The innovations of the modern age have put the American dream within reach for anyone. The only thing required is a computer or a smartphone, which gives users access to financial markets worldwide. Meanwhile, the American public has dreamt up an idyllic view of achieving the epitome of financial success through Wall Street and stock trading. This modern American dream has driven many to the lure of securities trading, especially during the pandemic. However, new traders, not enticed with the slow yearly gains of the Wall Street establishment, have looked to day trading to satisfy their desire for profits and lack of patience. Smartphones and social media facilitated this new trend as stock trading is more informal and accessible to all.
The problem is, succeeding in day trading has not become easier. Many aspiring new day traders have turned to the brokerage firm Robinhood, which claims to be “democratizing” trading. The brokerage began in 2013 exclusively offering trading through their smartphone app. Robinhood appeals to new traders by not requiring a minimum account size and having commission-free trading. The brokerage became a favorite for inexperienced traders as the company enticed anyone with a few bucks and a smartphone. This new institution became the trendy brokerage that everyone talked about on social media platforms, like Reddit. The site—which consists of different topic-specific forums known as subreddits—fostered communities of new traders who collaborated with stock ideas and beginner advice. The investment subreddits often recommended Robinhood to new traders.
The subreddit WallStreetBets concocted a plan to upend hedge funds and make a quick buck. The way they knew they could achieve this was by creating a “short squeeze.” Some hedge funds make money through betting against companies that are struggling, which they do by selling borrowed shares at higher prices while planning on the undervalued company to decrease in price so they can buy back the amount they owe at a lower price. However, these funds are susceptible to large losses from any upward swings. So, when the Redditors collectively bought the bankrupt GameStop earlier this year, they sparked a price rise from the high volume and atypical buy-ins causing an appreciation of the stock from under $20 per share to nearly $500 in just two weeks of trading. Hedge funds were forced to exit their positions early on, and this required them to buy back stock they previously borrowed to sell. This caused more momentum upwards and is why GameStop and other meme stocks like AMC reached the heights they did.
However, the average Robinhood trader with limited experience sees the propped-up stock of these overvalued companies trending on Robinhood’s top stocks and being discussed all over social media. And without understanding what caused the rise, the new traders get into a highly volatile stock without a plan. The traders incur substantial losses when a stock like GameStop inevitably loses its momentum and ends up back down near the price where it started. Inexperienced traders combined for millions in losses from the short squeezes that occurred in the first few months of 2021.
It must not go unsaid; trading stocks is inherently risky. However, some losses have been caused in part by the overreaching of brokerages like Robinhood. The brokerage implemented gamified trading procedures along with many questionable business practices. The bad faith dealing by Robinhood should be cause for concern, especially since the company has exponentially grown its customer base by attracting inexperienced traders. While Robinhood purports to be for the people, it has actually acted in its own best interest by implementing problematic policies employed to maximize profits. As a result, Robinhood has made investing more akin to gambling than the traditional notion of steady gains from long-term investing.
Robinhood has implemented an app design that disconnects its customers— predominantly new traders—from the consequences of their trades. Previously, Robinhood used confetti to celebrate transfers of capital into the firm’s account. They have also rewarded users with free stocks for depositing money into their Robinhood accounts and making referrals. Appropriately, the free stocks are given away using virtual playing cards and a casino setting. Robinhood has sought to maximize its users’ quantity of trades and the amount of capital invested. Further, Robinhood misled its customers into thinking that the brokerage firm executed their trades at prices similar to their competitors. In reality, according to the United States Securities and Exchange Commission, Robinhood deprived its customers of an aggregated $34 million from the poor executions caused by their use of payment for order flow. As a result of commission-free trades and the brokerage incentivizing risky behavior, Robinhood users are far more likely to frequently enter and exit positions than investors who use other brokerage firms.
Robinhood has not been able to escape the critics who question their practices which allowed unproven and underaged traders access to margin trading and the options market. While the options market is an advanced form of securities trading usually reserved for highly experienced and successful traders, Robinhood nonetheless granted inexperienced and risky traders access to this arena. Thus, they bear some responsibility for the death of a 20-year-old customer of theirs who committed suicide after believing that he incurred $730,000 of debt from options trading. The college student easily circumvented the company’s minimum criteria for access to options trading—which were installed to prevent access to those under 21 since these users inherently lack three years of trading experience. The company imposed minimum pre-requisites as a way to screen their applicants as required by regulation. However, the screening became a cursory examination of customers’ accounts with little scrutiny and easily skirted through changing one’s answers to trick the automated system Robinhood relied upon. In reality, the student had not suffered the obscene losses that his brokerage account showed. Robinhood’s interface had not been programmed to properly reflect the nuances of options trading, which led to the app incorrectly displaying the student’s accounts holdings.
The dangers of securities trading are clear. Yet, the industry as a whole does not seem to care about its customers and their ultimate goal of economic success. The race to the bottom creates an ongoing danger to consumers that needs to be curtailed. Robinhood transformed investing, which has pressured established firms to adopt similar practices to stay competitive. Established brokerages followed the commission-free model and have now also implemented company policies similar to those of Robinhood, resulting in an industry not concerned with long-term investment and savings but rather their own bottom line. Commission-free trades has put an enormous cost on amateur traders.
However, public policy has the opportunity to help correct the injustice that is being perpetrated against investors who believe stock trading is an intelligent use of their money but mistakenly and unfortunately end up gambling it away. Market regulators and legislators are likely to pass reform focused on the liquidity and sustainability of financial institutions. The officials propose plans which are most focused on securing market viability during volatile periods like earlier this year, where Redditors from WallStreetBets pumped up stocks of bankrupt companies. But, a consent decree Robinhood entered into with the Financial Industry Regulatory Authority (FINRA) has abated the firm’s impact somewhat. As a result, the company now must more strictly enforce its options eligibility criteria. Further, FINRA held that Robinhood failed to meet certain transparency and operating requirements and levied a $70 million fine against Robinhood, the largest penalty ever administered by the agency.
