Is Robinhood taking from the poor and giving to the rich?
New investing methods bring new problems
Robinhood, the zero-fee trading platform that has exploded in 2020, has turned more people into investors than any other service. The trading volume and new money has helped the stock market recover, and allowed more people to participate in the market rally. According to co-founder Baiju Bhatt, the app’s “mission is to help the everyman, the rest of us, to be part of the financial system.” Robinhood has been a blessing to the retail investing community and this blog is not meant to slander or degrade the work they have done. The goal is to educate readers on how Robinhood makes money so that they can decide the best course of action.
Selling “Order Flow”
Robinhood doesn’t charge a fee for its trading service, so how does the company make money? The answer is order flow, but this requires some background info to understand. First, there are three parties involved in a stock trade: the seller, the market maker, and the buyer. A market maker is a company that buys the stock from the seller and quickly sells that same stock to the buyer. Market makers are absolutely vital to the operation of the stock market because they keep markets liquid. Thanks to them, it’s possible to sell most US stocks in less than 5 seconds.
Market makers make profit by marking up the stocks before they sell them to the buyer. We’re talking 1 or 2 cents in most cases, like buying the stock for $10 and selling it for $10.01. Because this is a tiny profit margin, the market makers rely on order flow to make any real profit. By trading millions of shares, these market makers can turn the tiny margin into big money.
Because market makers need high volume, they are willing to buy that volume. We call this “buying order flow”.
Enter: Citadel Securities
Citadel Securities, owned by Wall St. billionaire Ken Griffin, is the largest market maker in the world. In the first quarter of 2019, Citadel made $244 million from filling orders. In the first quarter of this year, they made $652 million. That’s a 267% increase! The retail investing boom has definitely benefited Citadel and its wealthy owners. The concern is that it’s not just the higher volume that’s making Citadel richer, they may actually be making more profit per trade. If they are making more profit, that means they are taking those pennies away from the people selling the shares.
Why would Citadel and other market makers buy order flow?
Because market makers are so important to the markets, they usually don’t need to buy order flow. They are simply the best option for clearing a trade, so they don’t need to pay any money to be a part of that trade. So, why do market makers buy order flow, and why are they paying 167% more for order flow from Robinhood? The answer is flexibility. Because Robinhood doesn’t charge a trading fee, they have no obligation to place the trade in a way that benefits the client. They just have to place the trade. As a result, market makers get the shares cheaper from Robinhood and can earn a higher profit. When you sell a share on your Robinhood account, the sale usually goes through at a much lower price than it would through other brokers. Rather than buying the share for $10 and selling for $10.01, market makers are buying a share from you for $9.97. Who loses out on those 3 cents? The person who placed the trade, AKA you.
If the product is free, you are the product.
This saying is more commonly used when talking about Google or social media, but it holds true when we’re talking about Robinhood. Robinhood is providing users with a free service and then selling the orders they generate to market makers. They are using retail investors, often called “dumb money”, to ramp up trading volume and rich people seem to be the ones benefiting. We still use Instagram and Facebook knowing our attention is sold to advertisers because it really doesn’t harm us. The same goes for using Robinhood. Usually, paying zero fees makes up for the money a client loses to Citadel and other market makers.
Paying for order flow is an industry-wide operation. TD Ameritrade made $202m from selling its order flow in the first quarter of 2020, $83m of which was from Citadel. PFOF has become the new business model for brokers after the collapse of commission trading. This is not a Robinhood-only problem. The problem is that Robinhood is specifically targeting inexperienced investors who may not know how to get good trade execution.
Retail investors need to be aware of this
Payment for Order Flow (PFOF) may be unavoidable, but there are ways to keep your trade execution precise. The simplest way is by incorporating “limits” and “stops” into your trading strategy. You can do this for free, on your broker platform, and you can learn about how to implement them in this article.
Trade execution is also a requirement of a fiduciary investment agreement. If you hire an investment advisor, they are required by law to make sure trades are executed in your best interest. They can leverage a broad knowledge of the marketplace, and can even micromanage order flow by sending it to multiple market makers.
PFOF is future of trading
This isn’t all doom and gloom. PFOF often means lower prices for investors. Because the market is made more efficient, prices also more closely reflect the value of the stock. Investors can often get a better price from a market maker than they would from other sources. The system really does benefit everyone, but it’s a question of balance. Who is benefiting more?
I can’t answer this question. Many people have made money on Robinhood and saved a lot by not paying fees. It also gets young people into investing, as we’ve seen in the rise of finance Tik Tok, and we share that same mission at HC. On the other end, it’s clear that mega-corporations are making millions of dollars off of these new investors. This could be considered reasonable compensation for making the stock market more efficient, or it can be construed as manipulation or exploitation. At the end of the day, you deserve to know what’s going on so that you can make a more informed decision.
If you decide Hoskin Capital is the place for you, mention that you read about order flow on our blog and we’ll reduce our fee to 0.85% for life!
Thank you for your attention, I hope you learned something.
Best,
Nate Hoskin