Welcome to our much anticipated first episode of 2021, and what a start to the year it has been.
Last week was a train wreck as Gamestop, which was initially bid up by Redditers in an attempt to punish Wall Street, crashed back to earth when the very free brokerage platforms that purport to democratize investing for the 99% shut off trading in the most active stocks, benefitting hedge funds at the expense of retail investors.
As wild as the events of the week were, they are merely a symptom of something much deeper: latent hatred for Wall Street and the traditional financial system that repeatedly and seemly unfairly rewards a small number of people at the top.
Precisely because of this feeling that the system is broken and doesn’t serve the people, fintech is flying. Robinhood, Chime, Cash App, Coinbase, Affirm and Klarna have built insane user bases, because they are catering to huge swaths of Americans left behind by the incumbent industry.
These companies are the future of retail finance in America for sure. What will their impact be?
We’re joined by Lex Sokolin to discuss these topics, in an episode produced and published together with Fintech Blueprint.
So we are in a weird moment. I think the last several years have been a weird moment. Maybe the last 20 years have been a weird moment. But we’re in a particularly weird moment and I’m sure that our listeners have been saturated with a discussion of GameStop and Robinhood and the exposure of financial market structures. But I think we can add to this conversation and I think we can paint a broader picture of what’s going on after all this fintech has come together and has transformed the consumer fintech experience.
So for context, the very last bit on the GameStop saga is that Robinhood raised 3.4 billion, $3.4 billion, and is looking for another billion dollar debt facility so that they can continue to allow Reddit to speculate on GameStop. What do you think about this whole situation? What is going on in the first place?
All right, so I don’t want to jump straight into highest level concepts. I think that a little bit of context is still useful. I’m sure that you’re right that a lot of people listening to this have been following closely. In fact, they’ve probably been investing, or more likely their kids have been investing, you know? Their middle school and high school aged kids. So when you see them driving up in new cars, you’ll understand where it came from.
So, this is what? It’s effectively, call it a continuation, but a very extreme continuation of the idea of kind of distributed thinking power back to the people using the internet, and increasingly, I guess, internet plus good cheap technical infrastructure and technology products, which in a sense democratize access.
In fact, we’ve been talking about democratizing access to financial services and investing in banking probably for a long time, certainly since 2008, when the problem was concentration of effectively power and decision-making and risk-taking, bad alignment of interests, and too big to fail. That was followed by the anti-1% movement, Occupy Wall Street.
Where my mind goes directly in watching all of this, and I fully understand why this is so fascinating. I tend not to be the type that that watches car wrecks with great excitement, but this, there’s something about this, which I think is more than just immediate carnage. You know? I think it’s something of a, I don’t want to call it a watershed event because I don’t think the event in itself is what’s going to cause change, but I think it’s a very strong indicator of much deeper shifts in financial services that pulled together so many of the topics that we talk about, which is better products for retail users, better technology, better access, cheaper access, and all of that kind of coming together to challenge incumbent market structures.
Yeah. So to your point, let’s just lay the bricks. GameStop is a physical retailer of video games, often used video games that lots of eighties and nineties kids grew up with and love. GameStop has a horrible business in the same way that Blockbuster or Barnes & Noble or Borders or Kmart, at this point, have a horrible business, which is it is not the Epic video game store or the Steam video game store where the action really is. Therefore, if you are a quote-unquote serious financial investor and run a multi-billion dollar hedge fund, you go out and you say, I’m going to short GameStop because it’s going to die like the rest of these terrestrial mall shops.
That goes well until a Redditor sees your position and realizes it’s not based on the fundamentals of GameStop’s economics, but on just the sort of the amount of exposure you have to the stock and the mechanics of shorting, where you need to borrow the stock in order to sell the stock and make the price go down. This person realizes that it’s possible to create a short squeeze or an artificial price increase against the person with a short position who’s paying interest, who’s generating losses, and getting margin calls.
So not only does this Redditor invest, but also the entire Reddit forum of r/WallStreetBets backs this idea and people start to do the short squeeze by the millions. Other hedge funds realize that, come on, the fundamentals don’t work and continue to pour money against, say, the common investor, which only pisses everybody off and then the Reddit movement is less about GameStop and it’s much more about just the anger and resentment from 2008 that people have held through these various incendiary presidential administrations and so on and it becomes a symbol. So people through the internet self-organize to send a financial message and basically overpower the tug of war with Melvin Capital and some of the other backers like Steve Cohen and so on.
Now, what do they use to organize? They use social media. What do they use to trade? Well, of course, they use Robinhood to trade. Robinhood.
