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Democratised Capital Markets: A Force for Good?

In an article shared with the KCL Political Economy Review, Deputy Editor in Chief Aman Patel breaks down new trading platforms such as Robinhood and assesses their implications for students and adults alike

The crazes of GameStop, crypto, and Robinhood represent a significant shift in the way that Western capital markets operate. This shift is one towards democratisation where access to these markets has been expanded to include a far wider range of retail investors, including many students. This is important because now more than ever, the “average” person of a moderate income can invest in capital markets easily. This has occurred owing to the unprecedented developments of financial technology, or Fintech, and the creation of apps such as Robinhood. Robinhood is the forefront example of a new wave of commission-free stock trading and investing apps. By allowing the average person to trade with no strings attached, it has seen an explosion in popularity, with 2020 seeing the app facilitate 350 billion dollars worth of transactions.

The expansion of commission-free trading apps has been complemented by the rise of decentralised finance, or DeFi. DeFi has been spearheaded by cryptocurrencies such as Bitcoin. These are digital currencies that are run by a technology called blockchain. Blockchain is a type of database that stores data in blocks that are linked together as opposed to tables. Blockchain databases are also spread geographically rather than being under one roof. As a result, Bitcoin transactions are not bound by any national borders and are difficult to regulate. This lack of regulation makes investing in DeFi is both risky and potentially very lucrative as the recent explosions in cryptocurrency prices demonstrates. Not only has the act of investing become more accessible, but so have the very commodities in which individuals can invest. Does the democratisation of finance simply expand access to capital markets to those who do not understand the risks involved? Are waves of retail investors exposing themselves to a system rigged in favour of the elite? As a society we need to work out if we should be optimistic or pessimistic for its future.

How do these feeless apps generate revenue?

Apps such as Robinhood allow the user to invest their own money into stocks and shares that are traded publicly. You or I could easily download Robinhood and swiftly own a tiny slice of Apple or a few Bitcoins. What makes these apps so revolutionary is that they are commission-free and feeless. This begs the question, how did Robinhood turnover 673 million dollars of revenue in 2020? There are two main avenues through which this occurs. When retail investors like you or I purchase shares on trading apps like Robinhood, the app redirects the trades to a larger firm who can process them in bulk for a cheaper fee. This larger firm then compensates Robinhood for this saving. The payment to trading apps is a process known as Payment for Order Flow and serves as their chief revenue generator. The other avenue is a process called rehypothecation where Robinhood will use commodities and stocks traded on its platform as collateral for its own borrowing and investing.

There are advantages to these revenue streams, of course, chief amongst which is that they facilitate the feeless investing that consumers and retail investors can enjoy. However, there are costs to these approaches. The cost of Payment for Order Flow is that it can harm the quality of the transactions since Robinhood could sacrifice this for a firm that compensates more. This is exactly what happened in December 2019 and it led to Robinhood getting fined 65 million dollars. Payment for Order Flow has been shrouded in controversy for a long time and at one point it was outlawed by the Securities and Exchange Commission. On the other hand, rehypothecation has the potential to be disastrous for the economy as it was in 2008 during the Great Recession. At the time banks had $4 trillion raised against collateral belonging to their clients. When these banks failed to pay these loans, US and UK governments stepped in to bail out the banks to protect the wider economy. As Robinhood and other trading apps grow and their rehypothecated funds increase, so does the bubble that could potentially wreck the economy. What makes this a potentially more deadly situation than 2008 is that the collateral, in this case, belongs not to wealthy investors, but to more vulnerable retail investors. Those wealthy investors had diversified portfolios and more to lose whereas, by comparison, ordinary investors could have all of their savings and investments wiped out. What this means is that the government will have a greater need to bail out Robinhood and other trading apps should they fail. This is imperative in order to protect these vulnerable retail investors, many of whom are students that are not very financially secure.

Poor design?

