Robinhood, one of the major mobile investing applications, recently came under scrutiny after several traders were able to artificially inflate their investing accounts using “infinite leverage”. That’s right, thanks to a glitch in Robinhood’s system, several traders discovered a way to turn their small initial deposits into millions thanks to a glitch that allowed them to trade with essentially an unlimited amount of borrowed cash. This glitch highlights the dangers of using a startup brokerage company for your investing goals. It also reveals just how quickly things can go bad for a startup fintech company.
What is Robinhood?
Robinhood is one of the hottest fintech companies on the market. It is extremely popular with Millennials and new traders that are interested in getting involved in the market. Robinhood rose to prominence for being the first online brokerage company to offer commission-free trading. However, that competitive advantage disappeared after all of the major brokerage firms decided to offer commission-free trading as well. Robinhood still remains a popular option in the investing community with over 6 million current users. It’s a company that has actually been under scrutiny from regulators before, yet venture capitalists still view the startup as a potentially lucrative opportunity.
How Were Traders Able to Leverage the Glitch?
The glitch that allowed users to build massive positions with minimum initial investments was only applicable for Robinhood Gold users that had access to margin. Buying securities on margin is a common practice in the trading world. Margin is essentially money that is borrowed from a brokerage firm in order to purchase a security. The securities and cash in an account are used as collateral for the margin loan. Investors pay interest on their borrowed funds with the goal of making a higher rate of return with a successful leveraged trade.
So, how exactly were Robinhood traders able to leverage the glitch in their favor? First, the traders sold call options with money borrowed from the application. The glitch then incorrectly added the value of the options that were sold to the user’s purchasing power, allowing them to exploit an inflated purchasing power. One trader was able to leverage $4000 into $1 million dollars of borrowed funds by taking advantage of the application’s glitch.
The bug was quickly brought to Robinhood’s attention and has since been fixed in an update, but not before several users were able to create gigantic leveraged positions. Technically, these traders could be committing securities fraud with the loophole, but it remains to be seen if the SEC and regulatory authorities will take legal action. All of the accounts known to be exploiting the glitch are limited to position-closing trades only and that negative balances must be settled within 60 days. Robinhood could be facing a fine from regulatory authorities thanks to this oversight. The startup’s losses from the glitch are estimated to be right around $100,000.
The Danger of Making Investing Like a Game
This issue highlights the danger of making investing like a game. Robinhood is an application with a sleek user interface and ease-of-use that makes investing seem simple to a fault. It makes the barriers to investing low, which can certainly be viewed as a good thing. However, the way that the application is set up and allows users to easily enter into highly speculative plays like options trading might not be the best thing for the market overall. The risks and complexities of trading options are seemingly downplayed thanks to Robinhood’s design and focus on creating a “fun” experience for their clients.
It’s great that younger generations are learning about investing and trading thanks to applications like Robinhood, but Robinhood also has a responsibility to prevent their clients from entering into trades and leveraging their accounts in irresponsible ways. Case in point this glitch that several traders took advantage of. The application basically made committing securities fraud to seem harmless and inconsequential.
This glitch puts a spotlight on up and coming brokerages like Robinhood and the future of investing. Entering into highly speculative trades on margin comes with massive amounts of risk that can lead to financial ruin. For Robinhood users, it’s all too easy for their clients to enter into advanced trades. We don’t know the long term ethical and legal impact of companies like Robinhood, but we do know just how important it is for regulatory authorities to keep a watchful eye on them.