If you're a curious observer of Robinhood Markets' (NASDAQ:HOOD) recent initial public offering, you've likely heard the term "payment for order flow." Market pundits continue to debate whether it benefits or harms retail investors.
Traditional stockbroking models have gone out the window. Brokers used to charge a fee to execute a trade for a client -- nominal in many cases, but higher if there was some advice attached. Now, investors can buy and sell stocks completely free of charge through their smartphones, thanks to a consumer revolution led by Robinhood -- and its reliance on a different revenue source.
Payment for order flow involves Robinhood selling its customer's market orders to third parties, who execute them and earn fees for doing so, with a portion given to Robinhood as payment for routing the customer's order to that particular third party.
Put really simply, instead of the customer paying a direct commission, the customer has effectively become the product.
Image source: Getty Images.
How it works
Most people with an understanding of the stock market know that when someone purchases shares, there needs to be a willing seller. The two parties use a broker to meet digitally at a stock exchange (like the New York Stock Exchange or the Nasdaq Stock Market), where their transaction is facilitated.
But times have changed. The chairman of America's market regulator, the Securities and Exchange Commission (SEC), recently noted that only 53% of all customer orders actually go through an exchange. About 38% are handled by wholesalers instead, more formally known as market makers.
That's where payment for order flow takes center stage.
Market makers stand ready to buy and sell shares each trading day. They make money by setting the bid-ask spread. Let's say a market maker is willing to buy a share of Apple for $145.50, and it's willing to sell a share for $145.60. The difference of $0.10 (the spread) is its profit.
When a Robinhood customer places a market order to buy or sell shares of Apple, rather being matched with a seller in the market, they are instead routed to a market maker, because it can be relied on to absorb the transaction in the blink of an eye.
Market makers can compete with each other for this order flow by lowering spreads -- for example, one might charge a spread of $0.07 instead of $0.10, so the broker would route the order to that firm to get its customer a better price.
Alternatively, and controversially, market makers can simply pay Robinhood to route its customers' orders to them, partly removing the need to compete. It has drummed up concerns among regulators that retail investors are getting a raw deal when it comes to the pricing and execution of their orders.
In December 2020, Robinhood paid a $65 million settlement to the SEC after the regulator discovered the practice had deprived customers of $34.1 million, caused by inferior order pricing -- and that's after accounting for customers paying zero commissions.
Follow the money
Most market making firms are private enterprises, but the publicly traded Virtu Financial offers some insight into just how profitable payment for order flow might be. Although Virtu is not specifically listed as one of the market makers Robinhood routes orders to, it is listed on the New York Stock Exchange website among one of three designated market makers (DMMs).
|
Metric |
Q1 2021 |
|---|---|
|
Brokerage, exchange, clearance fees and payments for order flow, net |
$259 million |
|
Revenue |
$1.01 billion |
Data source: Virtu Financial.
Virtu lumps the expense in with other related costs, but the $259 million it spent in that category (in a single quarter) made up almost half of its entire operating expenses. Plus, it's growing -- it spent 49% more on this line item in Q1 2021 than it did in the same quarter last year.
For the full year 2020, Virtu spent $758 million on the brokerage, exchange, clearance fees and payments for order flow expense -- a number it seems sure to top in 2021 given Q1 numbers.
Investor takeaway
Payment for order flow is practically the beginning and end of Robinhood's business, at least financially. In 2020, at least 75% of the company's $958 million in revenue was generated from the controversial practice. In the first quarter of 2021, it jumped to 81% of total revenue.
Suffice to say, concentrating so much of the business on an activity regulators are so intensely scrutinizing presents an unparalleled risk to shareholders. Among the SEC's concerns is that retail investors are perceiving their experience as free, when in fact they're being charged fees they can't see in the form of paying a worse price for the shares they're buying.
To make matters worse, the SEC has outlined concerns about "gamified" investment platforms that encourage clients to trade by using appealing visual graphics. These features in part have fueled investor appetite for "meme stocks" like GameStop and AMC Entertainment, and the SEC says they contribute to worse outcomes for clients. The surge in both of these stocks (based on no real fundamental reason) was synonymous with the Robinhood platform.
Robinhood can be praised for bringing a wave of new, younger investors into the financial markets, and that's a long-term positive. But its main source of revenue isn't a legal practice in places like the United Kingdom, and the European Union has issued a warning to brokers, saying that accepting payments for order flow is not compatible with rules that put client needs first.
Investors considering a long-term position in Robinhood might want to weigh up the risks against the company's growth prospects, since for now it looks like they are confined to the U.S. -- and even that's not a guarantee.
This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis -- even one of our own -- helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.
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