The old way a financial brokerage made money was to charge a fee whenever someone bought or sold stock. A company like TD Ameritrade or Charles Schwab would charge $4.95 or $6.95 (or whatever) in exchange for facilitating the buying and selling. That was a big cost of trading, and it was in addition to the user paying fractionally more than the last price to buy, or getting fractionally less than the last price to sell. Maybe this was a good thing to some extent. Maybe it discouraged people from trading too often, and maybe that was useful because buying and holding stocks has often been a sound strategy. Putting a cap on trading by making it a pain, for a lot of people, was useful.
This isn’t how it is anymore, though. There are still trading methods that require a commission, like if you ask a human for help, but the Schwabs and Ameritrades of the world stopped charging those fees for standard online trades in 2019 or so. This shift was a long time in the making, but the firm most credited for pushing the industry over the edge to commission-free trading is Robinhood. The company says its mission is to “democratize finance,” and while that’s brandspeak, it’s a fair reflection of how it has operated. More people are going to be more inclined to do something if they aren’t paying a fee. Robinhood helped to build that world.
Something has to replace commissions, because brokers still have to make money. What Robinhood settled on was a practice called payment for order flow. It works because Robinhood doesn’t actually hold stocks. Robinhood connects a person who wants to trade stocks with a market-maker who actually has the stock or can quickly get it. The market-maker makes its money by buying stocks for a tiny hair less than it sells them and pocketing that spread many millions of times on many millions of trades. The market-makers need trades for this to work, and Robinhood provides them en masse. The companies pay Robinhood to fill those trades—for that order flow—and that makes up most of Robinhood’s revenue. It was about 63 percent of Robinhood’s receipts in the second quarter of 2022, and it was closer to 80 percent in recent quarters in which the stock and crypto markets were not careening into a crater, according to a recent federal filing. Payment for order flow for crypto is slightly different but mechanically similar; Robinhood calls it “transaction rebates.”
For the past year, a cloud has hung over Robinhood and, to a lesser extent, the rest of the online brokerage industry. The Securities and Exchange Commission has been skeptical of payment for order flow, and its chairman, Gary Gensler, said in August 2021 that the SEC might ban the practice. Robinhood argued against that, pointing out that the lack of commissions made trading more accessible, particularly in small amounts. Robinhood is now a public company, so it has to be bracingly honest with investors about risk factors, and it has been clear in its filings that anything bad that might happen to payment for order flow would also be very bad for Robinhood. Even negative publicity around it would be bad. But now, that cloud has just about lifted. The SEC will not ban payment for order flow, the Wall Street Journal reported on Thursday. It could yet curtail it in ways that would make it less profitable, the paper said.
It’s great news for Robinhood, which avoids the evaporation of most of its business model. But more than that, it entrenches something fundamental about how stock trading will work for retail investors in the United States for the foreseeable future. We’ll have more freedom and access to the stock market than ever. We’ll also be subject to a range of negative forces that Robinhood, for instance, has exerted on its users before. There’s good in it, and there’s bad in it. But mainly, there’s no going back from it.
Before legacy brokerages followed its lead into the zero-commission world, Robinhood arguably had as much in common with Facebook or Visa as it did with E*TRADE. Facebook and Visa make their users the product, by selling their huge communities of social networkers and credit-card holders to advertisers and merchants, respectively. Robinhood does the same by way of payment for order flow. Its main customers aren’t the people who download its app, but the market-makers who fill those people’s orders. (Robinhood does have a subscription product that makes up a minority of its revenue, it’s worth noting.)
This is good for many people who want to trade stocks. They don’t pay any money to trade, instead of paying $5 increments (or whatever) that add up over time. The technology on these apps is mostly good, I think, although I have never done anything more than thumbed around on Robinhood. Some have argued that it’s too good, even, for how attractive it makes it to trade. Payment for order flow sounds slimy, because you can imagine (and actually don’t even need to imagine) a company like Robinhood sending trades to a market-maker that wasn’t offering the best prices for its users and then taking payments that smell a lot like kickbacks. Robinhood says that the private market-makers it uses tend to offer better prices for users than a public stock exchange would. On the whole, it usually does not seem to be that insidious. Trading has a cost for the user, and this structure lowers it a lot, even as it makes a fortune for a market-maker and keeps Robinhood’s entire business afloat. The SEC not banning payment for order flow means that trading will remain cheap if you want to trade for cheap.
There are uncomfortable conflicts, though, even beyond cases where a brokerage might be tempted to take sides between a market-maker and someone trading on an app. Robinhood has not gotten in any trouble on that front for a few years now. The more fundamental conflict is the one between Robinhood’s interests and those of the actual users—or between users and any other brokerage relying on payment for order flow. Robinhood calls payment for order flow “transaction-based revenue,” because that’s what it is: money that Robinhood makes when users trade, even if it doesn’t take it in commission form.
Robinhood wins when you trade more. Of course, that would also be the case under a commission structure. But a commission is a natural brake pedal on trading a ton, and Robinhood has something more like the opposite: no fees, a platform that the company designed to look almost like a video game, and a parade of features and bugs that have over the years encouraged users to trade, trade, trade, and trade again, leading to a $70 million fine that the company paid shortly before going public in 2021.
If it turns out that it is good for retail investors to be relentlessly encouraged to trade stocks and crypto, rather than to buy and then hold for long periods, then this will be a situation in which everybody wins. Robinhood has in the past declined to talk about how its users’ portfolios perform. Several academics released a paper in the Journal of Finance in 2020 that found that Robinhood users did worse than the market. They acknowledged that the platform draws inexperienced traders but wrote that the gap was driven in part by the app’s features. It’d be interesting to learn how that compares to freelance stock-pickers who try to beat the market on other platforms. It would also be nice to get comprehensive data on how investors in payment-for-order-flow environments do compared to market averages.
None of this is to say that the SEC needed to ban payment for order flow. Gensler, the boss of the SEC, knows quite a lot about financial markets and has a regulatory aggression that has annoyed Wall Street. (That seems like a useful trait in an SEC chairman.) His agency spent some time on the issue and isn’t banning it. Meanwhile, it would be infantilizing to say that retail investors need to be saved from themselves, aren’t smart enough to use apps like Robinhood safely, and would be better off paying commissions. But the pendulum shouldn’t swing too far in the other direction, either. Apps like Robinhood can be a good place for people to make their money work for them in a less burdensome and expensive way than ever. They can also be a way for a company to guide its navy of users directly into a bank of rocks while getting paid to do it. Whatever the larger truth of Robinhood is, we’ll all get to find out, likely in perpetuity.
