The Millenial Robinhood: Take from the poor and give to the rich

Robinhood Markets has taken the financial world by storm by allowing its customers to trade stocks, ETF’s, options, and most recently cryptocurrencies all for free through an intuitive mobile app — completely upending the entire brokerage industries’ standard of charging around $7–10 per retail trade. Having raised $539 million at a $5.6 Billion valuation and with co-founders from Stanford, they are Silicon Valley’s poster-child for Fintech startups. Taking their name from a fictional character who takes from the rich and gives to the poor, Robinhood claims to democratize the financial system, which in the wake of the Great Recession, sounds incredibly appealing. Prior to Robinhood, founders Vlad Tenev and Baiju Bhatt founded Chronos Research, a company that built out trading platforms to facilitate automated trading for hedge funds and investment banks. They soon realized they could bring this same technology used by large financial institutions to the masses. The timing couldn’t have been more perfect — millennials were “disillusioned with the state of the financial markets” says founder Vlad Tenev. Robinhood offers access to the financial markets without the hurdles that retail investors are often traditionally met with.

And Robinhood has been incredibly successful, with more customers than any of their competitors in the brokerage market. Robinhood’s easy-to-use mobile application and free trading are vastly different from the status quo where you would have to pay $7–10 per transaction for trades made on the phone with a live representative at your brokerage firm. While only six years old, they have over six million customers — 2.5 million more than E-Trade, a company nearly six times as old as Robinhood. There are two interesting aspects to their customers. First, the average account size of a Robinhood customer is significantly smaller than that of its’ competitors. According to a JMP Securities analysis conducted last year, Robinhood’s average account size is around $1–5K with E-Trade’s around $100K, TD Ameritrade’s $110K, and Charles Schwab’s $240K. Second, Robinhood’s customers, on average, are significantly younger. Fast Company reported that nearly 78% of Robinhood’s customers are under the age of 35. Robinhood has the opportunity to make them lifelong customers, something valuable in the brokerage industry which has high customer acquisition costs. Having gained massive traction and media attention, the question always arises “How does Robinhood make money? How is their business model sustainable when you can use the app completely for free?” The idea of a commission-free brokerage isn’t new. In 1999, TD Ameritrade tried a commission-free project called Freetrade.com that eventually failed and became a product that charged commission. In 2006, a company named Zecco launched with free trading but was sold to a broker that charged commission. So let’s dive into how Robinhood generates revenue.

How Robinhood makes money?
According to Robinhood’s own website, these are the following ways they make money:

Robinhood Gold allows customers to borrow money on margin to leverage their trades. Although this can be very profitable, it can also be incredibly catastrophic when used by uninformed or inexperienced investors. Robinhood has caught slack for heavily marketing this feature and incentivizing active trading and leverage, potentially devastating financial tools. The final point regarding rebates is particularly intriguing. “Rebates from market makers and trading venues.” What does that actually mean? Who are market makers and trading venues? And why are they paying rebates to Robinhood? Robinhood over the last six months has come under heavy attack for their rebates from market makers. This is referring to a practice known as Payment for Order Flow. Let’s examine why market specialists aren’t too happy with this.

Payment for Order Flow
Robinhood is referring to a practice known in the brokerage industry as Payment for Order Flow (PFOF). Before we dive into this, we need to define a couple of things and describe how the brokerage industry works.

• Order Flow: Quite simply, it is the flow of orders received by broker
• Payment for Order Flow: When a broker receives a payment for sending their order flow to another broker to execute

When, the investor, wants to buy or sell shares in a public company, they can’t go directly to a stock exchange and be able to conduct a transaction. Instead, they send their order to a registered broker whose job is to then go to various trading venues and to get the best execution quality they can for the trade. While Robinhood operates as a broker, they aren’t directly connected to any trading venues. Instead, Robinhood’s sole job is to (1) attract potential clients and their orders. Robinhood then (2) sell’s these orders to various High Frequency Trading (HFT) market makers whose job it is to then to actually execute the trade. (3) Robinhood then gets paid a small amount from these execution broker services for each transaction.

Companies like Citadel, Two Sigma, Virtu, etc have market-making arms that pay massive amounts for order flow from other brokerages — hence the term “Payment for Order Flow”(PFOF.) This practice originally began with new stock exchanges trying to gain traction and attract customers by paying for volume. It now extends all the way to brokers (with the practice ironically pioneered by the infamous Robert Madoff.) Brokers claim that by selling their orders, execution brokers can bundle those orders and reduce overall execution costs. This is especially beneficial to small, boutique brokers who do not have the sophistication to execute their own orders. But why would other broker’s pay for this right to execute another broker’s order?

