"Is Robinhood Becoming the Prince of Thieves?" - 7investing 7investing
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“Is Robinhood Becoming the Prince of Thieves?”

Simon's September update takes a closer look at the SEC's investigation of Robinhood and what it could mean for investors.

September 14, 2020

– Advisor: Simon Erickson

Industries: Financial Services  

The classic tale of Robin Hood involved a noble hero who stole from the rich to feed the poor. Today, the heroic name is assuming a much more notorious connotation.

The Robinhood of the investing world is a commission-free brokerage, which allows investors to buy and sell stocks without paying any transactional fees. Many have applauded its commission-free approach and claim it completely disrupted the financial services industry. Larger brokerages like Schwab and Fidelity have followed suit and slashed their stock trading fees as well.

But the story has recently taken a more sinister turn. The Wall Street Journal recently reported that Robinhood is now under investigation by the SEC. The stock market watchdog is digging into whether or not Robinhood is properly disclosing its relationships with high-frequency trading firms. This investigation could have significant implications for individual investors.

To start with a bit of background, Robinhood began as the hero of the retail investor. Short-term traders could now jump in-and-out of stocks as many times as they liked, without racking up any commissions at all on the transactions.

However, those who are students of the stock market know that hyperactive trading is a recipe for lower overall returns. Buying and then selling positions too compulsively often causes investors miss out on the enormous benefits of long-term appreciation. In addition to that, any positions held for less than one year are subject to short-term capital gains taxes.

But the plot is thickening for our noble hero. Robinhood today makes around half of its revenue from Payments for Order Flow (“PFOF”). In these agreements, the brokerage sends buy and sell orders to be fulfilled by high-frequency traders, rather than sending them directly to the exchanges where the securities are listed (such as the NYSE or the Nasdaq). The company claims that by working with these transactional middlemen, it can leverage technology to save investors not only on commissions, but also on the actual prices on the executed trades.

The United Kingdom disagrees. In 2012, the UK banned PFOF entirely, claiming that high-frequency-trading middlemen were creating a less efficient and less competitive market that ultimately hurt the retail investor.

The CFA Institute’s 2014 paper supported the UK’s decision, and agrees that the move did indeed achieve the desired effect of helping individual investors. “We observe an increase in the proportion of retail-sized trades executing at best quoted prices between 2010 and 2014 from 65% to more than 90%, which is consistent with our hypothesis.” In other words, individuals got better pricing on the stocks they were buying without PFOF taking place.

I should clarify that PFOF is still legal in the United States, and many other large brokerages outside of Robinhood are also utilizing it (including Schwab/TD Ameritrade and E-Trade). However, Robinhood obtains a much greater percentage of its top-line from PFOF, which puts it at a much greater regulatory risk. It has also curiously been reported that Robinhood is receiving PFOF rates — in terms of revenue per $1 million of order flow — that is up to 10x that of what other brokerages are receiving. And the reasons for that aren’t yet entirely clear.

This SEC investigation comes at a crucial time for the investing world. Driven by a surging interest in retail investing, Robinhood now has more than 13 million accounts and carries a private market valuation of more than $8 billion. Yet it blows my mind that half of its total revenue comes from a practice that was deemed illegal in the UK less than a decade ago. If the United States were to similarly crack down on this practice, it would capsize Robinhood’s entire business. And perhaps even render the recent commission-free brokerage model uneconomical.

There’s no free lunch in the brokerage industry. Our modern-day Robinhood is encouraging margin accounts and greater trading volume, is sharing our data with high-frequency traders, and is now under the watchful eye of the SEC. Those are hardly noble causes, for the hero of the story.