Perfect name, right? Perfect name. I mean, designed for this, built for this, right?
It’s just so funny to me because, and I’ve said this elsewhere, but Robinhood is not Wall Street. Robinhood is a Silicon Valley company to the bone. This is not about Robinhood and Wall Street. The two are just different. Silicon Valley gives away things for free and then monetizes the users on the backend, and so Robinhood’s sort of take from the rich and give to everyone mantra, not a really good fit for this particular Robinhood because this particular Robinhood takes the rich and sells to the rich all of the retail order flow so that hedge funds can place orders within it
We can have a whole separate conversation around that, but in this case-
Well, it’s the classic if you’re not paying for the product, then you are the product.
I think that applies to retail investors on Robinhood.
Yeah. Look, this is not nefarious, like advertising is not nefarious, it’s just a business model that sucks for the consumer. Similarly, selling order flow doesn’t have to be nefarious, it’s just you have to understand what it is that you’re getting into. I mean, maybe just go to another broker that doesn’t sell order flow. It’s your choice. But regardless-
Yeah, typically, it is, right? Like I do want to dig into this point because I think it’s relevant.
So from memory, you were the one who called it out to me two months ago about, I think it was, I mean, it was a hundred million plus, I think, that Robinhood had generated in one quarter, maybe, in basically revenues associated with the order flow slash kind of anonymized trade data and trend data, I guess, that they were selling to basically hedge funds and high frequency trading firms. Am I remembering that correctly?
Yeah. So the numbers are quite severe. Robinhood probably made over a billion dollars in order flow payments in 2020. Now, if you dig into the market structure, again, it’s not really nefarious, it’s just market structure. So you’ve got the exchanges like the NASDAQ or the New York Stock Exchange, and on top of those exchanges, you have market-makers, which make sure that there is a market to buy and sell various securities.
One of those market makers is Citadel Securities, Virtu Financial is another company, and if you talk about high-frequency trading shops and things of that nature, they’re basically on top of exchanges taking orders and the way they make money as they take spreads. So they take a tiny spread on everybody’s transaction.
Now, if you’re in that business, you’re not taking a long or short position, you just want to execute the trades and you might pay 10% of your P&L to purchase order flow because you get to keep some of the spread. You can have sort of more cynical reads. I don’t agree with all of the cynical reads, but you could say they’re buying order flow in order to front run it, which is a conspiracy. Or you can say, which I do believe, they’re buying order flow so that they can hide larger trades in there. They can put block trades, a $50 million trade of Apple, without impacting the stock market, you can basically place into a giant stream of retail payments.
So for a market maker, paying Robinhood to be the lead gen makes a lot of sense. Again, you can be cynical with it, you can be conspiratorial with it, it’s just today’s market structure. So that’s where all of Robinhood’s economics essentially come from.
I think given the history, right, like dating back to 2008 and way way before that, the onus is, in a sense, on the financial industry, and these larger players, specifically, to kind of engender confidence that what they’re doing does make sense for everyone and it’s not self-serving and it’s not purely kind of self-interested and profit motivated in ways that are manipulative. I don’t tend to be the kind of frontline revolutionary in a lot of this stuff, but I absolutely understand the frustration of the retail investors. I think, maybe, we get back into it by picking up the story and how things evolved.
Basically, what happened is that due to, again, these market structures, and specifically clearing houses and collateral requirements at clearing houses, these same quote-unquote democratized platforms that were allowing retail investors to access stocks like GameStop to begin with then basically had to shut down the ability for retail investors to build positions.
What was happening, in effect, and where a lot of the conspiracy theory then comes in, is basically GameStop was on this run fueled by retail investors buying through platforms like Robinhood. So basically what happens is this run-up fueled by the Reddit forums that you’re talking about and the free stock trading platforms which is squeezing to the point of near bankruptcy, in some cases, perhaps, bankruptcy, of hedge funds that are short in the stock, effectively, the run-up gets artificially cut off because access to new buy orders is cut off for retail investors.
So the people that are driving this run-up, the people that are putting money into these stocks, are effectively prevented from continuing to do so, which then gives oxygen back to the hedge funds on the other side, who took the opportunity to effectively recover. Then, as expected at some point, the valuation of the company returns to at least some semblance of normality, meaning that retail investors take losses, at least those who were still in the stock, and the hedge funds are quote-unquote bailed out.
