Despite offering no-fee stock trades, Robinhood Markets is still getting paid. The company is using a controversial process called “payment for order flow,” to generate revenue. Despite its “free” trades, investors should always remember that there’s no such thing as a free lunch. Bloomberg’s Simone Foxman, Julie Verhage and Suzanne Woolley report:
Here’s how it works: Retail brokers like Robinhood focus on recruiting customers and building the trading interface, but don’t actually execute their clients’ orders. They outsource that to firms—including Citadel, Two Sigma and Wolverine Securities—that pay for the right to handle those trades. While orders from large, sophisticated investors can burn the market maker who executes the trade, retail trades are considered relatively safe.
These firms earn a tiny bit of money off each transaction, often 1 cent or less per share. Some see payment for order flow as a critical piece of market infrastructure—facilitating the fast and cheap buying and selling of stocks. But critics of high-frequency trading have long argued that the practice actually hurts the little guy, to the advantage of large firms. Federal rules dictate that brokers must seek the best execution for clients’ trades, but finding the best price possible is not necessarily a requirement. Consumer advocates say the system creates an incentive for brokers to route orders to the market maker that pays the most.
During last year’s fourth quarter, regulatory disclosures indicated that Robinhood shipped virtually all of its orders for stock trades to four high-speed market makers. The bulk was bought by Citadel, an affiliate of Ken Griffin’s $30 billion hedge fund. Citadel paid Robinhood an average of “less than $0.0024 per share” on the trades it was routed in that quarter. Those small numbers add up—Robinhood’s users have executed more than $150 billion in transactions.
During that quarter in 2017, Citadel and Two Sigma paid the company more per share of order flow than they paid TD Ameritrade Holding Corp., E*Trade Financial Corp. and Charles Schwab Corp., filings show. Robinhood was also allocating more of its orders to Citadel than it was to Two Sigma, which offered rebates that were a third smaller per share, and to Wolverine, which paid it even less per share.
It’s no longer possible to compare Robinhood’s payments with other brokers’. In an unusual move earlier this year, the company began filing disclosures on payment for order flow in terms of dollars traded instead of shares traded. “We report our rebate structure on a per-dollar basis because this accurately reflects the arrangement we have with market makers,” Robinhood said in another new section of its website, following questions from Bloomberg. It also said the structure benefits people who are trading small amounts of stock.
Today, on a per dollar basis, “all market makers with whom we work have the same rebate rate,” Tenev wrote in his letter. He also said that the rebates allowed the company to charge consumers less, “Robinhood’s zero-commission model has unlocked the ability for every American, not just large institutions, to participate in a variety of investing strategies that were previously economically unfeasible.” Of the pricing, Tenev said, “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.”
Some experts say payment for order flow can benefit retail customers, with little adverse impact. “If you’re an investor and you’re holding things for six months, a year, or two years and you lose out on half a penny, or a tenth, or two-tenths of a cent, it’s immaterial,” said Larry Tabb, chief research officer of Tabb Group, a consulting firm that works with high-frequency trading firms.
But regulators have scrutinized both brokers and market makers over rebates in recent years. TD Ameritrade, for example, faces a class-action lawsuit alleging its use of the payment- for-order-flow system is unfair. The company said it disagreed and would appeal.
Whatever the impact on consumers, some believe payments for order flow may not be a sustainable revenue source for Robinhood, thanks to regulatory pressures and consumer ire. “Robinhood’s revenue model could easily disappear,” said Tyler Gellasch, executive director of Healthy Markets, an investor advocacy group. “They’ve made it clear that they are comfortable living on this regulatory edge.”
Jeremy Jones, CFA
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