Robinhood Is Not About the Democratization of Markets: Jared Dillian

Robinhood Markets Inc. has been at the forefront of the democratization of finance, which is the idea that an average Joe can play in the stock market alongside the professionals. And back in January, they did, nuking a bunch of hedge funds betting against GameStop Corp. in one of the greatest short squeezes of all time. Hollywood is full of average Joe underdog stories, but is it true in real life? Not, at least, in the markets, where retail trading of “meme stocks” is, on balance, just a massive transfer of wealth from the unsophisticated to the sophisticated.

At issue is the longstanding practice in the equity markets known as payment for order flow. Brokerages don’t actually execute orders to buy and sell stocks anymore; they send them to market-making firms for execution in exchange for a small payment. This allows brokers to offer zero commission trades. Market-making firms like this arrangement, especially when it involves orders for retail investors because they are typically wrong and are profitable to trade against. So market-makers will pay brokers for the privilege of receiving these orders, on the idea that even though they are small individually, in the aggregate they are profitable. Robinhood earned about 75% of its $958.8 million in revenue from payment for order flow in 2020.

An outsider might view this practice, which has been going on for a few decades, as a conflict of interest. The broker isn’t guaranteeing that its customers will get the best price on a trade, but instead is sending orders to the market-making firm that pays it the most, where execution quality may not be the best. Robinhood says all market makers with whom it has relationships pay it rebates at the same rate, which means it isn't incentivized to send orders to any one specific market maker. The real issue is about how Robinhood’s messaging about democratization is inconsistent with its execution practices. Also, under the current arrangement, the costs of trading are hidden. With zero commissions, the client of the brokerage firm does not pay commissions directly, but does so indirectly through payment for order flow arrangements. New Securities and Exchange Commission Chair Gary Gensler has identified payment for order flow as a potential conflict.

To be fair, outside of a few insiders, nobody really knows how market makers operate anymore. In the old days when stocks were quoted in fractions, it was as simple as creating a bid-offer spread on a stock, and buying on the bid and selling on the offer. Then 2002 brought decimalization, and things got a bit tougher. The mathematics behind market-making today is incredibly sophisticated, and I imagine it takes into account correlations with different stocks and sectors, and I suspect that quants have programmed the algorithms to take into account the information value of a trade and whether the trade is likely to be right or wrong in the short term. (Some of my newsletter subscribers are employed by market makers.)