Sure, you talk about it’s the market structure, it’s the way things are designed, and they’re designed this way because it’s supposed to help everything work better and it’s supposed to help limit systemic risk, and the whole reason that this whole kind of piece that I just described happened is because of these collateral requirements at clearing houses, which are intended to ensure that large brokerage firms, like Lehman back in the day and this time Robinhood and others, don’t go out of business causing knock-on bankruptcies and instability across the industry. But now, perhaps, we get to the bigger question, which is, in a sense, is this inherited market structure from the past, from a much less cloud-based, API-based past, is it the right market structure, will it continue to be the prevailing market structure going forward?
Yeah. I think sometimes people will say kind of market structure as a flag for this opaque industry value chain, and I think in this case, we can have a very reasonable intuition of just what’s going on. That it is not an intuition, but which still creates outcomes that makes people feel like the oligarchs always get to win. You know? So why does the DTCC, the clearing house, which is where all of these equities live, why does it need collateral?
It needs collateral because trades take two days to quote-unquote settle. Everything else is sort of a rearrangement of paper. The truth is at the clearing house, the truth about who owns what. So if it takes two days for a trade to complete, for the equity to transfer ownership for the cash leg, the cash piece, to move from one person to another and everything to kind of check off and get reconciled, and it takes two days to do that, you’ve got two days of risk. You’ve got two days of if everybody dies, who owes what to whom?
Lehman and Bear Stearns and almost Merrill Lynch had these death or near death experiences as a result of that gap, that time of uncertainty, and therefore, like you said, there’s an insurance pile. You basically keep money at stake as collateral to have your brokerage house be alive. The moment people think that you’re not going to be alive, they’re going to take that collateral, and if you don’t have enough, you’re dead, because you’re over-levered and so on.
So Robinhood raising $3.4 billion, on the one hand, it’s like, oh man, these guys sure know how to fundraise and grow a profitable business, the other take is, oh man, if they don’t have 3 billion to put up, because they have 10x the collateral requirements for DTCC, they’re dead. Now from the outside, it’s hard to know, it’s hard to tell, but it’s up to our audience to drive to their own conclusions.
So as it relates to modern market structure, at this point, I’m pretty self-radicalized about the answer, but there are the real time trade settlement systems. Blockchain has been talking about changing collateral management and clearing and settling now for nearly five years and lots of people rolled their eyes about why would an industry want to strip out what works, quote-unquote, and put in something new? So it’s been very hard to actually get a blockchain infrastructure in place.
I guess the answer, based on this specific series of news events, is that it doesn’t work.
It doesn’t work great, yeah.
Hence the opportunity for improvement.
Yeah. It’s the sort of caricature, the cartoon, that I’ve drawn about it before is you can’t build a Spotify of CD-ROMs, which is what Robinhood is, if it uses the DDCC. Every single broker. It’s not just Robinhood that turned off the trade button, it was also TD Ameritrade, and it was E-Trade, right? All the brokers that are in this game. Robinhood just happens to have the most cognitive gap between its promise to its users and its behavior.
So we do have answers in the shape of blockchain-based market infrastructure, and the clearest sort of test of that is decentralized finance, which has not waited for equities and has just created its own digital assets. I believe Uniswap, the decentralized exchange, had $60 billion worth of volume that’s traded around with all real-time settles. There are lots of problems in defi to be discussed separately, but I think this example is just so educational for what doesn’t work about the current setup.
All right. So let’s use this as an opportunity to pivot into the larger point, which is a point you were making to me right before we started recording. Do you want to dive in and summarize it?
Yeah, let me tee it up as both a rhetorical statement and a question as to what you think. So there is a new American finance forming. We know what the new Chinese finance looks like in the shape of Alibaba and mobile payments and all that. We have not known what the new American finance looks like because the Betterments of the world, the SoFis of the world, despite being nice, solid businesses, did not seem to be too upsetting to the BlackRocks and the Vanguards and the Goldman Sachs’s. But I think what we see now is finally an emerging new American finance, and so what does it consist of?
It consists of fintechs, B2C fintechs, that have all footprints of over 10 million users, right? So you take Robinhood, you take Chime, which is now over 12 million people, you take Square and Stripe and Affirm, and of course, Coinbase, with its 40 million people. To me, this collection of five to ten companies represents the formative experience for anybody between the ages of 8 to 25 interacting with financial products today. So I think it’s starting to coalesce together, and the question, I guess, is what does it look like in five years? Is the average person just going to live inside of this ecosystem? Do you see that happening and do you see any pitfalls?
Okay, I’ll try not to jump straight to the second part of your question. But look, in terms of the first part of the question, this is everything that we, as fintech, have been talking about since the very beginning. This is finally like, oh, hey, there are much better tech and software solutions to solving all these traditional finance problems. Specifically, I think what we’re talking about is the set around retail, finance, and, specifically, like the quote-unquote last leg where users actually interact with these companies and these products.
