How Silicon Valley Engineered a Retail Trading Mania

By John Banks

2020 will be remembered for kicking off a global pandemic. But it will also be remembered for a market mania, driven to a surprising degree by bored sports gamblers, millennials taking a flyer with stimulus checks, and day-trading retail investors new to markets overall.

We know the Federal Reserve provided psychological support (through an implied promise to support markets no matter what).

And we know the U.S. government provided fiscal support, what one might call “helicopter money,” via the first round of $1,200 stimulus checks being largely directed toward stock market purchases (as confirmed by data from Envestnet Yodlee, a consumer finance software giant).

But now we know something else: Silicon Valley had a major hand in engineering the retail mania.

On the technology side, the retail mania was driven by two things: First, the frictionless appeal of zero-commission trading, including the advent of zero-commission options trading via Robinhood; and second, the addictive power of online trading platforms (OTPs) reimagined as smartphone apps.

Silicon Valley has amassed 20 years of experience — about 140 years in “internet time” — learning how to “gamify” the online experience and otherwise get people to click, respond, and engage. 

The casino gaming industry was the pioneer in this area. Countless aspects of a casino visit are designed specifically to encourage more gambling. For example:

  • The chaotic patterns in casino carpet are meant to be hard to look at, which keeps the gamblers’ eye gaze off the floor — and directed toward the slot machines and gaming tables instead.
  • There are no visible clocks in a casino, and no windows, because the idea is to lose one’s sense of time and forget whether it is day or night (to keep the gambler staying longer).
  • The drinks are free, for obvious reasons, with standard etiquette being to tip a dollar chip or two (or more if the gambler is feeling flush).
  • The air temperature in the casino is kept on the cold side, so the gambler stays aware and alert, and thus ready to gamble more (versus ready to go to sleep).

There are many more factors at work just like these. Some casinos have even experimented with scented air in the casino, doing trial runs to determine what scents might make people gamble more.

All of these touches are worth it because small changes in gambler behavior can lead to big gains in revenue and profits. If a casino breaks even on costs, and a few psychological tweaks can increase the rate and amount of gambling by another 5%, that extra 5% could go straight to the bottom line (and raise profits substantially). 

Silicon Valley took that whole behavioral engineering concept and scaled it to the moon.

For an advertising-driven website or smartphone app, the name of the game is clicks and engagement. The more that users click, or otherwise engage, the more money Silicon Valley makes. And when a website or app can have tens of millions, hundreds of millions, or even billions of users, the stakes are even higher than they are for casino gaming.

This is why Silicon Valley has recruited armies of Ph.D.s and behavioral scientists, creating a broad and deep body of research on the behavioral design of websites and apps, with the goal of getting users to stay longer, click more, or buy more.

This is where the “Online Trading Platform” (or OTP) comes in.

Robinhood, the OTP now taking the financial world by storm, is designed to be addictive in the traditional style of any self-respecting smartphone app.

Then, too, Robinhood was one of the first to aggressively push a zero-commission trading model, which means that stocks and options can be traded for “free.” The “free” part is in quotes because the cost comes from dealing with a market maker on the other side.

It is true that Robinhood charges no commissions for its trades. But through an arrangement known as “payment for order flow,” Robinhood’s orders are sent to giant high-frequency trading and market-making firms, which pay Robinhood simply for the chance to execute those orders.

The market makers then make money off the retail orders by capturing the “spread” whenever an order is executed — sort of like the foreign exchange kiosks that used to dot the departure areas of international airports.

So, this is where the dark genius of Robinhood’s design comes in:

  • Robinhood makes money from “payment for order flow,” which means that, the more buy and sell orders that Robinhood can redirect to market makers and high-frequency trading firms, the better.
  • Robinhood thus has incentive to get its customers to trade as much as possible, even while charging zero commissions (because revenue and profits are still tied to trading volume).
  • As such, all of Robinhood’s incentives, and behavioral engineering muscle, are geared toward getting customers to trade more — and they have all the traditional tricks and methodologies of a smartphone app to make this happen.

The Robinhood app is dead simple to use. It has big, simple buttons, and deliberately makes it easy to go from “no experience” to an ability to trade aggressively, including options trading and trading on margin, with few hurdles.

It also has multiple “nudge” and stimulus-response-type reward features, like bursts of confetti, to gear users toward trading more. “I liken it to giving the keys of a sports car to a 12-year-old,” said certified financial planner Tara Falcone to NBC News.

And the system works. Robinhood had 13 million accounts as of May 2020, more than Schwab or E-Trade. And the accounts are hyperactive.

“In the first three months of 2020, Robinhood users traded nine times as many shares as E-Trade customers, and 40 times as many shares as Charles Schwab customers, per dollar in the average customer account in the most recent quarter,” said the New York Times. “They also bought and sold 88 times as many risky options contracts as Schwab customers, relative to the average account size.”

That level of spread is eye-popping. On a dollars per account basis, Robinhood customers trade 40 times as many shares and 88 times as many options contracts.

And, the average age of a Robinhood customer is just 31, the New York Times reports — and half of them had never invested before. This speaks to the trend-magnifying power of social media, and the “bored in lockdown” factor combining with digital outreach to get millions of millennials on the Robinhood train via chat rooms, message boards, and online gaming communities (like the wildly popular Fortnite).

When it comes to a retail mania driving markets higher, this isn’t just the power of bullish enthusiasm, in other words. It’s the power of a Silicon Valley smartphone app engineering rapid-fire addictive behavior.

Then, too, we have clear evidence that mania-like behavior from retail investors, again driven by Robinhood users, has had an outsized impact on market activity.

This comes from both the volume and rapidity of turnover — the more shares that trade, the more impact it creates — and the concentrated leverage of call-option buying, which forces market makers to purchase underlying shares as a hedge when they write the options contracts.

Citadel Securities is one of the large market makers that engages in a “payment for order flow” relationship with Robinhood. By that meaning, Citadel pays Robinhood in order to have all those retail orders sent its way, because Citadel makes good money executing those orders (and then gives Robinhood a cut).

According to Citadel Securities data, as reported by Bloomberg, “retail traders now account for about a fifth of stock-market trading and as much as a quarter on the most active days.”

For retail investors to be driving 25% of activity on a given day is a staggering amount. That is more than enough to push prices significantly at the margins. “We continue to see retail investors becoming a more significant liquidity source in the marketplace,” Citadel Securities’ head of execution services told Bloomberg.

What does all this mean?

For one, it means that Silicon Valley had a major hand in engineering the retail mania of 2020, by starting with a traditional brokerage platform, removing the friction via zero-commission trading, and then cranking the behavioral engineering up to 10 via addictive smartphone-app techniques.

This in turn, along with the twin-turbo factors of fiscal and monetary stimulus, contributed to an epic lockdown rally and the fourth great bubble of the past few decades (behind the 2008 subprime bubble, the 2000 tech bubble, and the 1990 Japan bubble).

The question, now, is when that bubble will burst — and what happens when it does.