While this is a good start, the impact of Robinhood remains as a new wave of traders has already been inspired by the revolution of the investment industry. There is value in making day trading an attractive option for more people. Nevertheless, inexperienced traders should not be needlessly exposed to the gamification and wagering of investing that Robinhood and others have incentivized. Although there certainly is value in the internet providing new traders with access to free resources to learn from and become knowledgeable with, the speculative and illogical moves fostered by the influence of Reddit and other internet influencers cannot be curtailed. That is why reform efforts should look to provide consumer protection to the customers of firms like Robinhood as, ultimately, the firms are selling products that encourage risky behaviors.
Brokerages should be prohibited from gamifying, investing, and harming consumers through addictive interactions with their products. Likewise, regulations should prohibit brokerages from implementing business models that incentivize increasing the number of trades a customer makes. Rather, brokerages should be limited to profits based on fostering and growing their customers’ investments. Therefore, I suggest the SEC should outlaw payment for order flow (PFOF). Brokerages which rely on PFOF are able to offer commission-free trading by putting the cost of that policy on the quality of the execution of their customers’ trades. Meaning, essentially, customers get worse prices for the stocks they want to buy and sell, with the profits going to the brokerages and their market makers, who coordinate the transactions of securities. Additionally, PFOF incentivizes a brokerage to induce more frequent trading of their customers as they increase their bottom line when their users trade more. However, trading more does not correlate with higher success rates for trades; the opposite is true actually. Brokerages should go back to working with exchanges directly, or, at the very least, regulation should mitigate the current conflicts of interest that exist from this questionable practice that is new to the industry. This would incentivize brokerages to return to traditional business models by which their profits are derived from their customer’s appreciation of investments. The SEC is now beginning to consider the implications of PFOF, yet they have fallen well short of taking any meaningful step to prohibit the practice.
Massachusetts adopted a promising and innovative fiduciary rule. The rule requires brokerage firms to place their customers’ interests ahead of the company’s financial interests. This rule should have curtailed Robinhood’s focus on its own bottom line and required a fairer, more consumer-minded model. However, a lawsuit against Robinhood for violation of this rule is still ongoing, and enforcement of the rule is still unclear, as questions linger on whether or not Robinhood is even subject to this rule. Nevertheless, some states are following suit. Other state governments have begun the process to draft and adopt a similar rule. More states should be adopting this rule as it would put significant pressure on Robinhood and other brokerages. Additionally, I argue that there should be a nationwide implementation of this rule through federal legislation or FINRA regulation since adopting a rule similar to Massachusetts’ would provide federal officials with broad discretion to protect consumers from predatory brokerages. Implementation would help mitigate the profit-minded activities of all brokerage firms operating in the US. This would protect consumers more than other proposals discussed by federal officials. Importantly, this change would outlaw current practices and any future attempts by brokerages, like Robinhood, who undercut their customers.
Other reform measures are insignificant, like the change to margin trading. An additional area without adequate reform proposals is options trading. Current regulations and proposals do not protect inexperienced traders who are given access to margin and options trading. While the current minimum amount required to open a margin account is $2,000, this number should be increased dramatically. An average American can meet the capital requirement after just one or two paychecks. However, they may not be able to cover their losses if they lose while trading on margin, which could potentially lead to unfathomable losses from shorting a stock—which can only be done by trading on margin. Brokerages should be required to limit margin trading to those with several years of experience and possibly even require a net-positive trading record.
Further, options trading should have even stricter requirements than margin trading because a retail trader has a greater probability of failure with options trading than stock trading. Access to the options market should only be for the experienced or knowledgeable trader. This could include implementing requirements for older and more experienced traders that are far more restrictive than the current self-imposed and minimal criteria used by Robinhood. In addition, brokerage firms should be required to either educate traders on the nuances of options trading or otherwise require certificates of training. Brief online courses explaining the mechanisms of options trading should be a bare minimum for anyone before they buy their first options contracts. Lastly, brokerages should be required to provide financial advice or access to free tools through their trading platforms. Brokerages could help build the proficiency and self-sufficiency of new traders by informing them of the dangers or upside of certain market activities and can also use instructive tools to highlight good plans of entry and exit. It should be in the brokerage’s interests to look towards the long-term for their customers since building wealth and business relationships with customers can create a lifetime customer. Overall, changing the incentive structure that the brokerage business models are currently employing would serve the interests of both traders and brokerages in the long run.
If adequate reform is not passed, then rates of addiction and depression will likely proliferate amongst young Americans. It is possible that the risky behavior and financial illiteracy being fostered in stock trading will continue into new areas, particularly sports betting and video games, which are also capitalizing on the influence of technology. These other activities are similar to 21st-century stock trading, where users have slim chances to win big, but the companies pretend to be selling the winning ticket to the American dream. Be that as it may, it’s modern gambling.
About the Author: Cody Colton is a 2L at Cornell Law School. He graduated from the University of California Irvine, where he majored in political science with an emphasis on legal studies. Cody is interested in securities litigation and white-collar crime. He is an associate for Cornell Law School’s Journal of Public Policy and its online publication, The Issue Spotter.
Suggested Citation: Cody Colton, Modern Gambling: The Tragic Reality of Stock Trading in the 21st Century, Cornell J.L. & Pub. Pol’y, The Issue Spotter, (November 2, 2021), http://jlpp.org/blogzine/?p=3782.