Stock brokerages sell retail investors to hedge funds

Your stock broker is not your friend.

Earlier this year, online trading platform Robinhood faced severe backlash after it disabled the buy button for GameStop and a handful of other highly shorted securities.

Robinhood had stepped in to prevent losses for its customers after shares in GameStop began to skyrocket in value. After all, the free online trading platform wasn’t monetizing from users trading stocks on the app. No, Robinhood’s revenue source is actually payment for order flow. That means their customers are market makers and hedge funds buy this order flow.

Despite so many aspects of society being built around this concept, consumers readily forget that in most cases, if it’s free, such as the online trading platform Robinhood built, the users are the product.

Robinhood bled users and value as investors migrated to more established stock brokerages like Fidelity and Ameritrade.

Unfortunately, Robinhood is hardly the only trading platform that monetizes at its users expense. And payment for order flow is hardly the only way stock brokerages act against the interests of their users’ portfolios.

In fact, the core business model of most stock brokerages, particularly free online trading platforms, is centered around methodologies that exploit retail investors data and investments.

Here are a few things your stock brokerage hides in the fine print.

You don’t have any stocks in your name

Chances are, if you use any of the better known stock brokerages, you don’t have a single share that is registered in your name.

When you buy securities through a stock brokerage, the shares you purchase are held “In street name.” In other words, technically speaking, the shares are legally registered to Cede & Co., the DTC’s holding company. The DTC is a topic that we won’t delve into here, but the TL;DR on it is it is the middle man of the entire market. It is the nexus of all brokers, market makers, exchanges, and investors, and has a hand in just about every financial transaction made.

In theory, despite this arrangement, the buyer still “retains all shareholder rights,” known as “entitlement rights.”

In reality, entitlement rights mean your legal claim to ownership is secondary to a number of parties who help themselves to your portfolio holdings for their own gain.

In a 2003 complaint to the SEC about how average investors’ portfolios are regularly exploited for fraudulent purposes, Dr. DeCosta, a consultant for companies who were victimized by abusive short selling, lamented:

Shareholder Sam from Chicago will never know that the shares in his qualified retirement account have been illegally rented out to cover some MM’s sale of nonexistent shares.

Because the shares are held in the stocker broker or Cede & Co.’s name, they are afforded some lucrative privileges that are more often than not at direst odds with that of the lowly ‘entitlement rights’ party.

These privileges are how these trading platforms get most of their revenue.

Securities lending

Because the shares are held in street name, stock brokerages engage in a practice called securities lending.

They lend out their users’ shares. While these securities are in borrowed status, the borrower pays the stock brokerage a stock loan fee, or interest rate.

Security lending is a core part of trading platform business models. Stock loan fees are a primary source of revenue. In effect, one of brokers’ primary customer bases are not their users, but the parties who borrow securities from them.

The borrowers of these securities are more often than not hedge funds and other financial institutions. The reason they want to borrow these securities is to short the stock either directly or via financial derivatives.

Short sellers then sell the loaned stock into the market.

The addition of this ‘borrowed supply’ of stock into the market increases sell pressure which drives stock prices down. Every penny shaved off the market price of the shorted security is profit for short seller. The more it goes down, the more profit they make. They more security’s the borrow, the more they can drive the price down by diluting the market with sell pressure from borrowed stocks.

Importantly, there is no demand-side equivalent to short selling, making it a price distorting practice by it’s very nature, and almost exclusively to the downside.

As an account owner holding stocks in a brokerage, there’s little to no indication that your stocks are being lent out to be used against your portfolio. Considering the ‘entitlement rights’ owner doesn’t get any of the stock loaning fee. They have no vested interest in lending their shares out to be used as ammo against their portfolio.

That’s why stock brokerages go to great lengths to hide this practices in fine print legalese and give no indication whether or not user shares are being borrowed or actually in their account.

The less you know, the easier you are to exploit.

