One of the more overused adages about business on the internet is that “if you aren’t paying, you are the product.” It’s always been true, but it’s become acute lately. Microsoft, Apple, and Amazon mostly sell you things like phones, computers, web-hosting services, and Instant Pots. On the other hand, Google, Facebook, and Visa largely sell you.
You don’t need to pay for a Visa card, but Visa sells its cardholders to companies all over the world. Those vendors must accept Visa as payment, and give Visa a cut, or lose business. You don’t need to pay for most Google products, but Google converts your information into a lucrative advertising business. Facebook is free and makes its money off highly targeted, personalized ads. These companies offer things you can pay for—a credit card with a fee, a Facebook smart display, or YouTube TV—but their strengths are in their massive, monetizable audiences.
Robinhood is a you-are-the-product company.
So it’s worth revisiting the concept in light of the GameStop stock surge, particularly the role that Robinhood played in facilitating it. Late last week, as the price was soaring, the “free” stock-buying app restricted users from buying more of GME. It put restrictions on dozens more companies hyped by Reddit’s WallStreetBets community, then rolled them back. But it still has some buying restrictions on GameStop, AMC, and six other stocks.
Political figures running the gamut from Rep. Alexandria Ocasio-Cortez to Sen. Ted Cruz expressed outrage. Official Washington quickly formed a rare consensus: Robinhood had stepped in to put the kibosh on smaller, retail investors to protect hedge funds who’d thought GameStop’s stock price would go down, were made wrong by Redditors, and were now bleeding cash. In the process, the retail investors were frozen out of a once-in-a-lifetime profit opportunity.
Everyone’s right, in a way. On Robinhood, the deck is stacked against the proverbial little-guy investor. But it’s not stacked because Robinhood decided to freeze purchasing of a few meme stocks as they were rocketing in value. It’s because the investors who trade on Robinhood aren’t really Robinhood’s principal customers. Someone else is.
A lot of Robinhood users owned GME when the app paused buying of the stock.* Whatever the number, to get why Robinhood would lock its users out of buying something so many of them clearly wanted, it’s key to understand how Robinhood makes money—and how it doesn’t. Robinhood doesn’t make money, for the most part, by charging users to trade on the app. The company’s entire promotional posture revolves around “commission-free trading,” part of an ideological effort to “democratize finance for all.”
It also doesn’t charge users a percentage rate of assets managed on the platform. There’s a $5 monthly charge for a “Robinhood Gold” plan that opens up access for a user to borrow money and trade “on margin,” and Robinhood can make interest when it lends. (Keep this lending practice in mind—it becomes important.) But that’s also not the primary way Robinhood makes its money.
The company’s golden goose—accounting for around 40 percent of its revenue, per Bloomberg News—is a practice called “payment for order flow.” Bernie Madoff popularized it before he unrelatedly went to jail for masterminding the biggest private Ponzi scheme in world history.
It works like this: When someone executes a stock trade on Robinhood, the company goes to a third party to actually get the stock. This third party, a “market maker,” sells the stock for a tiny bit more per share than it paid for it. The difference in those amounts, repeated millions of times, makes big money for the market maker. The most common Robinhood market maker is Citadel Securities, which is why you’ve read that name a lot over the last week.
For the market maker, that privilege doesn’t come free. Firms like Citadel Securities pay Robinhood handsomely to route stock trades in their direction. This is that payment for order flow, and Robinhood has turned it into a mint. Analysts commissioned by the New York Times calculated that in the first quarter of 2020, Robinhood made nearly $19,000 from selling user orders per dollar in the average user’s account. (Analysts estimated the average account held $4,800.) On the same metric, TD Ameritrade made $1,881, E-Trade $1,326, and Charles Schwab $195.
Why did Robinhood make so much more more? Robinhood CEO Vlad Tenev hasn’t said. It would make capitalistic sense if the answer were that market makers realized they could make more money off Robinhood users than those on other platforms, either because Robinhood users trade more frequently, accept worse prices, or both. In 2019, a regulator fined Robinhood $1.25 million for not finding its users the best deals. (Today, Robinhood insists it doesn’t factor market makers’ payments into where it routes orders.)
