When it comes to completely rewriting the rulebook with regards to trading and retail brokerage, the revolutionary start-up, Robinhood has been at the forefront of that.
Robinhood uses a no-fee model which gives users the opportunity to buy Indices, cryptocurrencies, and equities. These assets are purchased at an equal rate with the institutional markets. A lot of people tend to see them as attempting to level the plane and bring democracy to the investing space.
Even with this, a group of people have raised questions as to how a brokerage which charges zero fees is capable of making a sustainable income.
This doubtfulness made these set of skeptics dig up some fantasizing SEC revelations about Robinhood. These findings revealed that they had a pretty fantasizing business model. Robinhood was selling their clients’ order flow to High Frequency Trading Firms.
As expected, this revelation brings up more questions than answers which made many to believe that the brokerage was anything else but not a redistributor of wealth in modern times.
Briefly, an in-depth analysis of the business model of Robinhood will be taken while discovering how this could affect the end users or traders.
Order Flow Routing and Payment
It was initially brought under the limelight in Robinhood’s SEC rule 206 disclosure for the Q2 of this year. These reports reveal the broker-dealers routing practices which they are under compulsion to publish.
The report published by Robinhood revealed that all of their orders were routed to 4 different High Frequency Trading Firms. These firms were Two Sigma Securities, Citadel Securities, Virtu Financial and Wolverine Securities.
Contained in the report, the financial relationship they possessed with these firms were outlined. Robinhood gets paid for every order they route to the market makers. A very good example is less than 0.00026USD per dollar of executed trade worth is paid by Citadel securities to Robinhood.
In summary, Robinhood makes money from the market maker anytime they send a trader’s order to the market maker instead of making money off the trader. After that, the market maker then executes the order at the rate in the market on their own books.
In their previous startup – Chronos Research, the founders of Robinhood worked with HFT firms. Chronos Research developed software used by these HFT firms for placing orders.
Other brokers such as TD Ameritrade Holding Corp., Charles Schwab Corp., and E*trade Financial Corp also practice the act of selling access to their order flow.
It has been established that this practice described above is thriving in the transparent equity and highly regulated markets. Could the same be happening in the budding cryptocurrency markets?
Robinhood’s Impact on the Crypto Market
Robinhood decided to dive into the cryptocurrency market early in the year and have launched in some states around the US and offer Ethereum, Bitcoin, Bitcoin Cash, Litecoin and Dogecoin. The fact that users could purchase coins with no fees was delightful to them.
Although, when the disclosure became known to the public, a lot of people in the crypto community expressed concerns about the business model Robinhood was operating.
These concerns were further aggravated due to the fact that cryptocurrency markets are still unregulated. This goes to say that Robinhood would not be at liberty to disclose any similar agreements with firms if they did have one.
It cannot be categorically said though, that Two Sigma and Citadel have agreements with Robinhood. Due to their founders’ skepticism, they both haven’t entered the cryptocurrency market. Virtu made claims to enter the physical bitcoin markets only on the condition that they become regulated.
However, HFT crypto firms such as Cumberland digital and Jump trading have over the last year been making markets. This brings the conclusion that there would exist some market makers who would be delighted to pay Robinhood for the orders routed through their books.
What’s In for the HFTs?
HFTs are out for something much valuable than making money on orders by buying the order flow. HFTs actually search for market data and information which they can input into their trading algorithms. To be specific, they are searching to have a better understanding of what the current flow of the market is like.
This search for data is crucial as they will be able to position their trading books for the flow of the institutional market. They make use of the data gotten from their computer models in order to structure order flow and separately segment the retail demand from the institutional demand.
This passive market making is the least of their profitable strategies. However, the identification of institutional order flow and the deciphering of direction, they can make use of directional strategies.
One of the reasons why large investors despise the HFT firms is none other than the fact that institutions are aware that HFT firms are trying to snoop their data and use it for their own gain hence the use of “dark pools” and “iceberg orders” through the OTC markets to cover their trading tracks.
HFTs have the ability to reduce spreads and provide liquidity in the markets. The net gain for the users in the market is intact as they would still be able to purchase their shares or coins without any commission.
A lot of opinions about this setup between Robinhood and HFTs having to pay them have been flying around. Claims suggest that, for Robinhood to make profits, they would choose only high paying market makers. By law, however, Robinhood is required to seek for its clients’ trades, the best execution which encompasses a lot of factors.
In reality, no-one actually loses out of this whole setup. The only downside there is that big institutions cannot place large orders without the HFTs sniffing them and using their data for its own benefits. The end user, on the other hand, gets the best execution based on the setup Robinhood has with these HFTs.