I’d love to talk about the mechanics of Central Banking or index funds, but the only thing that matters in financial markets right now is Gamestop. So…we’re going to talk about index funds. Seriously. But also we’ll talk about Gamestop so don’t worry. If you haven’t been reading up on the Gamestop saga then maybe circle back to yesterday’s article.
1) Robin Hood or Robinhood? The big story of the day is that Robinhood the trading platform shut down access to buying new shares of Gamestop. This essentially locks out potential new buyers and forces existing holders to sell on their platform. The stock dropped 70% at one point on that news. A lot of people are outraged by this. They feel like Robinhood is protecting big hedge funds from further losses and taking advantage of the little guy. WELL, WHERE THE FUCK HAVE YOU BEEN ALL THIS TIME? This is literally Robinhoods entire business model. They don’t charge commissions to trade. But they entice and encourage trading. And they make money from all that trading…by selling their order flow data to large hedge funds.
I often talk about about how financial firms are so intertwined in so many intricate businesses that they inevitably have some level of conflict of interest. And a firm like Robinhood has conflicts up the wazoo. By necessity. Their biggest clients are actually large market makers and hedge funds. But they’re selling a service to small retail investors advertising themselves as the firm that takes from the rich to give to the poor. When, in reality, they are taking the order flow from the poor and selling it to the rich. Who do you think is actually getting rich from all of this? The basic arithmetic of markets tells us that the more active average investor earns lower returns than the less active investor. It can be no other way. You may not see the costs. But they’re there whether they show up in spreads, commissions or taxes. So, while there are some stories of Redditors getting fabulously rich the average Redditor is probably losing their shirt, or at least losing more of their shirt than the average less active investor. But the ones who definitely make money along the way are the market makers and middlemen. So, Robinhood is serving as the middleman, getting wealthy along the way and selling order flow to rich hedge funds all the while encouraging irrational behavior from their clients that is guaranteed to generate lower average returns for those users.
A lot of people out there seem to think that this whole saga has somehow benefitted the little guy because Melvin Capital (a large short selling hedge fund) got crushed. It makes for a nice headline when we see that a hedge fund got demolished by a retail investing Reddit forum. It’s also a nice opportunity for politicians and charlatans to make it look like they care about the little guy. But people who think that all of this is part of some process of transferring money from the rich to the poor are missing the long-term macro math behind all this activity. All of this activity is, in the aggregate, hurting Robinhood’s customers and benefitting all the middlemen who make money from all your irrational activity. Oh, and if you think Gamestop’s biggest individual beneficiaries are Reddit traders then you aren’t familiar with the Executive Suite and Board of Directors at Gamestop or the hundreds of billions of GME owned by other hedge funds and institutional investors. This. Was. Never. David. Vs. Goliath.
Robin Hood? Methinks not.
2) Shut. It. Down? People are outraged over the shutdown of trading in GME. This one’s a complex topic. A firm like Robinhood has a lot of direct and indirect counterparty risk by allowing certain types of trading on their platform. No one knows the specific amount of counterparty risk they have, but if Robinhood felt as though this product could put their business at risk then they don’t have to let you buy/sell it. These are just middlemen after all. They aren’t obligated to make a market in anything you want and securities laws protect them in the matter of discretion regarding what they can give you access to.
This one’s real messy though because they’ve obviously been letting people enter into agreements in this product. And so shutting it down now looks like a bait and switch. But again, Robinhood is in the business of encouraging reckless behavior. The entire platform is designed to encourage you to trade more and be more reckless. So again, we shouldn’t be surprised when the customer’s reckless behavior creates a counterparty problem that forces the middleman to reconsider whether they really like all this reckless behavior.
But should Robinhood have shut down access to trading? I don’t know. I run a website called PRAGMATIC Capitalism and I encourage people to treat their portfolio like a literal savings portfolio. I manage money for people and eat my own cooking by allocating people’s savings into super duper boring portfolios. BY DESIGN. The entire Robinhood model is antithetical to almost everything I believe in about 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 stupid/active to have a market. So yeah, I want people to have free access to freely tradeable markets, but I also know that these firms need some level of discretion in managing how reckless their clients can be.