Additionally, Robinhood makes money by lending it out to its users so they can trade with it. That attracts an aggressive user, and industry analysts considered Robinhood users to be audacious—both in how often they traded and how risky their trades were—even before the GameStop fracas. Lending is a user-growth strategy, and Robinhood describes its risks honestly. In the company’s view, trading with borrowed money is like riding a motorcycle. “Sometimes you want to get to your destination a bit faster,” the company explains on its website. “By riding a motorcycle you can dodge through traffic and overtake slower vehicles. But it’s also riskier than driving a car.”
The pausing of certain stock purchases was the moment the habits of Robinhood users butted against the requirements of Robinhood’s business model. Borrowing money is risky for the user. When the stocks being traded in huge numbers are rising and falling in price so quickly, it becomes a particular risk for Robinhood, too. If the price swings wildly during the two-day period it takes for Robinhood and a market maker to actually settle a trade (well after a user on the platform has executed it), Robinhood could get low on funds itself, for any number of reasons, and not be able to afford its end of a given trade.
To avoid that possibility, Robinhood and its peers pay in advance into an industry-wide piggy bank—a “clearinghouse”—that makes sure trades settle even if one of the parties goes bust. The clearinghouse is meant to prevent system-wide failures, which would harm everyone. It seems particularly important for a market maker like Citadel Securities, which can be confident that even if Robinhood runs out of money, there’ll be enough cash to close agreed-on trades.
The amount a company owes the piggy bank depends on the clearinghouse’s view of the riskiness of their users’ transactions. Robinhood has millions of users. It reportedly added 3 million more just in January, including 600,000 on Jan. 29 alone as GameStop was surging. That’s a lot of users trading a lot of risky stocks, and it raised the eyebrows of the bureaucrats at the clearinghouse, the National Securities Clearing Corporation.
On Jan. 28—the morning after GME hit a high of $483—these regulators asked Robinhood to put up $3 billion to back up its users’ trades. Robinhood didn’t just have that lying around, and even after negotiating the amount down to $700 million, Robinhood needed to slow the riskiness of its traders to slow the risk for itself. So it stopped users from buying more of the stocks that posed the biggest risks. Robinhood then went on its biggest fundraising drive ever to build its reserves, allowing it to take on additional risk going forward—although not as much as its users wanted to impose on the company.
Robinhood wasn’t the only company told to throw more money into the piggy bank during the GameStop mania, or that had to stop purchases of GME to protect its own bottom line. It’s just the one that deliberately made itself the choice of millions of amateur investors with a promise to “democratize” the financial system, and which lured users with generous lending and a game-like app that many believe makes it hard to stop trading.
Robinhood fashioned itself as the trading app of the people. Its business model made it impossible for it to keep facilitating purchases of the people’s favored stocks.
A successful company that doesn’t charge users upfront is liable to eventually meet a moment when behavior that served it well in the past becomes impractical. Others have faced reckonings of the same kind just this winter, though in cases much different than setting up stock trades. Facebook let Donald Trump do more or less whatever he wanted for a half-decade, spinning up huge engagement numbers, then banned him after he lost an election and incited an insurrection.
In Robinhood’s case, what makes the money isn’t anything immoral on its own. It simply encourages traders to trade, trade, and trade some more. If a hedge fund can do it, why shouldn’t a thirtysomething on their phone do it too?
Payment for order flow ensures this encouragement remains highly lucrative to Robinhood and Citadel Securities, unless things become too volatile. Pausing trading had the effect of limiting risk (and upside) for a trader on the platform who wanted more GME, but its intent was to limit risk for Robinhood itself in its dealings with the companies that provide shares of stocks.
Think of Robinhood as a pizzeria. When the company put the brakes on GameStop stock, it wasn’t screwing over its customers by withholding its product, because the customers aren’t traders and the product isn’t stock. Instead, Robinhood was forced to look out for a much bigger customer—the professional financial system of which it’s a part—by making sure its product didn’t overheat. On Robinhood, the retail investor is the pizza.
Not every slice of pizza gets eaten. But it’s up to those investors to decide whether they’re willing to run the risk of getting chewed up.
Correction, Feb. 4, 2020: This article originally misstated that about half of Robinhood users reportedly owned GME. That figure was based on an erroneous figure from another article; that piece and figure have also been corrected.