I’ve got to hand it to the upstart brokerage “disrupter” Robinhood. They have been remarkably consistent in their message from day one. In October of 2018, co-founder Vlad Tenev put it this way:
We’ve grown to over six million customers in under four years by offering our services at a dramatically lower cost and better experience than others.
Mr. Tenev’s comment came in the context of a founder blog post where he felt the need to explain to his users, and to the world, why it’s so good for Robinhood’s users that Robinhood generates revenues by selling their user’s orders to market makers – a practice known as payment for order flow or simply PFOF.
The language to describe the good intentions of Robinhood and the myriad benefits to Robinhood’s users is a marvel. The double-speak in these platitudes is stunning – even by today’s low standards. Let me highlight a few gems.
“When you buy or sell stocks on Robinhood, like many other brokerages, we send your order to market makers like Two Sigma, Citadel [Securities], and Virtu, instead of exchanges like NYSE. Market makers don’t front-run your orders — they’re actually required by Regulation NMS to execute your order at the best price among all of the exchanges, and unlike exchanges, they don’t charge fees.”
OK. Great. This statement implies that the other alternatives to market makers, like maybe the NYSE, DO front-run your orders. This is a not-so-subtle implication that it is in fact the stock exchanges that will front-run your orders since Mr. Tenev is contrasting the choice to send your orders to market makers instead of sending them to the NYSE. Last I checked, front-running stocks was illegal everywhere. If Mr. Tenev has evidence of front-running stocks at the NYSE, I would hope that he would share it with the SEC. He certainly has a duty to do so if the NYSE is indeed front-running its customers. More than likely, however, he is just using the NYSE as a false-dilemma to defend his firm’s choice to use PFOF as the major source of Robinhood’s revenues.
“We send your orders to the market maker that’s most likely to give you the best execution quality. For even finer control, we offer limit orders and stop limits, which allow you to name your own price.”
Well, just twelve months after Mr. Tenev penned his post, Robinhood was fined $1.25M by its regulator FINRA for “best-execution violations.” According to Business Insider, “Robinhood also did not perform regular best-execution reviews on several order types, including limit trades, stop orders, and after-hours trades, the regulator added.”
“Our goal is to build the world’s most customer-centric financial company.”
By any reasonable definition a company’s customers are the other people and businesses that pay the company money. Recent changes in regulatory disclosure requirements for broker-dealers revealed that Robinhood derived fully 70% of its revenues in 1Q 2020 from – you guessed it – market makers.
Robinhood’s users are not Robinhood’s customers. This should not come as a surprise since Robinhood is backed by the same west coast VC technology firms that brought us Google, Facebook and other luminaries of what Harvard Professor Shoshanna Zuboff has correctly identified as “surveillance-capitalism.” Surveillance capitalism offers “free” services to users and it then bundles the collective behaviors of its users and sells predictions of those ensemble behaviors to the highest bidders. Google’s customers are Google’s advertisers, not those of us who use Google to search the internet. Robinhood’s customers are the market makers, not those using Robinhood’s tools to execute trades.
“For you, this means even more products with a spectacular customer experience and the lowest possible prices.”
Do investors and traders really need “more products with a spectacular customer experience and the lowest possible prices”? Is this what is going to finally lead the retail investor to the promised land of at least holding their own against institutional investors rather than chronically underperforming the market averages? Are free-trades the magic missing ingredient that explains the chronic underperformance of the retail investor who tries his or her own hand in the stock market?
The assertion that free trades and a “spectacular customer experience” will give Robinhood’s users a decisive edge is so naïve that it can only be read as a disingenuous sleight-of-hand. Anyone with even a couple of years of experience as an investor can tell you that it’s not commission costs which undermine retail investors. And besides, what does a “spectacular customer experience” even mean? If we are to judge by the standards of Robinhood’s Silicon Valley tech peers, it means an experience that is gamified and addictive. Isn’t it rather convenient to be able to apply such technology to one of the most potentially addictive activities of all time – stock market speculation?
Retail investors are undermined by their behaviors – not their tools and their commissions. Successful investing and trading is first and foremost a matter of having a viable plan and executing that plan consistently over an extended period of time.
Robinhood users do have a plan and they are consistent. The trouble is that their plans are not plans of their own making and their consistent behaviors are not behaviors that lead to long-term success.
Per 2Q 2020 regulatory filings, Robinhood generated $111M from market makers for driving its customers into options trades. Robinhood earned $0.58 per options trade versus just $0.17 per trade for an equity trade. Making it easy for novice investors to trade options must be part of the “spectacular customer experience” that Mr. Tenev foresaw for his “customers.”
Does anyone think that there might be some hidden costs in novice investors executing complicated options strategies that could possibly offset the benefits of those options trades being “free”?
Let’s see … so Robinhood is bringing a bunch of novice participants into the markets and providing a “spectacular customer experience” to trade options for free and they are earning hundreds of millions of dollars from market makers in return for delivering order flow.
Maybe it’s the NYSE that should consider reporting Robinhood to the SEC.
Oh, wait a minute, the SEC just announced that once again, it is Robinhood that is being investigated for misleading its customers about its payment for order flow practices. This time the fines being discussed have gone up by an order of magnitude to over $10M versus the mere $1.25M they were fined less than a year ago.
I wonder when the SEC is going to get around to investigating the NYSE for the “front-running” that Mr. Tenev and Robinhood’s market maker customers find so troubling.
“Spectacular” is a word that comes to mind.
About the Author
Dr. Richard Smith, Berkeley Mathematician and PhD in System Science, is a fintech entrepreneur and the CEO of The Foundation of the Study of Cycles. Dr. Smith has built a reputation as “The Doctor of Uncertainty” amongst his academic peers and has helped government agencies and Fortune 500 companies (including Pfizer and Johnson & Johnson) alike make sense of complex sets of data. With his background in mathematical theories of uncertainty combined with his investing and trading experience, Dr. Smith is an expert in risk management with critical insights that can help empower investors of all levels. Some of Dr. Smith’s findings are stunning – like empirical data-driven proof that even the world’s best investors, from Warren Buffett to Carl Icahn to David Einhorn and many more, could see their results significantly improved through the use of technology that helps course-correct irrational tendencies and cognitive biases. Dr. Smith’s software, backed by proprietary algorithms and Nobel prize winning research, has served more than 25,000 investors and helps steward more than $20 billion in assets. Dr. Smith is a regular speaker and lecturer and particularly enjoys opportunities to share his knowledge and help others gain an edge in the market.