The theoretical idea behind it is that the traders’ orders they are buying, are uninformed traders — often retail traders or other ineffective investors who are trading due to some irrational reason and not because they know an asset is misvalued. By purchasing what is expected to be “uninformed order flow”, a market-maker can buy at the bid and sell at the ask with less risk of trading at a loss with an informed trader who knows that the market is mispricing the security. Therefore, market-makers who pay for order flow can capture the spread while reducing the risk that the spread is too narrow to adequately compensate them for the risk of loss. The wholesale broker who purchased the order is obligated by the SEC to follow what is known as “best execution” which they define as the “lowest price, the speediest rade or the one most likely to be completed.” Therefore even with SEC regulation, the language still leaves a lot of room for interpretation.

Why Payment for Order Flow is Harmful
But the entire brokerage industry is not in complete support of this practice with many regulators and large industry veterans skeptical of its benefits. In fact, Vanguard, one of the oldest and largest brokerage services doesn’t engage in this practice at all. Here are a couple of the most common critiques against PFOF:

• Conflict of Interest

The brokerage you originally submitted your order to may end up selling your order to be executed by a firm that pays the most for it, instead of the firm that’s most likely to best execute that order. SEC regulation doesn’t really cover this area and they’ve stated that “the existence of payment for order flow raises the potential for conflicts of interest for broker-dealers handling customer orders.”

• Pulling Liquidity When It is Most Necessary

Some argue that the market-makers that pay for order flow use this information to understand when to drop providing liquidity to certain parts of the market during times of need which further increases the bid-ask spread and introduces further volatility into the market. The traders whose orders aren’t executed then have the bear the cost of missing the chance to have their order filled.

• Lack of Transperency

It’s unclear how your order is ultimately handled. Brokers treat the order you send them as “their” order and it is up to them to decide who they can sell it to execute the order. “Your order may get sold by your broker to an ‘internalizer’ or High Frequency Trading firm, who then makes even more money off your order [via the exchanges, ECNs, and/or dark pools] than they are paying your broker.” (Alpha Architect) Details on this incredibly sparse as most of these deals are done under the table without much information or transparency on the process.

The SEC has looked into conducting a pilot program to understand the effects of PFOF but nothing materialized. Currently, the SEC has three specific pieces of legislation regarding PFOF:

• Rule 10b-10: A broker-dealer must report on the trade confirmation statement that the customer’s order was sold and payment was received by the broker as a part of a transaction. Furthermore, pertinent details such as the “source and nature of the compensation” shall be available on the customer’s written request.
• Regulation NMS — Rule 606: Brokers must publish quarterly reports disclosing any arrangement for payment for order flow or profit sharing.
• Regulation NMS — Rule 607: When a customer opens a new account, on an annual basis, the broker-dealer must disclose their policies regarding PFOF and policies regarding how sold orders are routed.

Essentially the legislation regarding PFOF requires those who engage in this practice to disclose various pieces of information on a regular basis to parties who are subject to this practice.

In the book, Flash Boys by Michael Lewis, market specialist Christopher Nagy explains that combination of the complexity caused by RegNMS, rapid growth in the number of stock exchanges, and rise in HFT has significantly increased the value of a stock market customer’s order. Over the last couple of decades, market infrastructure has changed to adapt to modern technologies. Charles Schwab used to sell their order to UBS who in turn would sell their order to Citadel. Nagy explains that it is a shady/under the table kind of business because, ultimately, no one really knows the value of the information contained in these orders, only the HFT firms who used them for profit did, and they would release absolutely nothing. Ultimately from the perspective of HFT’s, customers without black boxes, algos, or sophisticated market technology — most retail brokers and even many institutional orders — had the most valuable order flow because their quotes were intrinsically late to the market. (Paraphrased from pages 179–182)

Luckily since last year, every firm that engages in this practice is required to disclose certain information on a quarterly basis (RegNMS Rule 606), allowing us to take a closer look at how Robinhood profits from this practice.

How does Robinhood specifically benefit from PFOF

An article on SeekingAlpha by Logan Kane was one of the first people to take a deep look into Robinhood’s 606 forms. He boldly claims that Robinhood “Takes from the millennial and gives it to the high-frequency trader.” To get a better idea of how much money Robinhood makes from this practice, he looks to other brokerages who also engage in this practice. In TD Ameritrade and E*Trade’s 606 disclosures, they report their payment for order flow as around “a tenth of a penny per share,” which is the industry standard metric used when measuring PFOF rates. But, Robinhood reports them in terms of “per dollar of executed trade value.” This makes it incredibly difficult to compare how much Robinhood is being paid versus other brokerage firms. At first glance, it actually seems as if Robinhood is being paid significantly less for their order flow than other brokerages, but taking a closer look points the exact opposite conclusion. From Logan Kane’s post:

Assume the average stock traded has a share price of $50. It takes 20,000 shares traded at $50 for $1,000,000 in volume, for which E*TRADE makes $22 per $1,000,000 traded, which sounds like a small number until you realize they cleared $47,000,000 last quarter from this. But off an identical $1,000,000 in volume, Robinhood gets paid $260 from the same HFT firms. If Robinhood did as much trade volume as E*TRADE, they would theoretically be making close to $500 million per quarter in payments from HFT firms.

