Written by Norman Isaac Mwambazi

Robinhood still expanding risky stock market lending ahead of IPO

On Tuesday this week, popular online stock brokerage Robinhood confirmed that it has begun the process of selling shares in …

On Tuesday this week, popular online stock brokerage Robinhood confirmed that it has begun the process of selling shares in the company to the public for the first time.

In a blog post, Robinhood said that it had filed confidential paperwork for the Initial Public Offering (IPO) with the Securities and Exchange Commission (SEC) and that the regulator is reviewing its registration. However, the company did not divulge details when exactly it will go public.

According to a separate filing to the regulator earlier this month, Robinhood reported that its lending to help customers buy stock “on margin” rose by $2 billion in the second half of 2020. This is where someone borrows money to buy stock, options, or other securities hoping to boost their investment returns.

Robinhood had $3.4 billion in outstanding margin loans as of December 31, 2020; which is more than 400% higher than it had outstanding by the same time in 2019, at $650.

Launched in 2013, Robinhood has become popular especially with young investors because of its commission-free trading through an app making it the go-to choice for Millenials and Gen Z consumers who spend most of their free time with gadgets online.

According to a recent study of mobile app usage trends by Global Wireless Solutions, Robinhood and Square Cash were the top two sites in total time spent throughout the pandemic among “power users” of finance and trading apps who clock more hours than the average customer does.

Robinhood’s commission-free trading model forces it to look for alternative ways of making money and this is where lending money for a fee so customers can invest more money in the stock market.

Customers borrowing from Robinhood have to pay $5 a month for a loan of $1,000 borrowed for investment purposes. If an investor wants anything above $1,000, they have to pay an annual interest rate on the loans.

The company used to charge an annual interest rate of 5%, it cut it to half to just 2.5% in December just a month before investors in Reddit groups decided to pick up meme stocks like GameStop, AMC, and Blackberry among others. This interest rate cut made it even cheaper for customers to borrow and bet on stock picks.

Many financial planners and advisers alike have long warned individual investors against buying, stocks “on margin,” saying that buying shares with borrowed money can swiftly lead to unexpected losses that exceed what was originally invested in the event that the shares plummet.

However, Robinhood, like any other company that sings praises for its business model says on its website that buying stocks on margin offers investors more flexibility, extra buying power, and less time waiting to access their account. It also says it can add risk.

“Our margin lending rate is one of the lowest and [most] competitive rates in the industry and we have seen margin lending increase alongside the rest of our business as we have welcomed millions of people into the financial system,” a Robinhood spokesperson wrote in a statement.

High rate of unpaid loans

Surprisingly or unsurprisingly depending on how you look at it, Robinhood’s stock loans have not always performed to the full expectation of the company and its customers.

Our friends at CBS MoneyWatch reported in February this year that as of the middle of 2020, Robinhood’s customers were 14 times more likely to fail to pay back their stock loans to the company than their counterparts who borrowed from rival brokerages like eTrade, TD Ameritrade and others.

To put this into perspective, Robinhood wrote off $42 million worth of stock loans in 2020 that customers failed to repay. The company said another $41 million in stock loans was bound to be lost.

Experts believe Robinhood’s aggressive lending may have also helped inflate the market bubble in GameStop shares and meme stocks in January this year. It should be remembered that in January this year, online retail investors flooded Robinhood’s trading platform and bought shares of shorted companies in a move against Wall Street’s investors who try to make money by betting a stock will go down in price.

These stocks included the earlier mentioned videogame vendor GameStop, theatre operator AMC among others and their stocks surged by thousands of percentage points in a few days and lead to a cash crunch at Robinhood forcing the company to suspend trading in those stocks for hours.

The company had to seek emergency funding from venture capitalists in order to meet its regulatory requirements, which rose because so many of its clients had crowded into a small number of volatile stocks.

Congress has since held two hearings on the affair and in the first hearing, Robinhood CEO Vladimir Tenev, and Steve Huffman, CEO and co-founder of the social media community and online forum site Reddit testified.

Joshua Mitts, a professor of securities law at Columbia University told CBS MoneyWatch last month that “The margin loans amplified the purchasing power and the ability of those investors to drive up GameStop’s stock price. What people are so upset about is that it was Robinhood’s own risky lending practices that limited its customers’ ability to trade and undermined investors’ confidence in the fairness of the market.”