Robinhood is drawing a lot of attention these days.
Success breeds scrutiny in the USA. More so than failure.
There is a dizzying amount of misinformed hot takes about Robinhood selling order flow. Let’s be clear – Robinhood lives up to its name – it created free trades for consumers by getting high frequency traders (HFTs) to pay for it. That consumer surplus was passed to subscribers, revolutionizing and permanently changing the discount brokerage industry.
Admirably, Robinhood discloses quite clearly how they generate revenue, but one thing they neglect to explain well is the rationale behind selling order flow, and that causes misplaced confusion on whether that practice affects the quality of trading (it doesn’t, it improves it).
The real story is life has never been better for a retail trader. Let’s clarify their business model. Robinhood makes money six ways, and the first five aren’t controversial:
1. Gold accounts at $5 / month: By far the most straightforward. A monthly fee for extra benefits
2. Net Interest Income: The spread between interest Robinhood earns on customer cash, versus what they pay the account holder in interest.
3. Margin Fees: The cost of borrowing funds from Robinhood.
4. Securities Lending: Securities lending is the short term loan of securities (stocks) in exchange for cash / collateral. This is how short sales are effected. According to iShares2, the blended average revenue this generates is 3-5 bps per dollar of securities. This practice is standard and for example is how Vanguard and other large funds reduce fees on their products.
5. Interchange Fees: Robinhood issues a debit card, and when used to buy things, the retailer pays a service fee to Mastercard (the network, ~2-3%) and to Robinhood (the issuer, ~21 cents + 0.05%)
Now, the one that mixes people up:
6. Payment for Order Flow: Before we do the what, let’s do the why.
Whenever anyone enters an order, whether Robinhooder, Financial Adviser, small hedge fund, large mutual fund, the first question is one, is there liquidity for this order? Two, if there is, who fills it, and how? Thanks to Regulation NMS, retail orders are required to be routed to the lowest price – so that takes care of that – retail trades will get the best price at the moment in time they submit an order that is actionable. Good news.
Question two, is who fills it? A market maker will fill the order, and whether a person or HFT, market makers earn money on the bid/ask spread. In general, a market market / HFT is agnostic to buying and selling for a penny, as over the course of hundreds of thousands of trades per day, the pennies add up. That critically assumes a random distribution of buys and sells.
The risk to a market market though is that the buys and sell are not random. If behind a 100 share order of a $100 stock is another 5,000 100 share buy orders because the buyer is a giant fund, then the market maker will get run over, and lose money. This is called “adverse selection” as in, they were counterparty to orders where they didn’t get to capture the spread.
If a market maker can effectively guarantee that it will never trade against an institution (presumed to be knowledgeable and large) and instead can trade against a retail trader (presumed to have random trades that are small) then it lowers its adverse selection.
By buying order flow from discount brokerages, retail traders win because the payment for their flow subsidizes their trades. The retail trader wins because they already legally have to be routed to the lowest price. The HFT wins because it lowers their adverse selection. Who loses? Who is actually paying the cost here?
The Robinhooding at question?
Institutions. The quality of fills at institutions has become slower, and more expensive, because they are competing for, at the margin, less liquidity.
Lastly, if you believe in looking where the bread is buttered so to speak, in the quarter Schwab announced $0 trading to keep up with Robinhood, their daily trades on the platform went up almost 100% – and selling that orderflow amounted to a whopping … two (2) percent of revenue.
Of course…don’t just take it from me (I am a biased investor and happy user) or Danny Jessy who is a CFA and did most of the work on this post. Here is a take from Dave Nadig at ETF Trends.
PS – I like writing about Coronado more than Robinhood, order flow and day trading so will get back to that important topic tomorrow!