But there’s a bigger problem here. GME has obviously become a pyramid scheme stock. That is, we all know the intrinsic value of GME hasn’t increased by 1,000% in the last few weeks. Maybe the intrinsic value was too low before all this, but it certainly hasn’t increased by 1,000%. So you have a definitive pyramid-like aspect to the trading here. And the problem with pyramid schemes is that the bigger they get the more money they pull in and the more they hurt the people who come in later. So, in the case of GME you have a stock that was trading at $10 that went to $100. The early investors are rich and more investors buy in later. By definition there is more long exposure as the value increases. And then the word gets out that people are going to drive GME to $1,000. So people keep buying and driving the price up. More and more people buy in. But who do they sell to? How are all of these people going to get out? Well, they need more people to join the pyramid of course. Except that’s not how this plays out. Eventually people realize it’s a pyramid scheme and when they all try to sell out to someone else the pyramid collapses and the people who get hurt the most are the people who joined late. So, in a sense, Robinhood is acting responsibly by halting the pyramid scheme before even MORE people buy in and get hurt.
Anyhow, this is a tough one. Robinhood’s a private business and they can control what they give their clients access to. But they’re in a hot mess of potential legal exposure here.
3) Bitcoiner FOMO & Counterparties, Counterparties, Counterparties. This whole story is really a story about counterparty risk. Actually, the entire historical story of finance is all about counterparty risk. For every buyer there’s a seller. For every borrower there’s a lender. There’s two sides to all these transactions in a monetary economy.
There have been tons of bad takes on this issue. But none worse than the Bitcoin advocates 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 operate as the middleman in a financial transaction you have immediate counterparty risk. For instance, cryptocurrencies like Tether are not DeFi. Tether is a cryptocurrency that is inherently backed by the ability of Tether to maintain their peg to the dollar. They are as decentralized as the Central Bank of Belize is with their peg to the dollar. In other words, there is absolutely nothing that is decentralized about this. It’s mostly just a narrative to bring in naive people, just like, ahem, “Robinhood”.
Sure, you could create a trading platform that gives people access to financial products without so much centralized intervention. But some entity is going to be regulated and necessarily overseeing a lot of the counterparty risk that is inherent in all the transactions on that platform. Or, consider the reality of the world when Bitcoiners realize that their scarce money supply is actually a problem for Bitcoin because, well, people need money for stuff and Bitcoin is held mainly by a few people. Well, credit markets will form off of that central coin. And what happens when someone starts creating credit? They take on counterparty risk, by definition. And suddenly, people will be creating contracts in credit for Bitcoin which are contracts that are not at all decentralized. This is how all money works in the long run. We can all try to reduce our counterparty risk, but we cannot eliminate it.
Look, I’ve got nothing against Bitcoin at all. I keep saying that Bitcoin is one of the most interesting things occurring 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 branches off from this that gives people access to things like credit and stock markets then you’re gonna end up creating a largely centralized system. So this fairy tale about a fully decentralized financial system is just that. So what we have, in the end here, is a whole bunch of narratives about how “Wall Street” is bad and how we need Robinhood or Bitcoin to save us all from that, but really these are just narratives based on misunderstandings, or, more likely, narratives from people trying to sell you a new centralized platform that will replace the old centralized platform through which THEY will get rich.
Anyhow, I am very busy watching the paint dry in my portfolio so I need to get back to that. I recommend you try it some time.
Update – As I suspected, this was all about counterparty exposure. We now know that Robinhood wasn’t shutting down GME trading to protect their hedge fund clients. They were doing it because the DTCC forced them to.
Mr. Roche is the Founder and Chief Investment Officer of Discipline Funds.Discipline Funds is a low fee financial advisory firm with a focus on helping people be more disciplined with their finances.
He is also the author of Pragmatic Capitalism: What Every Investor Needs to Understand About Money and Finance, Understanding the Modern Monetary System and Understanding Modern Portfolio Construction.