As GameStop and other stocks targeted by day traders in the r/WallStreetBets subreddit begin to climb, popular fee-free trading platform Robinhood is outright preventing users from buying and only allowing sales to close out positions. The company has been widely criticized for the trading restrictions and is now the subject of a class action lawsuit.
Given that Robinhood is playing a central role in retail investors pumping dark horse stocks, it’s worth examining once again how it makes money: namely, by selling users’ trades to other large firms before they’re actually executed. Those firms make money by effectively seeing what the retail investors on Robinhood are going to do before they actually do it, and acting accordingly. Those firms are basically buying information that then informs their own trades.
For the past few years, Robinhood has spent a great deal of energy marketing itself as born out of the Occupy Wall Street movement and champions a mission to “democratize finance for all.” The reality, however, is that this rhetoric distracts from the fact that it's actually helping preserve the status quo—namely by turning its customers (but more so their orders) into products.
The secret to Robinhood's success (and profitability) is simple: payment for order flow. To ensure trades are commission free, trades are sold to "market makers'' or large firms such as Citadel—Citadel Securities is Robinhood’s largest customer, and affiliate Citadel LLC tried to bail out Melvin Capital after its Gamestop shorts cost it billions. Market makers execute those trades (sometimes at an inferior rate) and can use their privileged position to place themselves in the middle and make a profit. Crucially, in this arrangement, more trades and more volatility mean there’s more for firms like Citadel to work with. Here is the Financial Times explaining how it works:
Citadel Securities pays tens of millions of dollars for this order flow but makes money by automatically taking the other side of the order, then returning to the market to flip the trade. It pockets the difference between the price to buy and sell, known as the spread.
Easy access to the market against the backdrop of wild swings in prices have led to higher trading volumes for stocks and options this year—increasing the raw material Citadel Securities uses to turn a profit. At the same time, the rise in volatility has forced spreads wider, increasing the potential income for market makers.
Market makers like Citadel are supposed to be honest dealers that seek the best price for orders, whether they internalize the order themselves or send it to market. Unfortunately, Citadel has not always done this. In 2017, the SEC fined Citadel $22 million because its algorithms were screwing the retail investors whose order flows it was purchasing.
“One strategy, known as FastFill, immediately internalized an order at a price that was not the best price for the order that Citadel Securities observed,” the SEC noted. “The other strategy, known as SmartProvide, routed an order to the market that was not priced to obtain immediately the best price that Citadel Securities observed.”
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Payment for order flow wasn’t invented by Robinhood (that honor belongs to Bernie Madoff), but the company's technique differs from others who use it in the industry in that it charges a percentage of the order spread. In 2020, payment of order flow has made the company a killing: for the first quarter, it accounted for $90 million in revenue for the company (70 percent), by the second it doubled to $180 million.
Payment for order flow is a wonderful system that makes a lot of money for everyone involved, except the consumer.
In December, Robinhood was fined $65 million by the Securities and Exchange Commission for "misleading statements and omissions in customer communications" about its revenue, but specifically around its payment of order flow process. The SEC found that customers were led to believe they were getting the best possible price for their orders, but were actually collectively "deprived" of $34.1 million because Robinhood chose to give their orders to firms that would give the company higher revenues rather than the best prices for customers.
"If the service is free, you are the product. Robinhood users thought the service was accountable to them, but actually it exists to serve giant Wall Street institutions like Citadel and other market makers,” J.E. Karla, editor of the business newsletter Contention, told Motherboard. “They will suicide bomb their own business models to protect the real powers from the consequences of their internal contradictions. When a system approaches a terminal crisis, its institutions will break their own rules to suppress elements that threaten the system’s continued viability. That’s what’s happening here. This specific episode may be over in a week or two, but it's a symptom of something very ominous."
While the GameStop stock saga has so far largely been seen as a case of the “the little guy” (as far as day traders with money can be considered “the little guy”) getting back at big financial players, the reality is more complicated. The financial system has many moving parts, and the day traders on Robinhood who imagine themselves as literal Robinhoods are really just grist for a larger mill. It’s worth noting here that whatever profits a few day traders end up realizing on GameStop, the huge firms that own the majority of GameStop stock will likely come out on top.
Robinhood may bill itself as an app for the little guy, but its platform, perhaps more than any other, is a great reminder that the stock market is a casino—which means you cannot forget that the house always wins.