“Just imagine that a bond is a slice of cake, and you didn’t bake the cake, but every time you hand somebody a slice of the cake a tiny little bit comes off, like a little crumb, and you can keep that. If you pass around enough slices of cake, then pretty soon you have enough crumbs to make a gigantic cake…golden cake. And Pierce and Pierce collect millions of marvelous,” she shrugged, “golden crumbs.” –Judy McCoy, Bonfire of the Vanities
This week, it was reported that the Securities and Exchange Commission (SEC) was probing Robinhood Financial for not disclosing to its customers that it received payment for order flow from high frequency trading (HFT) firms such as Citadel, Virtu, Wolverine, G1X, and Two Sigma Securities. Excerpt below taken from the Wall Street Journal:
“The investigation, run out of the SEC's San Francisco office, examined Robinhood's failure to fully disclose on its website—until 2018—that it took payments from high-speed trading firms for sending them customers' orders to buy or sell stocks or options, the people said. The practice, known as
payment for order flow, is a common—if controversial—way for retail brokerages to execute client trades. Critics say payment for order flow creates a conflict of interest for the broker that sells the orders. The practice has raised suspicions that it could lead to sophisticated traders exploiting mom-and-pop investors, although brokers and traders say such concerns are baseless.”
A new report required by the SEC for brokers who route customer order flow to other firms and venues titled “Held NMS Stocks and Options Order Routing Public Report” shows that Robinhood made approximately $271 million from HFT firms for the first six months of 2020. Until the SEC shined a light, Robinhood claimed on its website that it made its money from fees on margin accounts and interest on customer deposits. It is estimated that Robinhood, a private company, is valued at $11 billion. Upon the disclosure of the payment for order flow, co-Founder of Robinhood, Vladimir Tenev posted a blog stating:
"The revenue we receive from these rebates helps us cover the costs of operating our business and allows us to offer commission-free trading."
That sounds like something the owner of a small coffee shop might say to his loyal customers after raising the price of a cappuccino 10 cents to cover the cost of the new milk steamer as opposed to the CEO of a company, steeped in the world of high frequency trading, admitting to his customers that he left an awfully large piece out of the “how we make our money” story. Mr. Tenev and his partner, Baiju Bhatt, ran Cronos Research—a startup that made software for ultrafast trading firms—before founding Robinhood. We find it hard to believe that Silicon Valley venture capital firms and other large institutional investors just got excited about another online brokerage entering a crowded market with a cool brokerage app that didn’t charge fees. While it is true that Robinhood’s marketing appeals to a whole new investing populace, without fees for trading, they weren’t even worth around what E*Trade is currently worth. There had to be something else.
That something else is the payments they receive for routing order flow to the HFTs. Part of the draw of Robinhood has always been the fact that you trade for free. At least that part of the story is partially true. You don’t pay fees when you trade, you just may not get the best execution when you trade on their platform. However, the part of Tenev and Bhatt’s story where Robinhood is a democratizing force in finance that is seeking to upend traditional ways of doing business on Wall Street is nonsense.
Become one of Robinhood’s merry men—preferably one about 22 years old who likes to sports wager on his phone—and stick it to the man! Robinhood isn’t upending anything. They know how the HFT payment for order flow secret sauce is made and they built a model to exploit it. That is why sharp VC firms and other large investors think the company is worth $11 billion.
Robinhood’s false advertising practices were bad, and it appears they have corrected them, which is good. However, they need to explain why, in many circumstances, they receive more money from HFT firms for their order flow than their competitors. Luckily, with these new SEC monthly reports you can compare Robinhood to firms like Schwab, TD Ameritrade, and E*Trade, to name some of the biggest.
For comparison, we looked at these four firms’ reports for April 2020. We looked at Payment for Market Orders and Marketable Limit Orders (a bid or an offer under the current market price) for both S&P 500 and Non-S&P 500 stocks. On average, Robinhood is compensated nearly twice as much as E*Trade, twice as much as TD Ameritrade, and 295 times more that Schwab! What is interesting is that each broker has recently stated what percentage of the trade orders they route to HFT firms are done at or better than the National Best Bid Best Offer (NBBO). Schwab: 99%; TD Ameritrade: 98%; E*Trade: 96%; and Robinhood: 89%. So, the worst in execution quality has the most compensation for order flow. The inverse relationship between best execution performance and HFT remuneration for order flow certainly raises eyebrows.
What is it about Robinhood’s order flow that may be different to make it more valuable to HFT firms? The easiest explanation is that the firm’s client base is less sophisticated and therefore less likely to notice inferior execution than more sophisticated investors. However, we have to admit that we believe there aren’t that many retail investors at any brokerage who are paying attention to what may happen to their order in milliseconds. HFT “arbitrage” is a couple to a few cents per trade. They make a lot of money in blinks of an eye that aren’t noticeable until it is all whacked up at the end of the day—and even then, the guy who bought a hundred shares of some stock doesn’t know and probably doesn’t even care that he paid two cents more than he should have. This is how HFT makes those Bonfire of the Vanities “Golden Crumbs.”
For a possible answer as to why Robinhood’s order flow is more valuable and why they are relatively way behind their competitors for best execution, we have to look deeper into this world—a world that only a few know a heck of a lot about. A world that Robinhood’s founders just so happen to know a lot about.
When orders are given from the brokerage to the HFT, they normally have to comply with Regulation NMS. This means when a customer submits an order to buy 1,000 shares of XYZ, execution must exhaust the National Best Offer before moving down to the next best offer.
Customer wants to buy 1000 shares of XYX. Customer’s broker routes the order to HFT firm
Market Center A
Best offer: $50 for 200 shares of XYZ
Next best offer: $50.02 for 800 shares of XYZ
Market Center B
Best offer: $50.04 for 800 shares of XYZ
The HFT firm can buy 200 shares of XYZ from Market Center A. That exhausts the best offer. Then, in accordance with Regulation NMS, they would buy the remaining 800 shares at $50.02, also from Market Center A, as this is the next best offer.
However, if the order is routed to the HFT firm as what is known as an Intermarket Sweep Order (ISO), the HFT firm, after exhausting the best offer from Market Center A, can bypass the next best offer on Exchange A (800 shares of XYZ at $50.02) and go and buy the 800 shares in Market Center B at $50.04. This offer, two cents higher than the next best offer, is the HFT firm’s offer. In a blink of an eye, the HFT firm made two cents riskless profit (aka “Golden Crumbs”). If Robinhood puts more than the average Institutional Sweep Orders through to the HFT firms, then their order flow is certainly more valuable than their competitors.
Robinhood may have unwittingly shone a light onto the opaque world of payment for order flow and high frequency trading. Giving a larger amount of ISOs may not be illegal, but it doesn’t seem to be a good business practice. If this inverse relationship between level of remuneration for order flow and best execution continues, Robinhood may have a problem. We think this story will continue to develop.
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