Are share-trading apps a safe way to play the markets?
A year ago shares in struggling US video game store GameStop were worth just $3.25 a pop, yet at the end of last month they had reached $482. This stupendous surge was created by thousands of armchair traders, organising themselves on internet forums such as Reddit, who were attempting to outwit hedge funds who had placed massive bets on the chain’s decline in a process known as short-selling.
This has resulted in billion-dollar losses for some hedge funds, and big profits for traders who cashed out before the stock fell back to less than $100. Many of these speculators were using a new generation of share-trading apps, such as eToro, Robinhood and Trading 212. Have these services tipped the scales of financial power in favour of the little guy? Here we answer some key questions …
What’s the difference between these new apps and an established platform, such as Hargreaves Lansdown?
There are two main differences between the new breed of trading apps and old-fashioned brokers. One is the cost, the other is the market. Apps, from Robinhood to Trading 212, have broken ground by offering trades “feefree”. That’s a big difference from before, when an old-fashioned human broker would take a substantial cut for providing trading services and even newer online services – so-called eBrokers – would charge a flat fee per trade.
Just as important is market access. Until recently, most small investors focused on buying and selling equities (shares), bonds (loans to companies and governments) and funds that aggregate bundles of tens or hundreds of other financial products.
Trading apps broaden that out substantially. At one end of the spectrum, a growing number, including Robinhood and eToro, allow or even focus on trading cryptocurrencies – digital assets such as bitcoin, Ethereum and Monero – which tend to be very volatile. For those who want to stick with comparatively simple equities, the apps also offer financial tools that can increase the risk – and return – of bets, from buying on margin (taking out a loan to buy extra shares) to the world of options (bets that a particular stock will rise or fall a certain amount). These pay off handsomely if they’re correct, but are wiped out if they’re wrong.
Does it matter that all this is bundled together in a smartphone app?
Surprisingly, it does. New research published by America’s National Bureau of Economic Research suggests that giving people the same trading abilities in an app as on a website or desktop computer affects how they trade. By following people who had access, through two German banks, to both smartphone and website trading, economists found that trading on a phone was likely to result in riskier decisions and encourage people to chase past returns – buying assets that were already near the top of the market.
Those changes persisted even if the smartphone traders went back to their computers, suggesting that access to markets in their pocket fundamentally changed how they thought of day trading.
One of eToro’s headline features is the ability to “copy” the trades of influencers on the platform. Why would you do that?
Depending on who you listen to, there are a number of answers as to why you would do that, rather than entrust your money to fund managers with experience, qualifications and legal oversight. The influencers argue that users avoid paying the fund a fee and that by following influences who have real skin in the game – their own money invested in the trade – investors should expect better returns.
A more cynical approach argues that if enough retail investors move in concert they can ultimately change the price of an asset, as seen in the rise and fall of GameStop’s share price. Of course, knowing when to sell is harder.
Some of the financial instruments users can invest in are quite complex – is that wise?
Robinhood has repeatedly come under fire for the ease with which users can become hooked on – and then very rapidly lose a lot of money to – complex financial instruments. Take stock options: if you buy a stock for £20, and it rises to £25, you make £5; if it falls to £15, you lose £5. But if, instead, you spend £20 on buying 20 “call” options that guarantee you the right to buy the stock at £20, and it then rises to £25, you’ve made £100. But if you buy the call options and the stock falls even a single penny, you lose everything.
The outsized risk and reward have earned the app criticism for being closer to gambling than investing. That is compounded by the fact that some users may not fully understand the products they’re buying – with tragic results. In July, 20-year-old day trader Alex Kearns killed himself after apparent confusion over a negative balance on the app, which suggested he owed $730,000.
Some of these platforms offer commission-free trading, so how do they make money?
The platforms argue – truthfully – that they keep their overheads low and that fees for trades were obsolete already, given the declining cost of operating in an all-digital market. And even for old-fashioned brokers, the main sources of income weren’t what you might expect: the cash float in customer accounts alone generated 57% of the net revenue of American broker Charles Schwab in 2018, for instance. That’s money that customers have deposited to buy shares, but have not yet used to make a purchase (or perhaps money they earned from a share purchase, but have not yet cashed out). The broker doesn’t pay an interest rate on it, but gets interest on the same money as it sits in its own accounts.
The more controversial revenue source is payment for “order flow”. This sees large market makers – traditional City institutions who profit from the difference between the buy and sell price – pay retail brokers for the right to take their orders. The rationale is simple: if your job is to buy and sell stocks and a huge hedge fund asks you to buy £1m of a stock, you’re immediately going to be suspicious. What do they know that you don’t? What’s going to happen to the price of the stock after you agree to go and buy it for the hedge fund? But if a retail broker asks you to buy £1m of random stocks picked by disparate clients, you have no such concerns: it’s going to be much easier for you to get a good deal on those stocks. In fact, it’s going to be so much easier that it’s worth paying them to do it.
But that financial relationship has caused unease over the past week. Citadel, a large American market maker, pays Robinhood for its order flow, for instance, but another arm of Citadel is directly invested in one of the hedge funds that was taking the other side of the bet over GameStop. When investors spotted the apparent conflict of interest, they cried foul and now Robinhood, rather than trying to help the poor or save Maid Marion, has spent a week trying to convince its customers that there is nothing untoward in its relationship.
As these app-driven commotions destabilise stock markets, could they have an impact on real-world finances, such as the banking system, the value of pension funds and interest rates?
The GameStop bubble, which really did cost some large hedge fund billions, suggests there are some new forms of systemic risk that the financial sector needs to deal with. In a way, the industry is seeing the same transformation that politics and the media have seen over the past 20 years: the discovery that huge numbers of people, coordinating themselves on platforms such as Reddit and Twitter, can become a force that is as powerful as the old institutions.
It’s easy to see how such coordination could have far more damaging effects than a temporary bubble in a few “meme stocks” that cost certain hedge funds a lot of money: a deliberately coordinated run on a bank, an attempt to crash the exchange rate of a sparsely traded currency, or even a full-blown distributed takeover attempt could all have after-effects that would rock the real economy.