Lessons from Robinhood’s Execution Violations:

Understanding Best Execution Violations and Their Consequences

Introduction

Life as a retail trader feels like David v. Goliath (in the case of a trader, many Goliaths), as trying to navigate financial markets while competing against institutional investors is a daunting task. One important consideration is where to place trades. Robinhood, a trading platform targeted towards retail traders with its questionable promise of “commission-free trading” is one of the most popular. They have faced great scrutiny from the Securites and Exchange Commission (SEC) for failing to provide their customers with the best execution of their orders, as required by law. Let’s dive into the high-profile case of Robinhood, a brokerage with 23.9 million funded customers and $130 billion in assets under custody that was caught in violation of regulations that cost their customers millions. Then see what lessons we can learn to make our trading smoother and more profitable.

The Robinhood Saga: A Cautionary Tale

Robinhood is a revolutionary trading app trusted by 13.7 million monthly active users for its “commission-free” model, popular among retail traders. In December 2020, they found themselves in hot water with regulators, as the SEC charged Robinhood with failing to meet best execution requirements. The SEC discovered that from 2015 to late 2018, Robinhood’s customers lost $34.1 million due to poor trade prices. Robinhood preferred outsourcing trade execution to the highest bidder, over the best executing option for their clients. A clear ethical violation and regulatory violation as exchanges have a duty of best execution. So, what went wrong?

Key Violations:

Payment for Order Flow (PFOF):

Robinhood makes money by sending your trades to market makers who pay for this order flow. In 2020, for example, about 75% of Robinhood’s $958.8 million in revenue came from PFOF. This practice is legal, but only if they are upfront about it and uphold their duty of best execution. However, Robinhood did neither of those. The SEC in 2020 alleged Robinhood misrepresented its reliance on PFOF as a revenue source. From 2015 through September 2018, many of Robinhood’s retail communications omitted its receipt of payment for order flow. Essentially, they hid that they outsourced trade execution from their retail trader consumer base, which prevented traders from conducting proper due diligence on the cost effect of that outsourcing on their trade execution. Although payment for order flow is a legal practice, it must be properly disclosed, which Robinhood failed to do by omitting it from their communication to retail traders. PFOF must also be monitored to ensure it doesn’t interfere with a broker-dealer’s duty of execution, which also did not occur for the first 5 years of Robinhood operations, from their launch in 2013 until 2018.

Misleading Claims:

Robinhood’s promise of “commission-free” trades was misleading. The hidden cost of worse execution prices outweighed the benefit of no commissions. The promise of commission-free trading is a front to push hidden costs on the trader, hoping they go unnoticed. Specifically, the 2020 SEC proceedings mention that “Robinhood falsely claimed in a website FAQ between October 2018 and June 2019 that its execution quality matched or beat that of its competitors,” despite orders being executed at worse prices vs competing brokers. As a retail trader, this is particularly relevant as they found that misleading claims cost customers $34.1 million even after the “savings” from no commission. What occurred was Robinhood was aware that higher payments for order flow rates could lead to less price improvement, yet their Best Execution Committee did not review how that worsens execution prices for customers or how their price improvement statistics compared to those of other retail broker-dealers until 2018. For 5 whole years, Robinhood swept the harm their PFOF caused to retail traders, until the SEC stepped in, culminating in the 2020 settlement, detailed below.

Lack of Price Improvement:

Compared to other brokers, Robinhood provided less price improvement. This means you may have bought stocks at higher prices or sold them for less than you could have with other brokers. Joseph Sansone, Chief of the SEC Enforcement Division’s Market Abuse Unit said “Robinhood failed to seek to obtain the best reasonably available terms when executing customers’ orders.” Simply put, the SEC said Robinhood did not put their customers, retail traders, first in this instance.

Robinhood settled with the SEC in 2020, where they agreed to a cease-and-desist order, without accepting legal guilt. By settling, Robinhood did not violate the antifraud provisions of the Securities Act of 1933 and the recordkeeping provisions of the Securities Exchange Act of 1934. As a part of the settlement, Robinhood had to cease its false claims and had to pay a $65 million civil penalty.

Why Best Execution Matters

Best execution is not just regulatory jargon — it’s a fundamental aspect of protecting your investments. It ensures brokers strive to get you the best possible deal on your trades, considering factors like price, speed, and likelihood of execution.

Regulatory Compliance

Regulators, like the SEC, ensure brokers adhere to the best execution standards to maintain fair and transparent markets. Non-compliance can lead to severe penalties and damage to a broker’s reputation.

Investor Protection:

For you, the retail trader, the best execution means getting the most bang for your buck. Poor execution can eat into your profits or increase your losses, directly impacting your financial health.

Takeaways for Retail Traders

The Robinhood case offers valuable lessons that can help you avoid similar pitfalls and enhance your trading experience:

1. Know Your Broker’s Practices: Understand how your broker executes trades and any potential conflicts of interest. Research brokers that prioritize your best execution over their financial incentives.

2. Monitor Execution Quality: Regularly check the quality of your trade executions. Compare your trade prices with market prices and assess the level of price improvement. Many brokers offer tools and reports to help you with this.

3. Demand Transparency: Insist on clear disclosures from your broker about their order routing practices and execution quality. Understanding these details helps you make informed decisions about where to place your trades.

4. Use Trading Analytics: Platforms like Hoodwinked can provide insights into your trade executions. Use these tools to spot patterns of poor execution and get data-driven advice to optimize your trading strategies and cut costs.

Conclusion

Robinhood’s missteps highlight the critical importance of best execution in trading. By being proactive — understanding your broker’s practices, monitoring execution quality, demanding transparency, and leveraging analytics — you can ensure your trades are executed at the best possible prices. This way, you can protect your investments and trade more effectively. For Robinhood’s retail user base, this could have been avoided. If they used a transaction cost analytics platform such as Hoodwinked, they would have real-time feedback on the execution quality of their trades. Hoodwinked is here to prevent this. As a retail trader, you can save up to 20% in transaction costs with Hoodwinked and be aware of any exchanges that do not have the best execution of your trades at heart. Click here to get a free report of your trades from Hoodwinked.

Disclosure

The content of this blog is intended for informational and educational purposes only and should not be construed as financial advice. The strategies and insights discussed are meant to provide a deeper understanding of Robinhood as well as other brokers and should not be interpreted as specific investment recommendations. Readers are encouraged to consult with a professional financial advisor before making any investment decisions.