If you are trading stock, maybe you are using a commission-free broker. I know but there is Robinhood is one of the popular out there. The app steals from the huge hedge funders and gives it to the poor just like what Robinhood story does.
Robinhood is anything but a proverbial vigilante against inequality. That is because the app is offering a completely free trading environment and it is just free.
Payment for Order Flow
It is alive in Wallstreet for so long and is one of the predominant methods used by retail brokers to earn money. In the case of Robinhood, it's over 80% of its revenue.
What is it exactly?
The broker is paid by a third party to direct its orders to a specific third party and most likely it is, Wholesalers, exchanges, or even institutions. Basically, any entity that's willing to pay in order to execute those orders on its books.
Mostly the online brokers are the third parties like market makers and high-frequency trading firms. Robinhood is routing the orders in seven different kinds of market makers. This year, almost 60% percent of its revenue is from market makers. An awful power of market makers.
When it comes to Robinhood is supposed to root these orders it is obligated by law to send them to the market makers that are able to provide the best execution.
Whoever can offer the best pricing for Robinhood clients will be the chosen one. These brokers will choose the market makers and get paid with the same participants.
Is it a massive conflict of interest? yes, it is.
Brokers must choose where to route whether they get the best rates.
What if.
Broker is paying a higher rate
They get a fee based on the size of the spread being charged
In some scenarios, a broker could choose sub-optimal execution for its trader’s order, and that is where they get a lot of money. This business practice has too many conflicts of interest that even in other countries, it is banned.
They have a lot of ways to make more money and there are some obvious ways.
They use the spread to arbitrate the rates. Depending on whether the client placed a buy or sell order, they will buy or sell an asset between the bid and ask spread and profit. To these market makers, it's money for a jam. However, the amount of money that may be made by using order information is insignificant.
Gary Gensler, the current head of the SEC, is not a big supporter of the practice. After taking over as chairman of the SEC two months ago, he requested the agency's staff to make recommendations on how to change the market structure rules.
Gensler stated at a conference in June that the NBBO benchmark may not be as representative as it should be.
Robinhood has hired a former SEC commissioner as its top legal officer, which gives you a sense of how much regulatory pressure the company could face. Daniel Gallagher was paid $30 million in 2020. You'd be correct in thinking that's a ridiculous amount of money.
He was hired in the mid-year. So, it's evident that this business model isn't doing well, but what does this mean for regular traders and Robinhood?
It's a bit of a gamble for the traders. Brokers will argue that if their order flow is no longer compensated, they will have to hike pricing elsewhere. This might entail a return to commission-based trading, or the SEC may not outright prohibit the practice.
Perhaps strict reporting laws will be enacted to ensure that the broker obtains the best possible execution. It might also consider altering the national best bid and offer benchmarks. The SEC, on the other hand, will try to execute the policy that has the least impact on retail traders' costs.
It's already not the most popular government agency in the wake of the GameStop saga, so I doubt it wants to be associated with fee rises.
One thing is certain: drastic changes to the payment for order flow method could have serious financial consequences for Robinhood. According to its S-1 IPO filings in 2020, the practice accounted for 75% of the company's top-line revenue.
It reached an all-time high of 80 percent in the first quarter of this year. Consider what a reduction in this revenue stream might mean for profitability. This isn't a viable business model.
That's because Robinhood isn't profitable at all, with a 1.4 billion dollar loss in the first quarter being its largest to date. It's so dangerous that robin listed all of these as potential risks in its S-1 filing.
It stated that payment for order flow posed a significant risk to the company. That it would have little to no redress if any of those market makers decided to stop paying it for the flow.
It also notes the regulatory risk posed by payment constraints for order flow. Aside from the obvious risks to its primary source of revenue, there's also the question of its long-term viability. It acknowledges that it has experienced operating losses in the past and that it may do so again.
Thoughts
2020 was an odd year in the markets, and we're unlikely to see a repeat of the bizarre mix of stimulus, lockdowns, and wide-eyed millennial investors. Kickbacks to hedge funds for your orders are currently how things work in the world of centralized finance. As a result, dishonest money men are trading against you and begging for your gratitude. One of the main reasons I like to avoid it is because of this.
If there's one thing you should take away from this article, it's that nothing comes for free. Any service that comes out and offers you something for free is going to make money in some way. The money made by commission-free trading apps like Robinhood comes from your trade data. They profit from kickbacks and spreads, which you were eventually compensated for by the market maker.
Not only that, but they're also providing information about the order flow to these third-party billionaires. There's no way these folks weren't making money off of that knowledge. Of course, the tables may be turned. The inherent conflicts that exist for payment for order flow are finally being recognized by regulators and lawmakers. As they begin to impose more strict regulations on the industry, it is possible that users will pay higher commissions or brokers would see lower earnings.
The idea is that centralized finance creates an asymmetric information structure in which the trading counterparty knows more than you do. With decentralized finance, on the other hand, everyone can see exactly what they're getting. As a result, the playing field between traders and market makers is leveled.
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