Last week, Wall Street became the latest victim of its own making. As $30 billion of hedge fund Archegos’ liquidations roiled stock markets, bulge-bracket banks asked how exactly a discreet family office managed to lose them so much money.
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Retail investors should be even angrier. The episode laid bare the cozy relationships between bulge bracket banks and hedge fund bosses. Not only does Wall Street regularly turn a blind eye to these managers’ past wrongdoings. (Archegos’ boss Bill Hwang pleaded guilty of insider trading in 2012). These banks actively help wealthy clients get even richer at the expense of others. And though Robinhood has started democratizing some parts of investing, they have unwittingly unleashed the worst parts of Wall Street’s excesses without providing the solution.
As the Archegos saga continues to unravel, regular investors will learn how Robinhood has compounded market rigging that’s only getting worse.
Investment Banks: Proof of a Rigged Market
Even before Archegos, investment banks have long enjoyed the benefits of an unequal market. Though “Chinese Walls” supposedly separate trading from corporate finance operations, studies have shown that banks often break these rules to gain an edge over regular investors. (Scholars could have also visited a trading floor and save themselves the trouble of running a study).
Many of these significant banks also oversee market-making activities. Instead of paying commissions like regular investors, they receive income for the trades they make. It’s a system that prioritizes Wall Street incumbents at the expense of outsiders.
But then the SEC got in the way. In 2015, the Volcker Rule – part of the Dodd-Frank Wall Street reforms – made it far harder for investment banks to trade their own money. So, these banks turned to the next best thing – making money off other people’s trading instead.
Archegos and Hedge Funds: The Cash Cow of Investment Banks
Since the Volcker Rule’s passage, banks have increasingly relied on hedge funds and family offices like Archegos. With the right connections, these wealthy individuals could borrow vast sums of money from investment banks to make outsized bets on the market.
Sometimes, these bets were powered by insider knowledge, as highlighted by SEC lawsuits against Galleon Group’s Raj Rajaratnam and SAC Capital’s Stephen Cohen. But usually, these gambles happen in the shadows, with banks extending cheap credit to hedge funds in exchange for fat trading margins. As long as everyone made money, the banks had little reason to stand in the way. By 2020, firms like Credit Suisse generated almost 30% of sales from transaction-based revenues, up from 20% in 2015.
Bill Hwang’s Archegos Capital took these cozy relationships a step further.
“For a time after the SEC case, Goldman refused to do business with him on compliance grounds,” reporters at Fortune wrote. “But [Goldman] relented as rivals profited by meeting his needs.”
Firms like Mr. Hwang’s generated so much commission through back-door swaps (known as contracts-for-difference) that banks largely ignored the absurd risk-taking happening right under their noses. Only last week did these financial firms realize that Archegos only had around $10 billion of equity for $50 billion of stock – several billion dollars shy of the FINRA-mandated minimum margin requirements.
That’s why last week’s 25% decline in Archegos’ holdings not only stung. In four short days, the leveraged losses destroyed the firm’s entire capital cushion plus another $6 billion of bank capital (i.e., public shareholder money).
Robinhood Opens the Wrong Door
Regular investors have started getting a taste of these absurdities. In 2018, Robinhood released commission-free options trading, giving ordinary investors a way to bet vast sums of money with almost no starting equity. And much like fishing with dynamite, many young investors accidentally blew up their vessels in the process.
In June last year, Alex Kearns, a Robinhood trader, died by suicide after believing he owed almost $750,000 in stock market losses. The 20-year-old student had no options trading experience and only had around $5,000 in life savings. But that didn’t stop Robinhood from authorizing Mr. Kearns to trade high-risk options contracts with a virtually unlimited downside. His parents have since filed a wrongful death suit.
That hasn’t stopped thousands more retail investors from taking Mr. Kearns’ place; Reddit’s r/WallStreetBets catalogs countless posts of similarly devastating losses.
The problem boils down to high fees – a hurdle that even hedge funds face. Financial derivatives like options all have pricing structures that stack the deck against retail investors. No matter how many winners you have, the nature of zero-sum products means the average options trader will still lose money in the long-term. And what about Robinhood’s so-called “zero-commission” structure? The app-based brokerage merely converts the commission into higher premiums, much like how investment banks profit from hedge funds.
Even Robinhood’s fractional shares have started looking somewhat like Archegos’ contract-for-difference agreements. Instead of owning stock outright, Robinhood fractional share owners now buy derivatives from brokerages for an even higher trading fee.
The Missing Factor: Sell-Side Research
These unfair advantages persist because Robinhood has failed to democratize Wall Street’s even more critical element: the information that powers investment decisions. These include:
Detailed research reports, Real-time trading alerts, and Dedicated account managers who help wealthy clients navigate markets.
From an investor’s standpoint, these “sell-side” players are worth their weight in gold (no matter what doubters might say). Top investment analysts routinely show superior insight into the companies they cover, and many of these analysts will often correctly predict corporate earnings down to the penny. Even if they’re not perfect, these professional analysts have the time and resources that no armchair investor could hope to replicate.
Hedge funds have benefited handsomely, consistently outperforming the market gross of fees.
Meanwhile, regular investors are left watching YouTube videos and Discord chats of the next hot stock. Often, much of the information favors showmanship over substance — “I like the stock” has become the de-facto rallying cry for buyers. Other times, these online sleuths are correct, but their conclusions get immediately traded away by high-frequency firms before regular investors can act.
That means, as a group, retail investor performance looks much like hedge funds in reverse.
Robinhood has inadvertently compounded these inequities. Its newsletter, Robinhood Snacks, only provides cursory information about trending stocks. And former employees describe Robinhood’s customer support initiatives as “a pattern of ineffective support: customer service agents without qualifications to offer financial advice, licensed brokers too busy to help and pleas from customers that went unanswered.”
The Archegos Legacy
Investment banks will undoubtedly learn the wrong lessons from the Archegos fiasco. To them, it’s more important that Goldman Sachs and Morgan Stanley avoided significant losses by liquidating almost $20 billion in block fire-sales. The severe market impact on Friday matters little, as do the losses that regular investors endured. Former Archegos’ holdings Discovery (NASDAQ:DISCA) and CBS/Viacom (NASDAQ:VIAC) are still down over 40% and 52%, respectively, since the selloff began on March 22.
Meanwhile, Robinhood will continue as if nothing happened. Margin and options accounts are lucrative moneymakers, and Robinhood has every short-term incentive to keep investors churning their accounts.
Not all is lost – there are plenty of high-quality analysts who offer their advice online. Many of these consistently outperform their sell-side peers.
But until Robinhood levels the information playing field, investors should tread carefully. As the Archegos saga highlights, mixing high leverage with bold trading works right until it doesn’t. After all, what better way to catch a lot of fish than with a stick of high-grade dynamite?
On the date of publication, Tom Yeung did not have (either directly or indirectly) any positions in the securities mentioned in this article.
Tom Yeung, CFA, is a registered investment advisor on a mission to bring simplicity to the world of investing.
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