In my mind, it kind of split it into two pieces. One is basically providing access or products or tools or whatever to previously unbanked or underbanked. I think that Chime and CashApp are doing a ton of work in that space, and I’m very hopeful that that on-ramp for large numbers of people, you talk about Chime now having 12 million customers, I hope that becomes an on-ramp to a better future, to more opportunities, to continued financial education for everyone, and eventually to long-term financial wellbeing to everyone. I hope that doesn’t become an acquisition channel into high interest lending credit cards and things like that.
Can I just pause you here on Chime, because I think you’re much deeper on them than I am? They’ve really broken away in a way that square has broken away from Venmo in tapping into payments and really tapping into culture and influencers to drive payments. Chime has broken away from nearly every other attempt in the US at a neobank. They’re ahead of MoneyLion, they’re ahead of Aspiration, they’re ahead of, really, anybody else who’s tried to do the same. Why? What is it that they do that you think works?
So this could probably be a 50-page research report and series of financial models and various other things, but if I distill it in my own mind down to two things, it’s great technology and savvy marketing.
I think it started with great technology. Of course, great technology subsidized by the non-Durbin uncapped interchange, which everyone was using and is using. So it’s not like that was unique to Chime. But I think they did a great job of capitalizing on a market opportunity, building great technology, communicating a value proposition to customers, tapping into a segment that was underserved, and then very quickly from there raising tons of money, including from some influential people, and turning that money into a very, very, very effective national marketing effort. So everything from sponsoring the Dallas Mavericks to TV commercials, they’ve just done an amazing job of getting their brand out.
Then I think there’s also a component which is specific to the product set, and I’d have to dive back into it and refresh my memory a little bit, but the combination of get paid two days early, which they were one of the early companies to do, certainly, at scale, and I think they have basically kind of an overdraft alternative, free overdraft alternative. I think that combination really, really resonates and solves a lot of problems for a large number of people in America.
It just always boggles my mind what works in the States. Just the kind of national population and the kind of average financial situation you need for a overdraft financing product to be a core driver of neobank adoption, it’s almost tragic, right? Because overdraft protection is a loan for when you don’t have enough money, and to have so many people that are living always on the edge of needing just a little bit more money than they have, I mean, that is tragic at scale.
Chime has got 12 million people who benefit from this, so I do think it’s kind of going to this concept of a new American finance, where you have the Chime users who are on the edge, and then you’ve got the Robinhood users who are, we know from the Melvin Capital example, right, just like how much resentment there is against Wall Street and the hedge funds. It’s a scary power. It’s really a whirlwind.
Yeah. I mean, we look at this from the most hopeful, the most optimistic standpoint. Chime and Robinhood and, I think, the other companies that you mentioned that are really, really scaling fast now are providing that alternative that I think people, again, at least since 2008 and probably before, have been craving. The reason that people have been so angry for so long, and again, ala GameStop, it’s still there, is because the existing offerings, the existing marketplace, the existing industry doesn’t serve their interests or meet their needs.
That simple stat, right, that gets thrown out all the time, and I think actually some improvement has been made from the version that continues to, or at least originally, caught headlines, it’s something like 50% of Americans don’t have $400 in savings. For that stat to be true, something is broken, you know? I think Chime, and Robinhood, and Square, and these other companies you mentioned, are part of the solution. At least they have a huge opportunity to be part of the solution. I think they filled a space in the market and they filled it with products that people need.
Now, the opportunity, if we’re to move beyond, in many ways, as you mentioned, the stressed situation, financial situation for a lot of Americans, the opportunity is to turn that into financial education, financial literacy, better access to credit in ways that serve users, and eventually long-term financial wellbeing, right? It’s not to turn that into high interest credit cards and unsecured consumer debt and types of traditional financial products that kind of got us where we are now in the first place.
Yeah. Look, I guess I was professionally raised in an asset allocation diversification environment and I’ve internalized the importance of financial planning in the wealth management space, the importance of risk-adjusted returns, the damage that speculation can do to achieving goals in the long run, the problems of lotteries and options and all of these things, and so it’s a weird moment, right? Because I look at what’s quote-unquote popular, and it’s a lot of moonshots, it’s a lot of underwriting debt, it’s a lot of kind of speculative trading, whether it’s Tesla or crypto, and I think it reflects the financial situation that the country is in.
