The Robinhood phenomenon, or how these guys sell your deals to market makers
To everyone who was wondering how Robinhood succeeds, here’s a brief explanation. Disclaimer: the text is heavy with trader terms
Payment for Order Flow, or directing orders to market makers, is a major reason why Robinhood offer zero-commission trading
High frequency traders use data provided by Robinhood to massively accentuate the retail momentum
80% of Robinhood’s clients are millennials, with the average audience age of 26
If you're not paying for the product – you are the product
Established in 2013, Robinhood is a commission-free fintech company that offers discount online brokerage services. The company has a web and mobile-based trading platforms on which it is possible to trade stocks, exchange-traded funds (ETFs), options, and American depositary receipts (ADRs). Additionally, users from select locations can invest in certain cryptocurrencies.
The company has attracted attention after it reported $69 million in order routing revenue, according to a new estimate from Alphacution. The company’s business model revolves around revenue through payment for order flow, premium membership fees, stock loans, interest on uninvested cash, interchange fees related to its debit card, and other smaller revenue streams.
Roughly 80% of Robinhood’s customers are millennials and the average customer age is just 26, according to the Wall Street Journal. Robinhood’s marketing pitch is that you can trade for free.
Payment for Order Flow
“If You’re Not Paying for the Product, You are the Product.”
Among the revenue streams, payment for order flow (PFOF) is associated with most controversy. Robinhood generates transaction-based revenues by routing its users’ orders for options, equities and cryptocurrencies to market makers.
It’s a common practice among brokerages, and Robinhood’s revenues are said to be in excess of $150 million each year as a result of PFOF.
Brokerage firms that use PFOF receive a small payment as compensation for directing orders to a particular counterparty. The payment is usually only fractions of a penny per share but can be a significant source for companies dealing with a large number of orders. PFOF is a major reason why Robinhood is able to offer zero-commission trading.
In this situation, Robinhood sells the retail order flow to high-frequency traders (HFTs) and big hedge funds like Citadel. These traders could then use algorithms to front run the trades, which would massively accentuate the retail momentum.
Who wants the data?
The business of market makers is to profit from the spread between the bid and the ask. They provide liquidity to the market, which means they take the other side of trades. When a sophisticated institutional investor, such as a large hedge fund, approaches a market maker, this can be risky for the market maker.
The selloff led by a hedge fund normally involves large chunks of the company that cannot go unnoticed. If the market maker takes the other side of the trade and buys the securities that the hedge fund is selling, there’s a decent chance that the market will keep moving in the hedge fund’s favour. This exposes the market maker to downside risk.
In contrast, retail traders exhibit diametrically opposite trading behaviour. By virtue of being retail, their trading volumes are significantly smaller and they are not as sophisticated as to coordinate with other retail traders. They’re generally less sophisticated than institutional traders so for a market maker, it’s rare that you’ll lose money on making a market for retail traders.
The bottomline is: for market makers, it’s more profitable and risk free to make markets for retail clients and not institutional investors.
