We’ve all been on Zoom calls this year in which real life has made its way into a business meeting. You see a toddler’s hand reach across the screen or a cat trying to jump onto a keyboard while someo...
“What am I getting excited about? You’re gonna get us all pinched. What are you, stupid? What’s the matter with you?” - Jimmy Conway “Goodfellas”
It’s been an exciting week for eBroker Robinhood Financial. On Wednesday, the state of Massachusetts filed a complaint against the firm. The enforcement arm of the Massachusetts Securities Division said,
Robinhood failed to protect its customers and their assets, violating state laws and regulations. Robinhood exposed Massachusetts investors to "unnecessary trading risks" by "falling far short of the fiduciary standard" adopted this year that requires broker-dealers to act in their clients' best interest.
The complaint highlighted past fines and investigations into Robinhood by both the SEC and FINRA for Robinhood’s failure to disclose to its customers until 2018 that it made nearly 80% of its revenue through Payment for Order Flow (POF) from High Frequency Trading (HFT) market makers and did not reveal to its customers the quality of the execution customers received when their orders were routed up to 2019. The complaint also highlighted what it called the “gamification” of its customer base, the lack of oversight when encouraging customers to engage in trading relatively complex products, such as options on stocks, as well as the severe lack of customer support and infrastructure that has encountered a number of outages.
Then, on Thursday, Robinhood settled with the Securities and Exchange Commission for $65 million, without admitting or denying the allegations stated above that it “misled” customers in regard to their outsized dependence on POF for its revenue.
Tough week for the merry men and women of Robinhood? We think not so much. As we detailed back in September (see “Nobody Rides For Free”), we believe that Robinhood is a brilliant—yet diabolical—mouse trap built by two former HFT engineers to bring in unsuspecting investors and create the most valuable order flow for HFT market makers. Unlike its competitors (TD Ameritrade, Schwab, E*Trade) who also profit from POF, Robinhood actually shares in the HFT market making (which allegedly includes front-running the order flow) profits through the formula in which they are paid.
So, $65 million to the SEC to put this disclosure transgression behind them is just a speeding ticket on the way to a lucrative IPO next quarter. The company is currently valued at around $12 billion, and given the way IPOs have been going lately, and the fact that Robinhood actually turns a profit, the budget for the after-IPO party may be $65 million!
It was, however, in our opinion, a tough week for the shadowy and extremely lucrative world of HFT. After surviving and continuing to thrive after Michael Lewis’ novel “Flashboys” in 2014, where highly experienced electronic traders such as Brad Katsuyama were able to show in great detail how predatory (not all HFT operations are predatory) HFT were just beating—and many times downright cheating—non-HFT flows, both institutional and retail. However, like the unfortunate gangster Johnny buying the Cadillac with the stolen Lufthansa money in “Goodfellas” (earning the wrath of the murderous Jimmy Conway), Robinhood is shining a big light on HFT with their brazen use of HFT to print millions in revenue and grow their market capitalization by billions.
One question that we, along with many others, have is why market making firms like Citadel, Virtu, and Susquehanna pay more for Robinhood’s order flow than they pay to the other eBrokers mentioned earlier. There are a few reasons—some legitimate, such as consistent smaller trade size, and some that are not legitimate, such as failure to monitor and hold HFT market makers accountable to the quality of execution as per SEC Rule 605 (formerly 11Ac1-5). This is why Robinhood was fined by FINRA in $1.25 million in 2019 and they are still very slow in providing the full execution quality picture.
Now, they tell you what percentage of routed orders get the National Best Bid Best Offer (NBBO), but unlike their competitors, they still don’t tell what percentage of the order flow execution was better than NBBBO as all their competitors do. Considering the supposed reason for sending order flow to HFT market makers is to get superior execution, that’s a big deal. If Robinhood doesn’t hold Citadel and Virtu accountable to that standard, then that is great for Citadel and Virtu. That means they can just take the flow that makes them money and the rest gets routed to a visible exchange. A free option.
But here is what is really sinister about the evolution of predatory HFT market makers (the distinction being there are HFT market makers who are not predatory), HFT proprietary trading operations and brokerages like Robinhood. HFT firms have spent cumulative billions of dollars on creating their algorithms to send signals that allow them to use their speed to get in front of retail and non-HFT institutional flow. One such type of algorithm type is called “Trend Tracer.” Just like Google and Facebook, these algorithms track and then predict what cohorts of non-HFT traders are going to do before they do it. Of course they can’t predict with full certainty, that is what the actual “latency arbitrage,” also known as front-running actual orders algorithms are for! Nevertheless, if their trend-tracing algorithms are correct more than 50% of the time, they make money by stepping in front of the non-HFT flow.
Some find it disquieting that when you’re interested in buying a new set of golf clubs and you start your search for them with Google, within minutes, advertisements for the exact clubs you looked at show up on your Facebook page as well as many of the online sites you visit. Some find that scary, some find it actually convenient. However, what if Google had a division that, based on your “cohort” (the 10 million individuals that Google has determined act and as far as they are concerned, just like you) went out and purchased all the golf clubs you and your cohort looked at and sold them to you $100 higher? You’d be pretty ticked off right? This is what trend-tracing algorithms do, and they actually do buy those stocks (as opposed to golf clubs) before you and charge you more for them.
Much has been made, especially by Robinhood and their supporters, of the fact that the company has introduced millions of new, young traders to the markets. This is true indeed, and in fact, it is perhaps the biggest, uniform cohort in the investment community. College aged, male, heavy users of social media, and highly susceptible to dopamine-inducing tactics. By purchasing the Robinhood order flow, studying it, and tuning their trend-tracing algorithms loose on it is probably worth every penny paid to Robinhood times a lot more. They can get in front of that flow and because this flow has become so influential to the overall market, they can get in front of a lot more non-Robinhood cohort flow.
Since Robinhood came into the general public’s view just a few months ago, the very murky world of HFT and PFOF has become a lot more visible. Perhaps the worst thing for “The Flashboys” is with real numbers in the form of revenue from POF along with whatever multi-billion-dollar valuation Robinhood will get for its IPO, a lot more people are going to become interested in looking into a multi-trillion-dollar marketplace where algorithms run amok, skimming billions of dollars a year from it. Perhaps it could lead to reform, or a move to a system patterned off of Brad Katsuyama’s IEX which imposes “speed bumps” to level the playing field.
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John Tuohy is CEO of SWBC Investment Services, LLC, a Broker/Dealer and SWBC Investment Company, an SEC Registered Investment Advisor (RIA). In his role, John is responsible for identifying, developing, and executing the division's strategic plan and all business development, sales, and marketing activities.