Robinhood and other ‘low cost’ brokers are still quietly screwing over their users

Vlad Tenev Robinhood
The Robinhood app and Robinhood CEO Vlad Tenev.

  • Robinhood and other free retail brokers drew attention in January during the GameStop mania.
  • But these so-called “discount” or “no commission fee” brokers often do not provide best execution of retail customers’ orders.
  • Jonathan Macey is the Sam Harris Professor of Corporate Law, Corporate Finance and Securities Law at Yale Law School and Professor in the Yale School of Management.
  • This is an opinion column. The thoughts expressed are those of the author.
  • See more stories on Insider’s business page.

The ongoing fiasco that grew out of online broker Robinhood’s decision to limit customers’ ability to buy “meme stocks” like GameStop in January has produced a lot of noise, but also a silver lining.

Robinhood’s move, which angered customers and some online commentators, also brought attention to how retail brokers like E*Trade, Charles Schwab, TD Ameritrade and Robinhood handle orders on behalf of their retail customers.

When a customer attempts to buy or sell a share of a stock or other security brokers have a legal and moral obligation to provide their customers with “best execution,” which means that these companies must give their customers the best price “reasonably available.” But this certainly is not happening in US securities markets today.

Retail customer orders with commission-free broker-dealers like Robinhood – that do not charge customers a fee to execute their trade – are sold to high-speed market makers like Citadel Securities and Virtu Financial in a scheme called “payment for order flow.” In essence, Robinhood and other brokers do not actually match a buyer and a seller to complete a full stock trade.

Instead, Robinhood sells their customers “orders” by the millions to market makers like Citadel, who do the hard work of lining up buyers and sellers in exchange for a fee. These high-speed market makers process massive amounts of trades every day and have taken over the market. By paying billions of dollars in kickbacks to retail brokers, on a typical day Citadel processes 40% of all retail securities orders in the US stock market, making Citadel the most powerful middleman on Wall Street.

Citadel, Virtu, and Robinhood claim to benefit the retail investor by offering better prices than they might get on exchanges. It is true that Citadel sometimes gives retail investors a better price than the National Best Bid and Offer (NBBO), basically what regulators have determined to be the best selling and buying price for each security, displayed by the Securities Information Processor (SIP). But the NBBO SIP is a slow data feed that provides incomplete information on buy and sell orders displayed on exchanges.

The NBBO benchmark Citadel and Virtu use is widely understood to be outdated and incomplete. But brokers selling their order flow and the market makers who buy that flow and execute their trades have a strong incentive to ignore non-displayed orders because poor execution quality for retail investors translates directly into profits for them.

The best execution requirement requires best execution. It is not sufficient to provide a slight improvement on an inferior price. To illustrate how the market works, suppose that the displayed NBBO SIP for a stock is a bid, the highest price a buyer is willing to offer, of $10.00 and an offer, the lowest price at which a seller is willing to sell, of $10.30.

A Robinhood customer sends an order to sell 100 shares to Robinhood, which sells the order to Citadel. Citadel might, at its discretion, give a sort of imaginary “price improvement” over the NBBO SIP and buy the 100 shares from the seller at $10.01, a one penny improvement over the “best” bid of $10.00. This gives the retail seller price improvement of ($0.01 x 100 shares) $1.00 over the best displayed bid on the SIP.

But Robinhood’s customers are entitled to more than a discretionary increment of price improvement over the NBBO. They are entitled to the best price “reasonably available,” which means that they should have access to the vast swathes of the market that are not displayed on the NBBO SIP, but are available Citadel and Virtu through their network of systems that track buy and sell orders that are not displayed on the SIP.

In particular, it often is possible to execute a trade at the midpoint between the NBBO best bid and the best offer. Midpoint pricing would have given the Robinhood seller $10.15 for their shaper share price improvement of $15.00 rather than just $1.00. That extra $14.00 represents the profit that Citadel makes on the trade minus whatever pennies Citadel paid for the order flow.

Of course, if payment for order flow were eliminated, commissions for discount brokers likely would return, but even with commission of $7.00 per trade the retail customer is better off without payment for order flow.

In a nutshell, Citadel is in direct competition with the retail investor for the best prices and has paid retail brokers like Robinhood billions of dollars to help them cover up this conflict. In fact, on March 11, Virtu CEO Douglas Cifu admitted in a TV interview that retail customers of brokers like Fidelity, who don’t pay for order flow get better execution quality than customers on venues like Robinhood.

The biggest question facing Gary Gensler as he takes the helm of the Securities and Exchange Commission is whether Citadel and Virtu have a duty to seek the best price in the market or whether the “duty of best execution” has been truncated to mean that customers are only entitled to the NBBO SIP.

At present, Virtu and Citadel decide what, if any, price improvement to give to customers. Price improvement is arbitrary and discretionary. And it’s a zero sum game. The better the deal the retail gets, the less money that Citadel and Virtu make.

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Payment for order flow models “undermine the relationship between the broker and their client,” Duke Law professor tells Congress

Vlad Tenev, co-founder and co-CEO of investing app Robinhood.
Vlad Tenev, co-founder and co-CEO of investing app Robinhood.

