Robinhood Markets' initial public offering has been a mixed bag so far. The stock crashed hard after its debut last Thursday, losing 8.4% within hours of listing – the worst performance ever for an IPO of its size. The Financial Times identified concerns about regulation and the fragility of the pandemic day-trading frenzy as headwinds for the stock.
That may have been a transitory swoon, though: The stock bounced back Friday, and Cathie Wood’s Ark, a clear leader of the growth-investing pack, has been buying. As I’ve written here before, I find Robinhood long-term compelling as an investment, given a broad and continuing rise in mainstream investing, speculation and “meme stocks.”
That it looks like a good business, though, doesn’t mean it’s good for society. Critics, including Scott Galloway, a professor at New York University's Stern School of Business, have accused Robinhood of being in essence a form of legalized gambling. Galloway wrote last week that “the company preys on human weakness, in particular young men’s susceptibility to gambling addiction.” The critique is based on Robinhood’s dependence on active trading for revenue, even if that isn’t a good investing strategy overall; and its history of using gamification to keep users hooked.
Part of the risk of a $HOOD position is that regulators will eventually reach the same conclusion and impose restrictions on the business, just as they have with gambling proper. To get a better sense of how regulators might scrutinize Robinhood, then, it’s worth looking directly at the logic behind gambling regulation.
Freedom isn’t free (especially if you’re unlucky)
“Gambling” through Robinhood is legal, of course, because underneath it are stocks instead of a roulette wheel. But to take a step back, why does Galloway regard gambling as such to be a problem? Gambling is, after all, legal in many forms in about 20 U.S. states, and 45 states have official lotteries. For the vast majority of people, games like poker, roulette and slot machines are just good fun, and gambling for money has been part of human society for thousands of years. Most gamblers set budgets, and in investing parlance, bet only what they can afford to lose.
But the decision to legalize gambling is often a painstaking attempt to balance added revenue and personal freedom with some serious and well-known harms. Gambling has addictive properties, and a small portion of gamblers develop “problem gambling” behaviors comparable to drug or other addictions. The North American Foundation for Gambling Addiction estimates that about 2.6% of the U.S. population – nearly 9 million people – have experienced life harm related to gambling behavior. (One reason lotteries are more widespread is they may contribute less to problem gambling behaviors, while capturing revenue for the public sector.)
Those behaviors don’t just harm the problem gamblers themselves. Much like drug addicts, problem gamblers are more prone to behaviors like theft, fraud, domestic violence and unmanageable debt. A 1996 study found that an average problem gambler cost their employer $1,300 per month in lost labor (in 1996 dollars).
Overall, the same study concluded that the costs of problem-gambling in lost productivity, bad debt, criminal justice proceedings and the like totaled $307 million annually for the state of Wisconsin, its area of focus. That amounted to 42% of the revenue generated by gambling operations, leaving just $188 million in annual net benefit to the state after gambling legalization measures.
But neither the costs nor the benefits are evenly distributed. Not surprisingly, the 2.6% of gamblers who have a problem generate a disproportionate amount of gambling revenue – between 5% and 15% of casino, lottery and sports betting revenue, according to research conducted by the University of Chicago. That means a large portion of casino and gambling profits are extracted from individuals who aren't making careful decisions about their risk.
Similar tradeoffs are also true of cryptocurrency. A relative lack of regulation has created both huge new innovations and opportunities for the most savvy investors, and a high level of fraud or bad ideas that are more likely to harm novices. Legislators worldwide are clearly still searching for what they think is the right regulatory balance of risk and benefit.
Fixing market failure
So while gambling may be a net positive for business and society, those least able to control its addictive impacts bear a huge negative burden. And though we’re years away from definitive research, there is every reason to assume that Robinhood’s revenue also relies on the high-risk behavior of a few users.
This is to some extent inherent to day trading, which produces the same sudden, unpredictable jolts of pleasure that make gambling addictive. Robinhood generates more than half of its revenue from options trading, arguably the riskiest offering on the platform. The company has also tried to encourage heavy users through “gamification,” including dropping virtual confetti with a stock purchase and representing stocks as lottery-like scratch-offs. Robinhood removed some game-like features, including the confetti, in March, after Massachusetts regulators late last year filed a complaint targeting in part the app’s “use of gamification strategies to manipulate customers." Both are designed to keep players playing, and seem likely to have the greatest impact on those users most susceptible to problem behaviors already.
It’s also worrying that 43% of Robinhood users according to a data analysis of about 5,000 users by the fintech company Stilt. Credit scores below 670 are considered "fair" or "poor" by reporting agencies, suggesting Robinhood users are either already bad at managing risk or don’t have much disposable income they can afford to lose. Evidence of impacts here is still anecdotal, but it’s not hard to find stories online of novice traders losing all their money on Robinhood.
[Following publication of this piece, Robinhood disputed Stilt’s conclusions, describing the 43% number as “false.” The company sent CoinDesk the following statement: “According to data from Experian based on a sampling of approximately two million Funded Accounts in November 2020, approximately 65% of our customers with Funded Accounts have credit scores of prime or higher, and over 65% have debt to income ratios under 20%.” Prime credit is a classification used by financial institutions and refers to a score of roughly 660 or above. So according to Robinhood’s data, about 35% of its users have scores below 660 – substantially better than what Stilt found.”]
Evidence of impacts here is still anecdotal, but it’s not hard to find stories online of novice traders losing all their money on Robinhood. That suggests that the social costs of Robinhood, like those caused by gambling, aren’t fully captured in the direct costs to users – what economists call a "negative externality." Another classic example is pollution, because the price of something like a car doesn’t naturally capture the harms of dumping its by-products into the atmosphere (this is also an example of the tragedy of the commons). There are also "positive externalities" – education, for instance, produces social benefits well beyond what accrues to the user directly, meaning education will be underproduced in a pure laissez-faire market.
Crucially, Robinhood may also have its own positive externalities. The trading app really does seem to have “democratized finance,” attracting a younger and more diverse customer base than traditional brokerages thanks to its marketing and lower barriers to entry. That’s a benefit to society more broadly through both expanded wealth creation and, more narrowly, because it helps drive more accurate price discovery of stocks. (Yes, that may sound like an insane thing to claim in the wake of huge social bubbles in $GME and $AMC, but in the long run, it’s inevitably true.)
Markets are generally a very good technology for price discovery – it’s what they’re for! – but they’re not perfect, and modern governments generally see it as their role to correct market failure. The U.S. and other governments have almost uniformly stepped in to correct the market’s inability to price pollution, for instance, and to support the production of education.
The novelty of Robinhood’s offering means that legislators will take some time to evaluate its social benefits and risks. But enough stories of users getting wiped out could lead to restrictions. They wouldn’t simply parallel gambling rules, which have generally been based mainly on geographic restrictions.
Instead, Robinhood could find itself restrained by limits on gamification, or higher educational or credentialing requirements for accessing certain products. Much like the rising tide of restrictions on cryptocurrency, that could prevent some harm as well as some amount of good. Whether regulators get that balance right or not, such measures would certainly restrict Robinhood’s revenue, and that worry may hang over the stock for years to come.
UPDATE 8/4/2021, 19:15 UTC: This story has been updated to reflect that Robinhood removed the “confetti” interaction in March 2021.
This piece has also been updated with a statement from Robinhood about its customers’ credit scores.