Does Robinhood Brokerage Make Money in Shady or Questionable Ways?

Robinhood has gotten a lot of buzz as the smartphone app that offers free stock trades. From the very beginning, the most common question was “How Will They Make Money?” Here’s what Robinhood says in their Help Center:

Robinhood Financial makes money from its margin trading service, Robinhood Gold, which starts at $6 a month. Additionally, Robinhood earns revenue by collecting interest on the cash and stocks in customer accounts, much like a bank collects interest on cash deposits.

However, there is another source of revenue that they don’t mention in their FAQ, but they do disclose in SEC filings (since it is legally required).

Selling order flow. When you make an order to buy or sell stock at a retail broker, the broker usually decides which market-maker can fulfill your request. In turn, market makers are allows to pay brokers like Robinhood, E*Trade, or TD Ameritrade for this “order flow”. This is common practice in the industry. If you have a sophisticated brokerage account, you can choose to direct exactly where your order will go. (Being able to direct your orders isn’t necessarily better unless you know what to look for, i.e. tracking Level 2 quotes.)

Robinhood gets paid 10 times the rate of TD Ameritrade and E*Trade for their order flow? Then came an article Robinhood Is Making Millions Selling Out Their Millennial Customers To High-Frequency Traders where the author Logan Kane made the following observations (via @JBrown6109):

• These days, the people paying for order flow are often high-frequency trading (HFT) firms.
• TD Ameritrade made $119 million last quarter from selling order flow. Payments were about a 1/10th of a cent per share.
• E*Trade made $47 million last quarter from selling order flow. Payments were about a 1/10th of a cent per share.
• Robinhood does not have to disclose their revenue from order flow as they are private company. (And they don’t.) Payments averaged about $0.00026 per dollar of executed trade value. At $50 average share price, this equates to about a cent per share.
• This means that Robinhood is getting paid roughly 10x that of E*Trade and TD Ameritrade for the same amount of order flow.

Why? Here are some possibilities:

Theory #1: Robinhood is letting HFT “front-run” their customers, resulting is worse trade execution. If an HFT could give you 2 cents less per share, it would be worth paying 1 cent per share for that order. (Evil laugh.) However, this is countered by the SEC rule of National Best Bid and Offer (NBBO), which says that brokers must trade at the best available bid and ask prices when buying and selling securities for customers. This law may be hard to enforce by the millisecond, but would Robinhood or the HFT really blatantly break the law in this manner? Is it worth the risk to their business?

Honestly, I doubt it. Here’s the SEC Rule 606 Disclosure for Robinhood that shows where the orders are routed (source):

Yes, the names like Citadel and Virtu are well-known HFT firms. But Vanguard Brokerage doesn’t sell any order flow at all, yet most of their orders still go through Citadel (source):

Theory #2: Robinhood customers are broke and cheap, so they mostly trade a lot of stocks with low share prices. A lot of this argument is based on the amounts reported on the 606 disclosures. If you change the estimate for average share price traded to $4 a share, then Robinhood would get paid the same amount as the other firms. With zero commissions, anyone can afford to trade a few bucks of stock back and forth.

Theory #3: Robinhood’s order flow is somehow inherently more valuable than that of TD Ameritrade. Big brokers can fill some orders internally (one person is buying at the same time another is selling on the same platform) and they get to keep the market-maker profit. This rebuttal article says that Robinhood internalizes nothing and sells 100% of their orders. Maybe this “unfiltered” order flow is more valuable? Maybe the fact that their customers are younger and mostly non-professional traders make the order flow more valuable? More odd lots? More trades of single shares? More market orders instead of limit? Maybe Robinhood packages the data in some way that makes it more palatable to HFT firms?

HFT firms are using the data to build complex algorithms for their own trading, so they want to understand market behavior. Getting unlimited access to raw order data would certainly be key to understanding the behavior of “dumb money”.

Personally, I think it’s maybe a little #2, but more #3. Robinhood was founded by former HFT software engineers. They know exactly what type of information would be valuable to HFT firms. In fact, I think selling customer data (in aggregate) was a big part of their business model to pull off free trades from the very beginning. So they optimize the selling of your data quietly, while also making money on idle cash and margin subscriptions. It’s also a big money saver when they only answer customer service questions via e-mail and don’t have a phone number.

The bigger question: Do you care? Okay, so Robinhood gets paid by selling your order data. They get paid a penny per share. Some firm will know you bought 10 shares of Nvidia and sold 10 shares of AAPL exactly 54 minutes and 12 seconds after the new iPhone announcement. In some indirect way, this arrangement might give the HFT firms a greater trading edge in the future. In exchange, you get free stock trades today. Is this a bad deal?

They’ve also helped inspire more free trade competition:

• Firstrade: Free Online Trades On Everything: Stocks, ETFs, Options, Mutual Funds
• Webull App: Free Stock Trades + Free Share of Stock Referral Bonus

Bottom line. I view Robinhood as “free” in the same way that Gmail is “free” and Facebook is “free”. They make money via traditional means, but your personal data and behavior patterns are also part of the true price. The theme of this entire decade is that our personal data is the most undervalued asset (by us). Google, Facebook, Amazon, Visa, every major corporation – they are perfectly aware of the value of data. As the saying goes, “If you’re not paying for the product, you are the product.”