How Bernie Madoff’s Idea Makes Robinhood Millions
Robinhood Takes Order Data from the Poor and Gives it to the Rich
Robinhood is a trading platform and discount broker that needs no introduction.
It has a valuation of $11.2 billion and has recently taken mainstream acceptance in equity and options trading for its ambitious new investors.
It’s simple platform welcomes new users over traditional counterparts and it’s promise of commission-free trading has pushed the competition to provide similar services.
The question invariably becomes, what enables Robinhood to provide this service for free.
Robinhood has to pay for it’s infrastructure, a brilliant software development team, management, and now, due to increasing controversies, a decent legal team.
Well the answer is a wild one, filled with Bernie Maddoff (the great ponzi schemer who stole $65 Billion), and market makers.
Ironically, Robinhood does the opposite of what the legendary heroic outlaw did, they take trading data from its users and sell it to the rich market makers.
The Business Model
Payments for Order Flow
Robinhood is a broker that enables the trading of more than 5,000 stocks, exchange traded funds (ETFs) listed on U.S. exchanges, options contracts, cryptocurrencies such as Bitcoin and Ethereum.
The company generates significant income from payments for order flow, where they are paid for directing orders to different parties for trade execution.
According to Bloomberg, Robinhood was bringing in more than 40 percent of its revenue from selling its customers’ orders to market makers, like Citadel Securities and Two Sigma Securities.
Robinhood refers to this as “rebates from market makers and trading venues.”.
It is estimated that payments for order flow generated an estimated $180 million in Q2 of 2020 alone.
Payments for order flow is not a novel practice. In fact, it was first came about from legendary fraudster Bernie Maddoff.
The SEC states that:
“Payment for order flow is a method of transferring some of the trading profits from market making to the brokers that route customer orders to specialists for execution.”
Market makers are typically financial firms that specialize in actively maintaining quotes for stocks or options contracts and offering them both to buyers and sellers.
For instance, a market maker in XYZ stock may provide a quote of $1.00-$1.05. This means that they bid, or buy, a share for $1.00 and sell the the share at $1.05. The difference, or spread is $0.05. If you do this with millions of orders, the revenue can become sizable.
Market makers are compensated based on the spread between the bid and ask prices for these securities.
The broker, like Robinhood, makes a fraction of a penny per trade with this model.
This can be quite lucrative with enough trading activity, and Robinhood certainly does have a lot of activity.
Robinhood averages roughly 4 million trades per day and has 13 million users.
Robinhood is different from competitors as it charges market makers a percentage of the spread on each trade it sells, versus a fixed amount.
The CEO of Robinhood, Vladimir Tenev, stated that:
“Robinhood earns ~$0.00026 in rebates per dollar traded. That means if you buy a stock for $100.00, Robinhood earns 2.6 cents from the market maker.”
The SEC requires brokers to disclose their policies surrounding this practice, and to publish reports that disclose their financial relationships with market makers, as mandated in 2005’s Regulation NMS.
The basic problem with PFOF is that the broker and market makers have it within their interest not to provide traders with the most accurate prices for equities and options contracts at the point of transaction.
Since market makers make money on the spread between the Bid and Ask price of a trade, the greater the Bid price a market maker can get against the Ask price, the more money they'll make.
The SEC permits these businesses for two main reasons. Market makers provide market liquidity, where there otherwise would not be and to avoid exchange monopolies.
This is important as liquidity ensures that a corporation is able to meet short-term debt obligations, or current liabilities, without having to raise external capital or take out loans.
Market makers also help discourage natural monopolies that may form from existing exchanges as these market makers essentially create markets for exchanging financial securities.
Tenev claims that selling order data to market makers is justified as,
“We send your orders to the market maker that’s most likely to give you the best execution quality,” and “For even finer control, we offer limit orders and stop limits, which allow you to name your own price.”
The SEC dictates that brokers must seek the best execution for trades, but finding the best price possible is not necessarily a requirement.
In a alleged failure to comply with SEC legislation, Robinhood is facing a $10 million civil fraud investigation from the SEC over its PFOF deals with high-speed trading firms.
Robinhood began PFOF in 2013 but failed to fully disclose on its website that it received payments from market makers for customer trades until 2018.
FINRA stated that Robinhood failed to perform systematic best execution reviews.
As scrutiny from regulators grows, Robinhood may have to turn to more secure forms of revenue.
Other sources of revenue for Robinhood include a $5 monthly fee for a membership to Robinhood Gold, interest on holding cash in the account, lending stocks purchased on margin, and other fees.
Although, Robinhood claims a mission to democratize finance for all. A cornerstone of democracy is consent.
By failing to disclose such a controversial practice, Robinhood fails to legitimize its business and therefore fails to provide sufficient transparency so that users can openly consent to how their money is being used.