Of GameStop, Robinhood, Reddit, and Citadel

Total trading volume on the NYSE doubled from the year before. Annual turnover, a measure of how fast stocks trade, set a record of 319%. The year was 1901, and small investors with new access to the telephone and telegraph made gambles on directional bets at thousands of bucket shops across the country. That doesn’t feel a lot different than what we saw with individual investors, spurred by some conversations on reddit, who sent GameStop (NYSE: GME) up over 500% a few weeks ago. There are a few things worth noting here, the first of which is probably that there is not much worth noting here; even with the giant fluctuations in GME and perhaps a dozen other stocks, driven by individual investors and causing billions of losses to a few hedge funds, the overall volatility of the indices on which these stocks trade hasn’t really moved at all from the post-1928 average. In other words, the stocks and a few funds made or lost money, but the markets haven’t really changed at all. There is no news here.

That said, this is all so much in the news, that it’s probably worth explaining a few of these things. Let’s start with Robinhood. Most people at this point have probably heard of Robinhood, an app that lets individuals make commission-free trades, and really kicked off in 2020 as people with a lot of pandemic boredom, some stimulus cash in their pocket, and no sports on which to bet, went to work on day trading. But Robinhood didn’t spring forth, wholly formed in 2020, like Athena from Zeus’ head; it’s been around since 2012, and is part of a long trend, dating at least to the introduction of the Vanguard index funds in 1976, towards lower-cost trading. Today there are plenty of ways to make stock trades at zero commission, and Robinhood is one of them; but the question is, if these companies don’t charge a commission, how do they make money? It all comes down to something like degrees of separation from the actual stock exchange. If you “sit” on the actual exchange, there is a complicated pricing mechanism with lots of acronyms that most people probably won’t know, but basically you pay fractions of a penny per transaction. Citadel Securities is a market maker and high-speed trader that provides liquidity to institutions and retail investors, and makes money on the bid-ask spread with the speed of their transactions. In other words, a company like Citadel might offer to buy shares on the market for $100.00 and sell them for $100.03, making a few cents (or even fractions of a cent) per share on the transaction. Companies like Robinhood are paid by market makers like Citadel for trades; retail investors buying or selling shares through commission-free apps like Robinhood then get a slightly worse bid-ask spread, and that’s where Robinhood makes money. You might buy those shares for $100.01 and sell them for $100.02, paying slightly more in earning slightly less.

Is this good or bad for you? It really comes down to whether you’re investing or trading, and how much money is in play. According to a Wall Street Journal investigation of public filings, the cost to the investor might be as high as 60 times for Robinhood versus what it would be with a traditional broker like Schwab. That sounds terrible, but the reality is if you’re only trading a few shares at a time you actually are probably better off with something like Robinhood; it’s not until you get to hundreds or thousands of shares that the extra money you make from the improved bid-ask spread at traditional brokers offsets the cost of commission.

Now let’s come back to GameStop and who is losing money. With the price of the shares going through the roof, the people and companies losing money are those that had “shorted” the stock — in other words those who had taken positions that were effectively bets that the stock price would go down. Mostly, this means a small group of select hedge funds; but while these shorters may have lost $20 billion by Friday, that probably doesn’t even count as a drop in the bucket against the $42 trillion US stock market. There will likely continue to be a sort of populist, underdog, let’s-stick-it-to-Wall-Street “movement”, and more “GameStops” may appear on reddit, but ultimately there is no news here.

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