Robinhood Is Not The Villain It's Been Made Out To Be

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Includes: AMTD, ETFC, FB, SCHW
by: Treading Softly

Summary

When an order is submitted, brokerages have multiple choices of how to benefit from it.

Brokerages will try to internalize as many orders as possible.

Robinhood internalizes none of them but moves to the second step.

Robinhood the Villain, Revealed!

A recent article here on Seeking Alpha claimed to expose shady tactics within the SEC disclosures by Robinhood versus other brokerages. The Author claims Robinhood is making millions off of "selling out" their investors - who are particularly millennials. This was painted as shady and underhanded - Robinhood isn't living up to its name since its getting kickbacks from High Frequency Traders, HFTs!

This article contains a fatal flaw, it seems to misunderstand, or misrepresent the flow in which brokerages will process orders to extract profits from them. Robinhood does not claim it will not flow the same processes that E-Trade (ETFC), TD Ameritrade (AMTD), or Charles Schwab (SCHW) follow.

Let's review the SEC allowed and mandated process that your orders flow when you submit them to your brokerage to execute them.

From Submission to Completion

SEC Order
Source: SEC

According to the SEC, when you submit an order - market or limit, your brokerage has multiple options seen above in this somewhat dated graphic.

  1. The brokerage can send it directly to a stock exchange
  2. The brokerage can send it off to a "Market Maker." What are Market Makers? These are where those accursed High Frequency Traders fall! These companies pay a small fee to brokerages to get a first look chance to make accept your order prior to making it to the exchanges. We'll cover HFTs in detail further below.
  3. Electronic Communications Network is the third choice. It is designed to relay orders directly between brokerages - cutting out exchanges and is primarily used for limit orders.
  4. The brokerage can internalize the order. This means the brokerage matches buy and sell orders. This method we'll discuss in detail further down.

It is also extremely important to know that their is no SEC regulation on how long it takes a brokerage to complete your order. It is not guaranteed to be immediate and brokerages while expected to try to find you the best deal, at the very least must follow your orders instructions.

Robinhood as a brokerage has decided to direct all of its order flow to the 2nd option, meanwhile the larger brokerages will vary between them. For the larger brokerages, option 4 is favorable - and here's why.

Why Brokerages Want to Internalize Your Order

When a brokerage internalizes your order, it is the sole matchmaker involved. Larger brokerages will have an easier time doing so since their internal order flow is higher.

SEC interalizing Source: SEC

Let's the brokerage receives two orders, one to sell stock X for $20 and a buy order for $25. The brokerage can complete both orders as directed and pocket $5 per share of the difference. Realistically this spread will be pennies but spread over thousands of orders, the brokerages is making a quiet killing. This is why brokerages will internalize as many orders as possible.

Market orders, allowing a 5% range around the desired price allows brokerages more leeway to complete orders in house and pocket any available spread. Many brokerages will, if possible, give the seller and buyers a break on their prices so they feel they also have gotten a solid deal - but brokerages are not required to do so.

What happens if the brokerage can't seal the deal internally? Well since they are not required to complete it in a set time, brokerages can sit on your order or move on to another step.

The Market-Makers and Exchanges Get a Chance

Payment for order flow is a common practice. The previously mentioned author found out about Robinhood doing so, because it filed the required SEC disclosures for doing it - like every brokerage does.

Exchanges and Market Makers will pay, normally pennies per share or less, for order flow. Regional exchanges do this to link orders between brokerages etc. But another type of market maker is a HFT. These companies pay to get a crack at your order after the brokerage decides not to internalize it.

Ironically, HFT use the same judgment process your brokerage uses to decide whether to accept your order, as you placed it, or to send it off to an exchange. HFT are often vilified as fleecing retail investors, but ironically, your broker gets first crack at fleecing you.

HFTs, unlike brokerages, have agreements will as many brokerages as possible, thus giving them a wider range of orders to try and match for a positive spread. Since they pay for the right to get the orders first, HFTs often receive a smaller profit off the orders then the brokerage itself would have.

Robinhood is Shady for Sending it to HFTs for Money?

This is the sole thrust of my esteemed fellow authors article. HFTs are possibly paying Robinhood more for their order flow than its competitors. Why are the willing to do so, unless they are making a quiet killing off of it?

It all boils down to quality and quantity. The standard brokerage is supplying HFTs will their seconds, the orders they were unable to complete themselves, meaning the best deals are already captured from the order flow. Robinhood does zero internalization. None. Meaning every possible deal and profit is flowed out of Robinhood to the paying HFTs. This is the key reason for the higher payouts. HFTs gamble that from the order flows they pay for that they can extract a profit. Robinhood's order flow is a literal unfiltered goldmine for them.

But this does not hurt investors. Your orders are unable to be changed. A market order does little service to an investor expect possible expedite the completion of an order with less concern on the final price, a limit order expresses exactly what you want. Facebook (FB) similarly offers a free service and uses your information to sell advertising. Robinhood monetizes order flow, again which is a well accepted and the normal practice, in order to offer commission-less trading.

Investor Takeaway

Is Robinhood assisting in the fleecing of unknowing investors? Short answer: No. Long answer: No more than your brokerage fleeces you itself before passing on your remains to the next service to do so. Limit orders allow you the greatest strength to get the price per share you want, and if your brokerage or an HFT can get a better deal - it doesn't have to share its gains with you.

Investors should avoid market orders unless they have little concern over the exact execution price and want to ensure a faster order execution. Otherwise this storm about Robinhood is a tempest in a tea pot and not a startling reveal.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.