This Time, Robinhood’s brazen shutdown of the purchase of securities in the midst of retail investors’ short-selling of institutions has made retail investors truly aware of the cost behind the free service.
The most dramatic event in the U.S. financial industry in the last two weeks has been the concerted efforts of retail investors in the U.S. stock market to “kill the teacher with a fist in the air. Through communities on Reddit and other social media platforms, many retail investors made a concerted effort to buy large amounts of shares of game retailer GameStop, movie theater chain giant AMC, and popular mobile device maker Blackberry in order to short Citron Research (Citron Research) and Melvin Capital (Melvin Capital), among others. Hedge funds, which eventually had to cut their positions to fill their short positions. Short-sellers have lost nearly $20 billion on one stock, GameStop.
What is most striking about the incident is not the loss of shorting institutions, but the fact that Robinhood, the most influential Internet free trading application in the market, was the first to shut down the buy function of GameStop, AMC, Blackberry and many other securities before the opening of the market on January 28, when retail investors reached the climax of shorting institutions, and then several securities trading service providers followed. This aberrant behavior was met with a great deal of public criticism, and Robinhood, which is most frequently used by retail traders, was brought to the forefront and scrutinized.
Rep. Alexandria Ocasio-Cortez (D-N.Y.), a popular member of the U.S. political establishment, tweeted about the need for more details on Robinhood’s efforts to prevent retail investors from buying related stocks, and supported holding relevant hearings. Robinhood subscribers also filed a lawsuit in the District Court for the Southern District of New York on Thursday, demanding that it immediately restore the ability to trade the securities in question and seeking damages from Robinhood.
What kind of Internet securities trading application is Robinhood, and why did it take the lead in shutting down the buying function of the relevant securities? These are a series of questions that are well worth delving into.
Robinhood is a Silicon Valley-based startup that was founded in 2013. It is currently the hottest Internet securities trading App in the United States, with over 13 million registered users by late 2020. Its target customers are young millennials, and its weapon to attract users is the all-free and user-friendly experience of buying and selling securities. From its inception to 2019, Robinhood’s user base has been rising exponentially, blowing away traditional investment trading providers Charles Schwab, TD and E-Trade. with the full-scale Epidemic of the new crown in 2020 in the U.S., Robinhood’s business has grown even more exponentially. Robinhood is currently valued at about $11.7 billion and is actively preparing for an IPO.
Is Robinhood really free? Simply put, it’s true. But if we look deeper into its business model, we will find that there are actually a lot of details behind this answer that are worth exploring.
Using Forbes’ estimates of Robinhood’s revenue structure, we see that it relies on “Payment for Order Flow” for the bulk of its revenue. 70% of its revenue in the first quarter of 2020 came from payment for order flow, while the remaining 30% came from The remaining 30% of revenue is split 50/50 between value-added subscription fees and securities lending.
Unlike the securities market in mainland China, securities trading in the U.S. can be done on multiple markets. This means that securities listed on the NYSE can be traded in a market other than the NYSE. And this market can be a public stock exchange, a third party market maker or even a high frequency trader. In the exchange for direct trading (Direct Order) can often get the transaction of the best price (National best bid and offer, or NBBO). And through the high-frequency trading firm (High-frequency Trading Firm) indirectly to complete the transaction will be the final transaction price and NBBO will have a small price difference between. This price difference is the arbitrage space for high-frequency traders, and is the main source of income for free brokers like Robinhood. The high-frequency trader accepts a large number of trades from Robinhood and then uses the small but definite spread to arbitrage the profit, and then returns a portion of the profit to Robinhood.
It is because of this business model that in 2018 U.S. securities regulators passed an amendment to Rule 606 to force securities services firms to mandate disclosure of the order’s trading pipeline to improve transparency in order delivery. We can then use the Rule606 report disclosed by Robinhood to understand the final order delivery path of Robinhood’s orders.
According to Robinhood’s SEC 606 report disclosed in the fourth quarter of 2020, 100% of its completed trade orders were filled through Non-Directed Orders (NDO). The largest share of these non-directed orders is with Citadel Securities, one of the five market makers that finalize aggregated trades. It contributes more than 1/3 of Robinhood’s revenue.
It is important to note that Citadel Securities is a market maker, and that its owner, Ken Griffin, also owns a hedge fund by the same name, Citadel LLC, which specializes in profitable algorithm-based high-frequency trading. The China Securities Regulatory Commission (CSRC) has penalized Citadel LLC for “spoofing” in high-frequency trading and closed Citadel Securities’ trading account on the SSE. In early 2020, the China Securities Regulatory Commission (CSRC) closed Citadel Securities’ trading account on charges of violating trading rules after paying a settlement of RMB 670 million (US$97 million). In early 2020, after paying a settlement of RMB 670 million (USD 97 million), the CSRC closed the charges against Citadel Securities for violating trading rules and reopened its trading seat in Shanghai.
