in mathematical theories of uncertainty combined with his investing and trading experience, Dr. Smith is an expert in risk management with critical insights that can help empower investors of all levels. Some of Dr. Smith’s findings are stunning – like empirical data-driven proof that even the world’s best investors, from Warren Buffett to Carl Icahn to David Einhorn and many more, could see their results significantly improved through the use of technology that helps course-correct irrational tendencies and cognitive biases. Dr. Smith’s software, backed by proprietary algorithms and Nobel prize winning research, has served more than 25,000 investors and helps steward more than $20 billion in assets. Dr. Smith is a regular speaker and lecturer and particularly enjoys opportunities to share his knowledge and help others gain an edge in the market.