By: Kirk Kaczmarek

Stock Exchange, Boom, Economy, Pay, Percent, Plus

I clicked the YouTube link, and my phone screen showed the stock portfolio of reddit user u/ControlTheNarrative. His face was stoic in the upper right hand corner of the screen as he showed viewers his 358 contracts for Apple stock valued at $57,684. The clock struck 9:30 AM, and the market opened. u/ControlTheNarrative audibly gagged and closed his eyes in disbelief as his portfolio value immediately plummeted to -$2,600.[1] u/ControlTheNarrative was one of a handful of amateur investors who exploited a glitch to obtain “infinite” leverage when trading on Robinhood in late October 2019.[2]

 

Robinhood is a free stock trading app that allows unsophisticated investors easy access to the stock market.[3] Among the services Robinhood provides is the ability to buy stock on margin.[4] When you buy stock, you simply exchange money for a share of stock. When you buy stock on margin, you borrow money from a broker to purchase the stock, offering your own cash or other securities as collateral; this is called leverage.[5] Robinhood also allows users to sell covered calls, which is a contract for the sale of stock set at a certain price before a set time.[6]

 

Robinhood allowed users to buy stock on margin at a 2:1 debt to capital asset ratio.[7] u/ControlTheNarrative and others would then buy stock on margin, and then immediately sell a covered call on that stock at a price slightly below what they just paid.[8] Normally, a broker would see this transaction and either recall its debt or at least refuse to issue a new loan.[9] Because of a glitch in the app, Robinhood did not behave like a normal broker. Robinhood combined the stock value and covered call value to effectively double the user’s assets.[10] u/ControlTheNarrative and others took advantage of this glitch by using their falsely inflated asset values to buy more stock on margin at a 2:1 ratio without any limit, thus obtaining “infinitely” leveraged positions.[11] Unsurprisingly, this scheme failed spectacularly, leaving the amateur investors severely in debt.[12]

 

Although Robinhood has seemingly run afoul of consumer protection law, it has not suffered legal consequences resulting from the infinite leverage incident.[13] And strangely, while Robinhood has not paid out any ill-gotten gains to users who may have benefited from the glitch, it may still hold liable investors like u/ControlTheNarrative who lost money.[14]

 

Robinhood’s commission-free investing business model is risky, because amateur investors may not behave in ways that do not conform to industry norms. At least two people in addition to u/ControlTheNarrative were able to leverage up to $1 million based on initial capital of only $4,000 and $15,000 respectively.[15] Sophisticated investors may not have taken such outlandish bets. But the risk has not stopped established firms from adapting Robinhood’s model. Charles Schwab and Fidelity removed trading commissions in October 2019.[16]

 

When software glitches can cause such gross investing mismanagement, brokerage firms ought to be held accountable. However, the SEC ought to also exercise caution in issuing new regulations for fear of stifling access to the stock market for amateur investors. Rather, the SEC should enforce consumer protection laws already on the books, while firms should beef up their insurance to protect from future technical failures.

[1] GG Boys, Guy loses $50k swinging during earnings on Robinhood, YouTube (Oct. 2019), https://www.youtube.com/watch?time_continue=0&v=d80ahvRSV8E&feature=emb_title.

 

[2] See Edward Ongweso Jr., A Robinhood Exploit Let Redditors Bet Infinite Money on the Stock Market, Vice (Nov. 6, 2016, 12:48 PM) https://www.vice.com/en_ca/article/gyz9kj/a-robinhood-exploit-let-redditors-bet-infinite-money-on-the-stock-market.

 

[3] See Robinhood, https://robinhood.com/ (last visited Jan. 24, 2020).

 

[4] See Supercharge your Investing, Robinhood, https://robinhood.com/about/gold/.

 

[5] See What is Margin?, Robinhood, https://learn.robinhood.com/articles/3ya72NeLXpiAvpV5QPQVl6/what-is-margin/; and Adam Hayes, Leverage, Investopedia (Apr. 24, 2019), https://www.investopedia.com/terms/l/leverage.asp.

 

[6] See Placing an Options Trade, Robinhood, https://robinhood.com/support/articles/360001227566/placing-an-options-trade/; and Akhilesh Ganti, Covered Call, Investopedia (Oct. 14, 2019), https://www.investopedia.com/terms/c/coveredcall.asp.

 

[7] See Modern Wall Street, Turchman: “Someone hacked Robinhood, bet against Apple & now owes $150,000”, YouTube (Nov. 6, 2019), https://www.youtube.com/watch?v=1SqeS8nSZA0&feature=emb_title.

 

[8] See Ongweso Jr., supra.

 

[9] See Modern Wall Street, supra.

 

[10] See Ongweso Jr., supra.

 

[11] See id.

 

[12] See id.

 

[13] See Regulators could punish Robinhood for glitch (CNBC television broadcast Nov. 6, 2019), https://www.msn.com/en-us/news/videos/regulators-could-punish-robinhood-for-glitch/vp-AAJXirx.

 

[14] See id.

 

[15] See Ongweso Jr., supra.

 

[16] See Kate Rooney, ‘Infinite Leverage’ – some Robinhood users have been trading with unlimited borrowing money, CNBC (Nov. 5, 2019, 1:43 PM),  https://www.cnbc.com/2019/11/05/some-robinhood-users-were-able-to-trade-with-unlimited-borrowed-money.html.

 

image source: https://pixabay.com/photos/stock-exchange-boom-economy-pay-3972311/

 

 

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