There are risks to the revenue streams of commission-free trading apps but what about designs and user experience? Another criticism is that they have been designed to look and feel like games. The gamification of Robinhood led to a lawsuit from the Massachusetts Securities Division. The regulator argues that the app’s design trivialises the real risks to capital that arise from investing, especially to young people who are more at risk. The app’s game-like design is not the only risky element to its design according to the lawsuit. Robinhood has also been accused of not adequately accommodating the app to its rapidly swelling user base. There were over 70 app outages between January and November of last year. This is a serious problem as many Robinhood users are short-term traders who buy and sell within the space of a week or even a day. It is for this reason that outages have also led to lawsuits from outraged users who suffered heavily.

What does the GameStop saga teach us?

Source: Unsplash

It would be hard to discuss the democratisation of finance without talking about the recent GameStop saga. Retail investors from the Reddit board r/wallstreetbets saw hedge funds (firms that invest with pools of money) start to heavily bet against the survival of the company GameStop and so decided to purchase as many shares as possible to raise its price, thereby hurting and even bankrupting some of these hedge funds. To some, the saga represented a chance for the “little guy” to take on the elites at their own game. Aptly enough for its namesake, this was mainly facilitated by Robinhood. However, once the increases in share price started to impact these hedge funds which still owed GameStop shares to lenders, Robinhood froze purchases of GameStop on its app. Its justification was to protect its investors from market volatility. However, a pessimist would argue that this move was implemented instead to protect the interests of the financial elites whose money is pooled into these hedge funds. Whilst Robinhood supposedly protected its investors from the volatility of GameStop, its investors could still easily empty their savings into Tesla shares. Tesla shares are also volatile owing to the erratic behaviour of its CEO Elon Musk. Musk’s decision to smoke marijuana on a popular podcast saw his Tesla stock plummet by 9% the day after. Both Tesla and GameStop shares are volatile, but Robinhood has no issue with its investors purchasing Tesla shares since they are not currently hurting the pockets of the financial elite. This hypocrisy is the reason that Robinhood is facing numerous lawsuits claiming that they acted unlawfully and unfairly.

Should we just leave it to the professionals?

Source: Unsplash

There are indeed serious issues associated with the democratisation of finance. A pessimist would argue that all it will serve to do is expose the uneducated to risky speculative trading. However, the view that most are too uneducated to know where to invest is unfair. It can be argued that everyone is in the dark, not just the average person. Nobel Prize winning psychologist Daniel Kahneman has argued that investment bankers almost never replicate trading success year after year and so suffer from an “illusion of skill”. It is also argued that average retail investors engage in blind speculation, meaning that they are only investing for returns with no regard for the actual value of the company or commodity. Financial elites and the average person alike have done this throughout history far before the advent of DeFi and trading apps. A good example of this is a craze for tulips that took place in the early 17th century Netherlands. More importantly, financial knowledge is expanding and democratising along with trading itself. On balance, the pessimistic view that belittles the average investors’ knowledge and ability to invest holds little weight.

What can we expect for the future?

The West is in the teething stages of democratised finance and this is a reason to be optimistic for its future. The numerous lawsuits being levied at Robinhood demonstrates that over time, feeless trading apps will become less gamified and will better protect their investors. Legislation is key and steps are already being taken such as the SEC fining Robinhood for failing to satisfy its duty of best execution. Owing to this regulation and scrutiny, apps like Robinhood will continue to open capital markets up to a wider pool of investors in a way that will become ever more beneficial to the lower-income retail investors that populate such platforms. There are even calls for private markets to democratise, allowing a greater pool of investors to invest in start-ups and private companies through public funds and retirement accounts. Although the advantageous access to capital markets of the elite will likely remain to a degree, the lawsuit on Robinhood for freezing GameStop trades shows that it is diminishing. The developments in Fintech ensure that Western capital markets will continue to shift towards democratised access, a process that should be celebrated by those within the sector and nurtured by those that regulate it.

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