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PUMP THE BRAKES

The dark side of the democratization of trading

Reuters/Nick Zieminski
Stopped out.
  • John Detrixhe
By John Detrixhe

Future of finance reporter

Can stock trading be too easy?

That’s been a question since the retail trading boom took off last year. As armies of armchair investors download brokerage apps, stock prices have looked increasingly detached from economic reality. Those concerns have been underscored in recent days as trading enthusiasts on Reddit go to war with hedge funds, driving money-losing companies to dizzily high market valuations.

“This kind of trading is not unprecedented,” James Angel, a professor and market structure expert at Georgetown University, said of the retail investing boom. “You look at market history and we’ve seen these periods of intense euphoria and speculation occur regularly. It seems like each generation needs to discover the stock market.”

This time around, a few things have come together to make stock trading easier and more accessible than ever. The best-known shift is the move to commission-free trading. Instead of charging fees to execute trades, one of the main ways Robinhood and others make money is by selling those transactions to large trading outfits.

(If you want to know more about payment order flow, you can read about how the retail trading boom is shaking up the US stock market, or why cutting brokerage fees to zero doesn’t make it free, as well as about the hidden costs of SoFi and Robinhood and how Ponzi mastermind Bernie Madoff enabled the US retail trading boom.)

Robinhood and the retail trading boom

Trading ramped up this summer as brokerages fees raced to zero. Think about this way: In the old days, a $20-per-trade commission would eat through $500 capital after 25 trades. That same trader, assuming they were buying and selling stocks that didn’t fall in value, could theoretically use that $500 to trade indefinitely on an app like TD Ameritrade or Robinhood.

 

And there’s more to it than that. Robert Cortright, the CEO of DriveWealth, whose company provides brokerage for digital wallets like Square’s Cash App and Revolut, told Quartz last summer that the rise in retail trading has been building up for the better part of a decade. He says one of the keys to the bonanza is so simple it’s often overlooked—the proliferation of more than 2.5 billion smartphones around the globe.

He also thinks the advent of “fractional trading” has been underestimated. What this means for regular people is that you don’t need to buy an entire share of Google, which costs about $1,850. Instead you can buy a tiny sliver of the stock, making it much more affordable for new investors to get started.

Again, let’s think it through: Before fractional trading, high stock prices placed something of a speed bump on trading. A trader with $1,500 in capital wouldn’t be able to wager on Google shares. Now that trader can keep placing bets no matter how high the shares climb.

Robinhood isn’t the first company to make stock market speculation easier

Robinhood calls these phenomena the democratization of finance. Some economists call it “marketability”—admittedly a much more boring word. William Quinn and John Turner, authors of Boom and Bust: A Global History of Financial Bubbles, write that the ease of trading has been a key element over the centuries for bubbles to take shape. They note that these financial hurricanes disappeared in Britain after the Bubble Act, which was put in place after the South Sea Bubble in the 18th century and resulted in the “widespread absence of companies with transferable shares.”

Quinn and Turner’s research suggests that this marketability, or democratization, helps lubricate speculation. Other historical examples include the spread of brokerages in Paris during the Mississippi Bubble in the 18th century. The advent of mortgage-backed securities, which allowed institutional investors to buy and sell mortgages almost like they would a stock or bond, arguably played a similar role in the housing bubble during this century.

The pros and cons of retail trading

In many respects, the surge in retail enthusiasm for the stock market is a good thing. Long-term investments in the stock market have tended to be a wealth generator, and not just for hedge fund managers. It’s also helpful for corporate America, supplying another source of capital for companies to build businesses and hopefully spend on research and development and hiring more workers.

The downside is that financial booms are prone to busts, which can push the economy into a recession and, at its worst, potentially damage the banking sector. When that happens it puts people out of work and destroys savings. The enthusiasm that sucked in a new generation of investors can turn to disappointment and cynicism, undoing the likelihood of regular people continuing to support the economy with their capital. The whiplash can hurt the most vulnerable people in society who had nothing to do with the financial mania.

“If the results harmed only shareholders, one could argue that they should be free to take that risk,” Eric Rosengren, president of the Boston Federal Reserve, said during a virtual conference in November. “The fact is that customers, suppliers, and employees are also hurt by risk-taking behavior.”

There’s no easy answer about where to go from here. But financial history suggests there’s a place for a bit of friction—perhaps in the form of collateral, or higher margins for trading on credit—to provide a brake when trading madness sets in. What’s clear is that financial booms and busts have become more common over the years, and innovations have made it easier than ever for regular people to join in, for better and for worse.

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