More portfolio erosion, more money for stock brokerages

To make matters even more concerning, the harder securities are to borrow, the higher the stock borrow fee.

Most often, when stocks are hard to borrow, it’s the result of aggressive short selling. Aggressive short selling hammers down stock prices by hitting the gas on artificial sell pressure.

In other words, brokers are able to bring in more revenue by finding inventory to lend out on securities that are under attack by short sellers.

More portfolio erosion for users = more profits for stock brokerages.

Unusual case study

One of the interesting idiosyncrasies of the GameStop saga is that for most of 2021, the stock borrow fee on this difficult-to-find security remained inexplicably low. In fact, the interest rates on GameStop shares moved in inverse correlation to what is industry standard.

As the number of stocks available to borrow dropped, so too did the interest rates. This is in contrast to industry standards, a mystery that remains unsolved and continues to this day.

This is one of many idiosyncrasies and glitches around this security since the massive price run up in early 2021.

Options for retail investors

It can be difficult (and in most cases impossible) for a trading platform user to determine if the shares held in brokerage account are lent out.

Some stock brokers say they have the option for users to opt out of securities lending, while other offer user a portion of the stock lending fee for taking the risk.

For many, a portfolio based on a cash account means the securities in that portfolio are not lendable. On the other hand, shares held in margin accounts allow stock brokers to lend securities from that account, even if the securities were paid for in settled cash.

The terms vary from broker to broker. But either way, you need to trust that your broker is always operating by the book, the shares are still not registered in your name, and you have no way of knowing if the shares in your account are real or simply ‘borrowed’ shares owned by you and another investor at the same time.

Otherwise, retail investors must be proactive about getting their shares held in their name.

That requires them to pursue direct registration.

How to direct register your shares

To direct register your shares, retail investors need call their stock brokerages and request it. This often involves transferring shares out of the trading platforms account all together and moving them to that of the issuer/transfer agent.

While selling directly registered stocks can occasionally take a little longer, investors can be sure that their shares are not lent out and used against them and other investors for that particular security. They can also for once, actually legally own stock, registered in their name.

ComputerShare and American Stock Transfer are both direct registration stock issuers that make you the legally registered owner of your shares. Every company has a transfer agent, so determining who that is for a particular security will be an extra step a retail investor will have to take if they want to actually own their investments. What hard wallets are to crypto, direct share registration is to the stock market.

Most retail traders don’t realize their brokerage accounts is really stuffed with IOUs, but they are.

Perhaps if they realized that there isn’t a single stock in their portfolio that is actually registered in their name, direct registration would be more widespread.

Also in his 2003 report to the SEC, Dr. DeCosta noted:

Until all of the legitimate shares, that is those with a certificate in existence to back it up, are pulled out of the DTCC by shareholders demanding delivery of their certificates, those that bought “fake” shares are oblivious to this fact. This pooling phenomenon gives power to the malfeasor and blindness to the victims.

Wall Street is not ‘the market’ nor ‘the economy’

The short sellers erode the value of the stock investments and pocket the difference and the broker profits from lending them the security.

This is why you will see Wall Street defend short selling as though questioning the practice is ridiculous – they all profit from it at the expense of retail investors and target company.

Despite efforts to equate itself with the market and the economy, Wall Street is neither. Wall Street is made up of banks, hedge funds, brokers, private equity, market makers, and similar types of organizations.

The market and economy on the other hand, are workers, companies, families, suppliers, consumers, and others that are definitively outside of Wall Street. They are the people who produce actual value in the economy in the form of products, services, and innovation.

So next time you see a suit on CNBC or in an article in Barron’s say it’s good for the economy or bad for the market, read between the lines. There is an incredible amount of action behind what retail investors see from their trading platform’s ‘my portfolio’ screens.

And believe it or not – they aren’t always in your best interests.

It is well enough that people of the nation do not understand our banking and monetary system, for if they did, I believe there would be a revolution before tomorrow morning. – Henry Ford