Robinhood’s upcoming initial public offering presents “alarming” risks to investors as regulators could stifle the brokerage app’s main source of revenue, according David Trainer, CEO of investment research firm New Constructs.
81% of Robinhood’s revenue in the first quarter of 2021 came from a controversial practice known as payment for order flow. The brokerage app argues that payment for order flow allows it to offer free trading to their customers. In June, SEC chief Gary Gensler questioned whether payment for order flow provides investors with best execution.
“Payment for order flow raises a number of important questions. Do broker-dealers have inherent conflicts of interest? If so, are customers getting best execution in the context of that conflict? Are broker-dealers incentivized to encourage customers to trade more frequently than is in those customers’ best interest?” the SEC chair said in prepared remarks.
If the SEC ever outlaws payment for order flow, Robinhood may not be able to offer commission-free trading, which would put the app at a disadvantage against competitors Fidelity and Charles Schwab. Unlike Robinhood, those firms generate more revenue from other services, he added.
In June, SEC chair Gary Gensler said the US regulator is reviewing payment for order flow, but the practice is still legal. Trainer noted that Robinhood hired former SEC Commissioner Dan Gallagher as chief legal officer in 2020 and paid him $30 million after seven months.
“$30 million to one person is a lot for a firm without any regulatory concerns,” Trainer said. “The mounting regulatory risk Robinhood faces makes us concerned that the public may see Robinhood’s stated goal to ‘democratize investing’ as a ruse to lure them into speculative trading and gambling that benefits Robinhood more than the individual investor.”
Trainer also said that Robinhood’s valuation is worth no more than $9 billion, significantly less than the firm’s expected $35 billion price tag.
According to Trainer, Robinhood’s $35 billion valuation implies the firm will be able to maintain its pandemic-era profitability, grow revenue by almost 3,000%, and compete with established rivals like Schwab. But the app lacks scale and with the meme stock frenzy fading for now, its best years may already be behind it, he said.
The Securities and Exchange Commission is looking at changing rules around share trading after the day-trader frenzy around meme stocks showed equity markets may not be as efficient as they could.
Chairman Gary Gensler said Wednesday he has asked the regulator’s staff to submit recommendations on a range of market rules, including the high fees paid to Wall Street brokers for executing small-investor orders and the rise of commission-free brokerage apps.
Their recommendations will address the issue of payment for order flow, or the compensation online brokers receive when stock orders are routed to third-party firms like Virtu Financial and Citadel Securities in order to carry out the trade.
Shares in Virtu fell 7.7% after Gensler’s comments. The high-speed trader handles about one-third of individual investors’ order flow in US stocks, according to the Wall Street Journal. Virtu’s stock rallied this year alongside the meme-stock frenzy, while Citadel Securities isn’t publicly traded.
Gensler previously called out popular investing apps like Robinhood that have introduced millions of amateur investors to stocks through the lure of zero commissions. He criticized the company for encouraging the gamification of the stock market, and for not doing enough to educate its user base of the risks associated with investing.
Robinhood’s business model, which operates on a system of payment for order flow, allows it to offer so-called “commission-free trading.” But some lawmakers have called for increased examination into the potential conflict of interest it presents its users.
The SEC will look into this practice, that uses phone alerts and other notifications to get investors to trade more, Gensler said at a Piper Sandler conference in New York.
“The question is whether our equity markets are as efficient as they could be, in light of the technological changes and recent developments,” he said.
Most of these issues came to regulatory attention after day traders used social platforms like Reddit to bid up prices of heavily-shorted stocks like GameStop, fuelling an over 1,200% surge in the video-game retailer’s stock in January.
New SEC rules could impact the business models that online brokerages use, meaning Robinhood and its competitors would have to operate under new guidelines.
“Brokers profit when investors trade,” Gensler said. “For those brokers who have these arrangements – and not all do – higher trading volume generates more payment-for-order flow. What makes the current zero-commission brokerage environment different is that investors do not see their costs as they’re executing trades, so they may perceive them as free.”
The brokerage app’s payment for order flow generated $331 million in revenue in the first quarter, said the Journal, citing a securities filing from last week. That’s more than triple the $91 million Robinhood reeled in from the business during the first quarter of 2020.
Payment for order flow is the compensation brokerages earn by having third-party firms execute client orders. When Robinhood’s clients buy and sell stocks and options, Robinhood routes the trade orders to outside firms who actuate carry out the trade. The outside firms pay Robinhood for routing the order to them.
The practice is Robinhood’s largest source of revenue, and has drawn criticism from investor advocates who say it encourages brokerages to maximize their revenue at the expense of customers.
The SEC alleged that the brokerage routinely provided inferior trade prices, even as Robinhood marketed its trades as commission-free and executed with quality that matched or beat peers. The second-rate prices have cost clients a total of $34.1 million, even after accounting for the lack of commission fees, the SEC said.
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.
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.
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.