While it seems that Robinhood and Gamestop are officially the new gambling version of a multiplayer online video game (, , ), this story reminded me of this which is my favorite detailed-yet-understandable explanation of how Robinhood makes money. There have been many similar attempts to explain their business model, but this felt the most balanced. Even the footnotes are educational.
For example, he explains how the biggest brokers like TD Ameritrade used to handle payment for order flow, which you could equate to a discount on the stock price (“price improvement”):
“We’ll buy stock for you, you’ll pay us $5 to do it, we’ll get a discount on the stock and we’ll pass on 80% of the discount to you.”
Compare this with how Robinhood chose to do handle payment for order flow:
“We’ll buy stock for you, you won’t pay us to do it, we’ll get a discount on the stock and we’ll pass on 20% of the discount to you.”
Robinhood also happens to get paid more for their order flow than other brokerage firms. I’ve also explored this question back in 2018: My basic conclusions were that:
- Robinhood would be breaking the law if they broke the SEC rule of National Best Bid and Offer (NBBO) that requires brokers provide the best available bid and ask prices when buying and selling securities for customers. They wouldn’t do that, would they?
- The order flow from Robinhood is probably more valuable because it is from small, retail investors (“dumb money”).
Well, it turns out that:
- The SEC did in fact claim that Robinhood broke the law by not providing the best available stock prices to its customers. Robinhood paid a $65 million penalty to settle this claim in December 2020. See: .
- Various industry insiders agreed that order flow from Robinhood is indeed more valuable because all the orders come from “dumb money” and is thus much more reliable for high-frequency traders to make money from than order flow from institutional customers.
If you don’t read Matt Levine’s entire explanation, here is the bottom line: Robinhood customers were essentially being charged an extra roughly 3 to 5 cents a share through poorer execution prices. If you only traded a few shares, then you still basically paid nothing. If you traded 100 shares, that might add up to $3 to $5 a share. Roughly breakeven. If you traded 1,000 shares, that might add up to $30 to $50 a share. For some people, Robinhood’s “free trades” were a better deal. For others, Robinhood’s “free trades” were a much worse deal.
Supposedly, Robinhood doesn’t do this anymore and satisfies NBBO again. But it still shows the general way in which Robinhood makes money today. High-frequency trading firms pay somewhat higher prices for the trading flows from Robinhood users, and Robinhood keeps as much of that money as possible while still barely satisfying NBBO. Other firms like of how they do better than NBBO (“price improvement” again), which is also a quiet dig at Robinhood.
[Fidelity’s] price improvement can save investors $18.53 on average for a 1,000-share equity order, compared to the industry average of $4.25.
All this no longer matters because Robinhood is no longer the sweet spot for newbie traders. People like to make fun of the Robinhood name because in a way they secretly stole from the “poor” average traders and sold their orders to the “rich”. However, they also forced everyone from Fidelity to Schwab to all offer commission-free trades. Robinhood did deliver something to us common folk!
The important difference is that firms like Fidelity and Schwab still have wealthy clients that demand phone numbers with helpful humans that answer after only a few rings. Meanwhile, Robinhood only provides an overwhelmed e-mail address than can take days or weeks to finally address your problems.
When Robinhood first came on the scene, they were the new sweet spot for cheap trades for small balances. However, now that free trades are everywhere, the sweet spot in my opinion has now shifted to something like a Fidelity or Schwab account. You get total commission costs either equal to or lower than Robinhood, plus better customer service from more knowledgable reps. If you still prefer a trendy new app over a stuffy old broker, check out my . Most of them have a phone number, and they’ll be less busy. (WeBull, M1 Finance, and Firstrade for sure have phone numbers.)
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