From this, it is quite clear there is something fishy with how Robinhood is getting paid for their order flow. Why would they use a different metric? Why does Robinhood get paid so much more for their orders when compared to larger, more established brokers who also sell their orders? What is so special about a Robinhood order? HFT make most of their money when large institutional orders hit the market, causing it to move. Small, retail orders are noise to market-makers. When Robinhood sends them a constant stream of purely retail flow it helps market-maker distinguish orders that hit the market as likely to be retail vs institutional, which in turn helps the highly profitable trades that HFT’s engage in.

There’s currently no way to be completely sure your Robinhood trades are not being front-run, but why else would HFT’s pay so much for your trades if they aren’t able to profit off of them? This brings up a serious question of execution quality. Time and time, these market-makers have been found to violate securities law. What’s worse is that almost every single firm that Robinhood sells their orders to has had run-ins with federal agencies.

• In 2017, Citadel paid a $22.6 Million fine for making misleading statements on how they priced trades when internalizing trades
• In 2013, Two Sigma was subpoenaed and questioned by the NY Attorney General over how it collected financial information from stock analysts.
• In 2015, Wolverine Securities paid a $1 Million dollar fine for improper information sharing.
• In 2014, G1 Execution Services had to pay a $2.5 Million fine for improperly selling billions of unregistered penny stocks.

Robinhood’s Response
After the SeekingAlpha post brought in a lot of media attention and scrutiny to the issue, Robinhood published a letter with a response. Founder & Co-CEO Vlad Tenev explained that rebates are the source of income that allows them to offer commission-free trading. It stated that Robinhood doesn’t take payment amount into consideration and instead orders are sold based on which market maker will best execute your orders. But Tenev is being quite vague here without telling us what metrics they use and prioritize when measuring execution quality. Brokers have been known to conflate execution quality stats and use confusing metrics that aren’t often reflective of how well they’re able to execute orders. Tenev claims that Robinhood makes very little per trade from PFOF and brings up their payment rate and how if you were to buy a $100.00 stock on Robinhood, Robinhood would only earn about 2.6 cents from selling your order. But once again, using the “per dollar of executed trade value” metric hides information about the true nature of the transaction between Robinhood and the market makers. In response to this specific issue, in a statement to Bloomberg, Robinhood asserted that “We report our rebate structure on a per-dollar basis because this accurately reflects the arrangement we have with market makers,” and that “the structure benefits people who are trading small amounts of stock.” While these arguments seem sound, Robinhood needs to be more transparent on how they’re coming to these conclusions and what data they’re using to do so.

Does it matter to the average customer?
At the end of the day, does Robinhood’s average customer really care about any of this. If you’re a young investor who only trades a few shares a couple of times a month, do you really care about minute details regarding your execution quality? Especially if the entire platform is free to use. This business model is not entirely new, billions around the world use Google & FB completely for free. Google & FB take the user’s personal data and produce massive profits while also creating and maintaining amazing products for the world to use. Most people are aware of this and continue to use their products, Robinhood’s pretty much the same. If you use a traditional broker like E*Trade, TD Ameritrade or Fidelity, you’re paying a flat fee per trade, but the price improvement you receive through a higher execution quality will likely save you more than you spent on commission when you’re trading larger blocks. But at the same time, if you are a sophisticated investor trading large blocks, it is unlikely that Robinhood is your main broker.

The main issue I have is that Robinhood owes it to its customers to be more transparent about how they make money off of this practice. If they honestly believe there’s nothing wrong with payment for order flow and that it is actually beneficial, they need to show the proof and the data behind their decisions. They state their mission is to democratize the financial system, but it looks like quite the opposite, they’re trapping novice, retail investors for large HFT firms to prey on. They catch you with the commission-free trading, but you are paying in other ways.

Given all I’ve said, I don’t hate Robinhood. In fact, ever since I discovered the company around four years ago I’ve been fascinated and impressed with what Robinhood has been able to accomplish. Their app is fantastic and incredibly beautiful, many friends and people I know are investing, learning and engaging with the stock market in a way that was never possible. An incredibly cynical view is that the name Robinhood is pretty ironic given that they lure in less wealthy, uneducated, millennial retail investors with a flashy app and free trades only for them to rob you behind the scenes. Incredibly damning for a company that claims to fight the problems that were discovered in the great recession. On the upside, one could say that Robinhood has done a lot of good by bringing more people into the financial markets. Given the sheer volume of young customers they have, Robinhood has the potential to do good. It is very likely that these young customers are going to be lifelong customers. Robinhood has the chance to change the way it operates and become the trusted financial tool for millennials to lean on.

Thanks for reviewing and editing: Bala Chandrasekaran, Matthew Rastovac, Arsh Khandelwal, Bryan Sun, Sam Feizi, Sid V., and Varun M.