Stock exchanges were created to allow firms to raise capital from a pool of investors in order to pursue investments and create a reliable market for those investors to trade their shares. Over the years, exchanges became instrumental in allowing individuals to save for retirement or make other long-term investments.
But with the privatization of stock exchanges around the world, the creation of massive markets for financial derivatives, and computer power facilitating high-frequency trading, the nature of trading has become more speculative.
The process has only intensified with the introduction of playful trading apps such as Robinhood, which use behavioural economics insights to simplify and gamify investing. Boredom due to the pandemic, government stimulus checks, and trading communities such as WallStreetBets also contributed to speculative trading.
In fact, if one were to analyze the current nature of the stock market, the plausible conclusion would be that some sections of it have the features of a large-scale casino. Massive wild bets are being placed by speculators, and highly leveraged financial instruments are readily available to inexperienced investors.
In addition, share prices experience dramatic intraday swings that make no economic sense. The share price of GameStop, for example, fluctuated between $172 to $348 on March 10. Crazy swings, with no news whatsoever. Fuelling the action are hundreds of thousands of posts on Twitter and Reddit, urging investors to buy GameStop because “it’s going to the moon!” Not the most rigorous analysis.
Just like in a casino, “the house” stands on the other side of many of the trades, and a fundamental rule is kept: on average, the house always wins.
In the case of the stock market, the definition of the house is somewhat wider than in a traditional casino. First, there are the exchanges themselves. Since becoming for-profit public corporations, their focus has shifted to increasing the volume of trading. The more trading there is, the more money they make.
Second, one should include big investment banks, high-frequency traders and hedge funds. These players have an edge over small retail investors either due to faster and better trading platforms or better information, which helps generates billions in profits.
Sure, in the GameStop saga, the army of redditors caught some hedge funds off guard, and caused them significant damage, but overall, GameStop and other “meme stocks” — stocks loved by young investors and promoted with funny memes on social network platforms — represent a negligible part of the market.
To illustrate the edge that some market players (the house) have over small retail investors, consider the following question: How is it possible for Robinhood to offer commission-free trading to its customers?
The answer is simple: Robinhood is selling its customers’ data known as “order flow” to firms like Citadel Securities. In 2020 alone, Robinhood generated $682 million (U.S.) in revenue from this controversial practice.
Citadel is one of the largest market makers on Wall Street. A market maker’s role is to provide quotes (prices) at any point in time, in which it’s willing to buy or sell specific securities. It is playing simultaneously on both sides of the market as a buyer and as a seller.
But Citadel is actually buying order-flow data not only from Robinhood but also from eight additional brokers (TD Ameritrade, E-Trade, and Charles Schwab among them) and is able to construct an extremely accurate picture of supply and demand in the market for certain securities. When it’s making a market for those securities, matching buyers and sellers, it’s using the data it purchased to front-run the order flow and earn pennies on each trade.
For example, assume that Citadel knows that investor A wants to buy one share of Tesla at $600, and investor B wishes to sell one share at $599.90. Using this information, it can now sell one share to A at $599.97 (better than she was willing to pay) and buy one share from B at $599.92 (better than he was hoping to sell it for), pocketing 5 cents is the process.
This may not sound like a lot, but multiply those pennies by billions of trades, and you have an extremely lucrative business model. Accordingly, in 2020, Citadel Securities reaped a stunning $6.7 billion (U.S.) in profits.
Terrance Odean, professor of finance at the Haas School of Business at the University of California, Berkeley, studies retail investors’ behaviour.
In a recent working paper, Odean and three of his colleagues analyzed trading patterns on Robinhood’s platform. The researchers found that Robinhood users are relatively inexperienced investors who tend to move as a herd and trade mostly the 20 stocks that appear on the app’s “Top Mover” list. The study showed that Robinhood traders, on average, lost money on their trades. Losses varied between five per cent and 20 per cent within one month of trading.
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“Robinhood investors are trading against someone who knows more than them. Hence, even if they make occasionally successful trades, on average, they are going to lose to the professionals,” Odean said in a Zoom interview from his home in California.
Indeed, high-frequency traders (HFT) have a huge advantage compared to small investors. According to a recent estimate, this costs retail investors about $5 billion yearly.
Hedge funds and HFT claim they are essential to a well-functioning market as they provide liquidity to the markets — the efficiency with which stocks could be traded without affecting their market price.
But this card is overplayed, and when a sudden crash occurs in the market, liquidity suddenly evaporates.
Odean fully agrees. “When the s- – – hits the fan, the market makers are suddenly gone. In the crash of 1987, there were a lot of phones that weren’t being answered. Same thing with the flash crash of 2010 when the Dow Jones index dropped nine per cent in a matter of minutes.”
One way to attempt to make the stock market fairer is to introduce a financial transaction tax (FTT). Initially proposed almost 50 years ago by James Tobin, who won the Nobel Prize in Economics, an FTT will discourage short-term speculation by “throwing sand in the wheels of the financial system.”
An FTT would also penalize frequent traders more heavily than retail investors, and if significant enough, it could incentivize long-term investing and discourage day trading. In 2012, France implemented an FTT on stocks and derivatives purchases, which varies between 0.1 per cent and 0.3 per cent.
In addition, the controversial practice of selling the order flow to market makers should be prohibited. In a recent interview, Charlie Munger, billionaire investor, long-time partner of Warren Buffett, and vice-chairman of Berkshire Hathaway, called Robinhood’s business model of selling its customers order flow a “dirty way” to make money, and said that commission-free trading is a lie.
Another policy change that needs to be considered to reduce market volatility as a direct lesson from the GameStop saga is prohibiting “naked short” positions that expose a short seller (an investor who bets that the value of shares will go down) to an infinite amount of risk. If potential losses are capped, this will eliminate “short squeeze” assaults by investors as in the case of GameStop.
Recent months have highlighted yet again how certain sections of the stock market are unhealthy and speculative. The fact that an army of reddit investors managed to score a victory against a big hedge fund, doesn’t change the long-term odds of what is currently an unfair game.
But, a few policy changes may help restore the stock market’s original purpose, protect some investors from losing money and divert gamblers to a real casino.