On January 25, 2021, Melvin Capital, the loss-making short seller first mentioned in this article, announced that it had received a combined investment of $2.75 billion from hedge funds Citadel LLC and Point72. Citadel LLC and its partners invested $2 billion and Point72 invested $750 million. This was immediately followed on the 28th by the shutdown of the buy feature on Robinhood for the underlying short-selling securities.
Although Robinhood stated on January 28th that “this was a risk management decision and not pressure from market makers,” the decision was made on Twitter and Reddit. However, on Twitter and Reddit forums, retail investors generally believe that Robinhood has succumbed to strong pressure from its “owners”.
If Robinhood chooses to go back to the market makers, it will be the retail investors on the platform that will be betrayed when their biggest “money maker” – the large market makers – and the retail investors they serve have conflicting interests. It may appear that retail investors are receiving free trading services from Robinhood, but in reality, these free services are secretly priced out.
In addition to the “betrayal” at key moments, the day-to-day trading is also a process in which Robinhood is constantly “bleeding” the market makers.
As mentioned earlier, Robinhood completes aggregated trades through the market maker’s trading platform. This means that when Robinhood submits a trade to a market maker, the market maker will know the price and quantity of the buy or sell order that needs to be processed before the trade occurs. This data provides the market maker with a wealth of information about retail trades that it can use to improve its high-frequency trading algorithms. Of course, market makers also gain access to the arbitrage space that exists in the trades themselves mentioned earlier – that is, the small spread between the price Robinhood users pay and the NBBO.
According to the disclosed regulatory filings, Robinhood earned $271 million in revenue from all order flow payments in the first half of 2020. These revenues are the hidden revenue behind Robinhood’s “free” services, the core of Robinhood’s business model, and the “free” payments that every retail customer who trades on Robinhood’s platform unknowingly makes. It is also the “invisible transaction tax” that every retail trader who trades on Robinhood’s platform for “free” unknowingly pays.
Because Robinhood’s primary revenue is directly related to the volume of “free” trades, Robinhood does everything it can to “incentivize” its retail customers to trade frequently.
In December 2020, Massachusetts securities regulators filed a lawsuit against Robinhood, alleging that it actively marketed its products to inexperienced investors and failed to implement adequate protections. The indictment states that Robinhood lured retail investors into opening accounts and kept customers trading actively through a variety of aggressive tactics. In using the app, Robinhood encouraged active trading through various “gamification” tactics, such as giving away free shares, various push notifications, and even digital confetti rewards for completing tasks to stimulate uninterrupted trading. The regulator also mentioned that a customer with no investment experience on the Robinhood platform completed over 12,000 trades in just six months, with an average of over 100 trades per transaction. When we understand the existence of “invisible transaction taxes” due to small spreads in the actual trading process, we can see the strong driving force behind Robinhood’s aggressive promotion of frequent trading.
In December 2020, Robinhood closed its investigation by the SEC at a cost of $65 million. The investigation questioned Robinhood’s failure to adequately disclose its business relationships with high-frequency traders, and the SEC alleged that Robinhood did not use its best efforts to help retail investors obtain the best possible order price (NBBO) when placing orders with market makers, nor did it clearly and completely disclose to its customers the fact that trades were being completed. When advertising for retail investors to open accounts, Robinhood claimed that its order execution quality was comparable to or even better than that of traditional brokerage firms. According to SEC estimates, Robinhood’s “non-NBBO transaction prices” cost retail investors a total of $34.1 million from 2015 to 2018.
There is a common saying in the video game world: If you are playing a game without paying for it, then you are part of the game experience. In other words, you are a free companion to those paying players. Paying players gain an unfair advantage by buying props and equipment, and get the best gaming experience from beating free players.
The Internet world works the same way. We use Google‘s search engine, Google Maps, and Google Pay for free, while providing Google with the search keywords, clickstreams, location information, and payment information, etc., that we generate in the process of using them for free, allowing Google to build a digital marketing empire with global coverage on top of that. But when the Australian news media wanted to charge Google for their high-value content, Google immediately flipped out and threatened to stop Google’s search engine services in Australia (see my other article “Google’s showdown with the Australian government” for more details).
When Robinhood was offering trading services to retail investors for free, every retail investor was happy without realizing the value they were paying behind the scenes. This time, Robinhood blatantly shut down the purchase function of the relevant securities during the retail investors’ short-selling of the institution, making the retail investors truly realize the price behind the free service.
Any free service has a price, you just don’t know it. If you ever really realize this cost, you will find that the free services are often the most expensive.
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