I think one of the biggest symptoms is Coinbase. I think in 2012, if you were to ask me this question, I would have gotten it 100% wrong, right? Is the future of American asset management or wealth management, is the future of that something like Betterment or Wealthfront, which is floating at 25 or 30 billion of assets, or is the next generation going to be buying digital assets on Coinbase, which is now at 90 billion in assets? Of course, the answer in 2012 would have been Betterment or Wealthfront, and it was wrong.
The answer is clearly Coinbase with its 40 million users and absolutely astounding rise to what is likely over a billion in revenue last year and an IPO that’s going to, it’s not an IPO, it’s a direct listing on the NASDAQ that’s going to hit this year and I think in the private markets Coinbase is trading around 50 billion in enterprise value. I think it’s just as big as symbol of the change in the underlying consumer preferences as you can look for. I think it’s a super bright signal.
But I wonder if I’ve just self-radicalized, if I persuaded myself of this happening or whether you think that’s right and you see it as well?
Okay, so it’s extremely difficult to argue with reality and the reality you just laid out. I guess the questions I would ask are around the kind of, I don’t want to call it a problem to be solved, but like, what is the point of investing and like what goals are people theoretically trying to achieve by investing, and then what are, given all those inputs, the best ways of doing that? I think it’s very clear that kind of over-intellectualizing just gets you to, I don’t know, either the kind of like private wealth model where there’s this like asymmetric information set up which results in high fees or the assumption that super-complex self-rebalancing passive portfolios are the only or optimal solution.
I think both of those things kind of take less account for the human psychology, maybe, than they should, you know? I think if only account for the human psychology, then it’s easy to get to speculation. I think, especially if you look back over the past 10 years of, maybe it’s more than 10 years now, kind of like stock market bull run, especially in technology, I, like you and many of you are surely listening to this podcast, am totally convinced that the future of finance and future of the world is increasingly digital. So it’s tough not to view all the companies that are doing great work in that space as being highly valuable, even on like a discounted cashflow basis, traditional investment valuation type base.
That said, the world moves in cycles. Ideally, we collectively should be accounting for these things and not just, I guess, looking for investment solutions that happen to be high-performing over the past few years. God, I sound like my dad.
We are all our dads at this point. Look, I did a write-up on this topic earlier this week and it got picked up by Zero Hedge, which is exciting to get the exposure, but then I looked a little bit more into the demographics of Zero Hedge and it’s like the anarchist libertarian right-leaning sort of internet wave, the same part of the Reddit wave, with a perma-bear point of view on the economy, which is that the Federal Reserve is over-printing money. Which it’s hard to argue with on the one hand because of the 3 trillion last year, on the other hand, nobody’s spending that money because inflation is not going up, instead they’re putting it into capital assets like the stock market and certainly into crypto assets. So that leads to the conclusion of these inflated prices and kind of a wealth effect and a disconnect from quote-unquote fundamentals and a manipulation of the machinery of money.
I just found myself articulating these views which maybe are conspiratorial, and I worry that I’m sort of falling off the cliff a little bit in my points of view. But it definitely feels like the price levels of everything are super high and thinking about risk adjusted returns and thinking about the longterm would really serve investors well, especially as we kind of pick up these topics of financial health and financial literacy and so on.
So I guess the balances for this new American finance are it has democratized access, everyone’s got everything for free now from credit to trading and so on, but it also creates this whirlwind, this kind of Twitter version of financial services.
Look, my take away from this conversation and the events we’ve observed recently, they’re just clearly such strong underlying forces here which make it very clear that things need to and will move in different directions than they have in the past. It’s tough to perfectly predict, I guess, what’s going to be new versus the kind of age-old adage of history repeating itself and kind of reversion to the mean, especially around all things economic, but it fundamentally feels like things will continue to look the way they do now and increasingly different in the future.
As in using whatever 1990s or early-2000s frameworks to think about retail finance, investments, banking, the whole kind of financial services universe. It feels very limiting.
I totally agree with you there. I think it’s definitely a wake-up moment for a lot of the traditional financial incumbents who are serving these customers, or different generations of these customers. I think the one place that a lot of institutions often go is they start talking about the institutional client segments and the wholesale business and the large capital markets machinery, and I think it’s important to understand that that machinery, that capital market structure, to make big funds and to do trades with other institutional money managers, that is all a value chain that at end of the day ends up benefiting some particular individual, whether it’s a holder of a 401k account or a holder of a deposit account. Even our kind of high-end institutional finance feeds and stops at the end with people. So we have to very closely watch what people choose, what systems they prefer, and what incentives they like.
Thanks so much for joining me for this conversation, Will. Fascinating stuff.
Thank you, Lex. This was great.