Written By Vib Das
With attacks and public outcry against Robinhood and other online brokerages making headlines recently, it’s easy for a reader to fault them for purposely throttling trades in a select few stocks. While yes, this sudden stoppage prevented many from purchasing shares in GME, AMC, and the many other “meme stocks”, the intention was not to harm the individual investor in favor of the institutional one.
Rather, Robinhood was acting to uphold its duty as a registered broker-dealer. The clearinghouses affiliated with Robinhood abruptly increased their equity deposit requirements almost ten-fold (Robinhood.com, 2021). Unable to adequately meet the requirements imposed by the clearinghouses, Robinhood was forced to throttle purchases in those volatile securities mentioned above in order to ensure the company would have time to supply sufficient collateral to the clearinghouses.
This is all well and good, but the recent debacle with Robinhood actually brought back one of its recent mix-ups with federal agencies into the spotlight: payment for order flows. Since Robinhood cannot execute trades directly, it “is required by law to work with market makers that can give their users the best market prices for a given trade’ (MacMillan and Torbati, 2021). Here is where things gets interesting. This past December, the SEC levied a $65 million fine on Robinhood for “fail[ing] to seek the best reasonably available terms when executing customers’ orders, causing customers to lose tens of millions of dollars” (Denham, 2020). Essentially, instead of finding the most competitive market prices for their users’ executed trades, Robinhood sent its order flows to the highest bidders. More often than not, the highest bidder turned out to be none other than Citadel Securities, the same trading giant currently finding itself under public scrutiny alongside Robinhood (MacMillan and Torbati, 2021).
What’s wrong with selling order flow? Why is it controversial? Well, it wouldn’t be – if brokerages upheld their duty to their customers to get them the best possible prices. However, “many brokers… contract in advance to sell their customers’ orders for a fee,” removing price competition from the equation (Levin, 2021). By pre-selling order flow to individual market makers, they are effectively transferring over their responsibility to the very people taking the opposing positions of the investors. A market maker’s only duty is to provide liquidity, not ensure that the people transacting with it are getting the best possible prices. Of course, with competition between market makers, prices invariably end up as efficient as they can be – but without competition, bid/offer spreads can widen considerably.
This is why the SEC charged Robinhood in December, and this could potentially open the doors for new fines and regulations around order flow payments to large trading firms in the near future.
What’s more, Robinhood bills itself as providing commission-free trading. While, technically, yes, the company does not charge users a fee for trading securities, there are hidden costs users unknowingly pay. There exists a trade-off between commissions and price execution (executing a trade at a certain price). Since Robinhood does not make money on facilitating customer trades, it seeks the highest fees for its order flow in order to generate revenue. Market makers posting the higher fees are less likely to offer the most competitive prices since they are already richly spending on order flows. Due to this, Robinhood customers were paying “tens of millions of dollars” in hidden fees from the slightly higher buy prices and lower sell prices offered by Robinhood’s selected market maker (Denham, 2020).
In a recent Clubhouse session, Robinhood CEO Vlad Tenev was interviewed by Elon Musk and vehemently denied any misdoings on Robinhood’s part, asserting that the company acted to protect its users’ best interests. While this may be true at surface level, it doesn’t take much for someone peering behind the curtains to sense foul play behind the scenes. Perhaps Robinhood should more strongly and transparently adhere to its brokerage responsibilities – or better yet, forego order flow payments – if it truly seeks to “democratize finance for all”.
References
Denham, H. (2020, December 17). Robinhood agrees to $65 million civil penalty to resolve SEC
charges. Retrieved from https://www.washingtonpost.com/business/2020/12/17/robinhood-secinvestigation/
Levin, C. (2021, January 11). Time to stop trading conflicts that cost investors billions. Retrieved
from https://www.ft.com/content/8a88d1e9-8a76-47c3-9fb7-b720fab55f5d
Douglas MacMillan, Y. T. (2021, January 30). Robinhood and Citadel’s relationship comes into focus as Washington vows to examine stock-market moves. Retrieved from
https://www.washingtonpost.com/business/2021/01/29/robinhood-citadel-gamestop-reddit/
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