  • Duke Law Professor Gina-Gail S. Fletcher appeared in a hearing with the Senate Committee on Banking, Housing, and Urban Affairs on Tuesday.
  • In the hearing the professor said payment for order flow models pit brokers profits against their clients’.
  • Other experts on the panel even called for the payment for order flow model to be banned altogether.
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In a Tuesday hearing held by the United States Senate Committee on Banking, Housing, and Urban Affairs, Senators sat down with five experts to discuss “Who Wins on Wall Street? GameStop, Robinhood, and the State of Retail Investing.”

In the hearing, Duke Law Professor Gina-Gail S. Fletcher was asked by Sen. Sherrod Brown (D-OH) about stock brokerages using the payment for order flow business model.

Payment for order flow (PFOF) entails brokerages selling customers’ buy and sell orders to market-makers like Citadel Securities, Virtu, or Two Sigma. This allows the firms to generate revenue without charging commissions for trades.

When asked about the PFOF model, Duke law professor Gina Fletcher said that payment for order flow models “undermine the relationship between the broker and their client.”

The testimony was a rebuke of brokers like Robinhood, which rely on payment for order flow for the majority of their revenue.

Fletcher said that payment for order flow “pits the broker’s primary revenue source directly against the clients to whom they owe a duty of best execution.”

She also noted that it allows brokers to “say that they are offering zero-commission trading to retail investors when commissions are being subsidized by wholesalers.”

Professor Fletcher continued: “Under the payment for order flow model, brokers are incentivized to put their own profit-seeking interest above their clients’ in deciding where to route orders.”

Other experts on the panel included Rachel J. Robasciotti, the founder & CEO of Adasina Social Capital, who said that payment for order flow allows brokerages to profit while they give clients trading execution prices that are well below market value.

Robasciotti argued that the practice should be banned altogether due to the lack of disclosure adding, “if you don’t see what you are paying you are probably paying more than you would be comfortable with.”

Other experts weren’t as quick to call for a ban on the practice, but the group all agreed that the Securities and Exchange Commission should look into the payment for order flow model to decide if it should be allowed to continue.

To find out if a broker is getting paid for order flow, check out this article to learn more.

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SEC chair nominee says he will evaluate payment for order flow practice at the heart of the GameStop saga

WASHINGTON, DC - JULY 30: Commodity Futures Trading Commission Chairman Gary Gensler testifies before the Senate Banking, Housing and Urban Affairs Committee in the Dirksen Senate Office Building on Capitol Hill July 30, 2013 in Washington, DC. Gensler and Securities and Exchange Commission Chairman Mary Jo White testified and took questions from Senators during the hearing titled, "Mitigating Systemic Risk in Financial Markets through Wall Street Reforms." (Photo by Chip Somodevilla/Getty Images)
Gary Gensler.

  • Gary Gensler is being considered to be the next chairman of the Securities and Exchange Commission. 
  • He said the agency under his watch would at look ensuring investors get “best execution” for their trades and whether payment for order flow provides that. 
  • Gensler’s confirmation hearing comes in the backdrop of questions about the “gamification” of trading for retail investors. 
  • Visit the Business section of Insider for more stories.

Gary Gensler, the nominee to be the next head of the Securities and Exchange Commission said the agency under his watch would review issues surrounding protection and fairness for retail investors. 

There’s been a “gamification” in trading for retail investors, and in recent months there has been “unprecedented volatility” in many stocks. This has been seen most notably in video-game retailer GameStop, said Senator Sherrod Brown of Ohio, the ranking member of the Senate Banking Committee during a virtual confirmation hearing on Tuesday.

Gensler, who was nominated by President Joe Biden to be the new head of the SEC, said the agency should review, among others, a practice by some trading firms to pay third-party brokers to execute customer orders.

The SEC should examine questions over “how to ensure that customers still get best execution in the face of payment for order flow,” Gensler said during a Tuesday virtual confirmation hearing held by the Senate Banking Committee.

Payment for order flow refers to a practice of compensating brokerage firms to route trading orders from their customers to certain market makers to execute the trades rather than directly to an exchange. The practice has raised questions over if it creates a potential conflict of interest and if it might lead to sub-par execution for customers.

Payment for order flow was thrust into the spotlight this year after Robinhood in late January placed trading restrictions temporarily on some popular stocks, including GameStop.

After a massive short squeeze on GameStop that sent its share price soaring, trading app Robinhood temporarily restricted trading in a handful of volatile stocks at the center of the Reddit-driven frenzy.

Public interest in market structure and payment for order flow has been “reignited” by the recent trading in GameStop shares, Senator Mark Warner from Virginia said during the hearing.

Last month, the House Financial Services Committee held a hearing on January’s short-squeeze episode. Legislators heard testimonies from Robinhood CEO Vlad Tenev, famed GameStop retail investor Keith “Roaring Kitty” Gill, and Citadel CEO Ken Griffin. 

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