Robinhood Gets Almost Half Its Revenue from Bargain with High-Speed Traders
bloomberg.com
bloomberg.com
Whoever you use to place stock market orders is also getting paid the same way. People have a funny idea of what a retail brokerage does. They do not execute orders on exchanges for you; that's a specialized capability that long ago became its own kind of company. Retail brokerages specialize in picking up the phone when you call with a complaint or request, and in advertising to acquire users.
You shouldn't care. The reason your order flow is valuable isn't that Citadel is trying to screw you. Rather, they can (occasionally) quote you better prices than they do the market as a whole, because they know you're not a giant investment bank or hedge fund about to roll over them like a freight train with a giant block order that will demolish every level of the order book. Internalizers can essentially arbitrage the difference. They're required by law to meet or improve the NBBO.
It should be shocking, but it probably is not, that according to the Rule 606 reports mandated by the U.S. Securities and Exchange Commission, no major online broker, with the sole exception of Interactive Brokers, sent more than 5% of its orders to an organized exchange. More than 95% of their orders go to internalizers!
Later: Like, a minute later I read their Rule 606 report, and they do in fact get rebated for sending order flow to dark pools. They also get paid to take institutional orders and trade them against their customers.
For what it's worth, one can't internalize options orders in the same way one can equity orders, purchased options flow must make it to the market. I'm not familiar with the history of this decision but I suspect it's since options are less liquid and have higher spreads, so internalization would get a much worse deal than say auctions. You can rebates from certain exchanges for initiating auctions on them, and can selectively initiate auctions on exchanges which benefit you more, but options orders themselves make it to the market
* They might be first in the queue on a price-time exchange, and so naturally get the order
* They might be on a price-size exchange, and so get some of the fill simply by being present.
* They probably participate in the auction process, and will naturally get some portion of orders that IB initiates
* One has to initiate an auction of the client order, at least in the USA - see https://www.sec.gov/rules/concept/34-49175.htm#P193_52817, specifically "Unlike internalization in the over-the-counter equity market, the options exchanges' rules permit a firm to trade with its own customer's order only after an auction in which other members of that market have an opportunity to participate in the trade at the proposed price or an improved price. This auction provides some assurance that the customer's order is executed at the best price any member in that market is willing to offer". In practice the placing firm will bid for the auction at that price, and non-competitive prices don't get posted since then the firm has to lose money.
* counterparty data is reported by the OCC so regardless of where the order was executed you will know who was the counterparty. It's fairly easy for IB to know whether Timber Hill executed an order, whether or not they intentionally routed it there.
Second, I actually have inside knowledge of a sort about how Timber Hill USA worked before getting purchased by Two Sigma, and they did not work with IB to take customer orders and weren't to happy when they did get customer orders that originated from IB, specifically because people then run around complaining that IB is up to spooky business internalizing with Timber Hill.
https://www.sec.gov/reportspubs/investor-publications/invest...
The buyers make money by either taking the spread on an order, reducing risk in their own portfolio or using the order to create impact and internalizing the tail.
The author goes on to say "Robinhood is well on their way to making hundreds of millions of dollars in cash income by selling their customers' orders to the HFT meat grinder. High-frequency traders are not charities. The only reason high-frequency traders would pay Robinhood tens to hundreds of millions of dollars is that they can exploit the retail customers for far more than they pay Robinhood."
You can probably back out what the HFTs margin is on this stuff by looking at public financials... KCG was public for a while.
Essentially, your trades have a lower cost basis than those of institutions. But the markets are generally priced assuming institutional traders. So if firms know you're not an exchange they can save some money on you, and Robinhood literally passes some of those savings to you.
(I don't love Robinhood or anything, but the model makes perfect sense.)
On a more meta level, my firm suspects that Citadel is trying very hard to price other players out of the market even if it's at the cost of their current profitability, so they might be driving up the terms of newly minted deals. I don't work on the retail desk so I don't know.
Now if only they'd give the option of Portfolio Margining instead of just Reg-T margining, I'd let the HFT's pair-program with me in person.
Later: to be clear, my subtext is that Robinhood customers aren't actually paying anything and are sort of getting a free lunch here. The money Robinhood pockets from your trades isn't available to you in any form, at least until someone starts the brokerage that pays you to trade.
1. RH user wants to buy 1000 shares of XYZ. Offer price is $10.00
2. RH forwards the full order to their execution venue partner. They get paid (assuming SeekingAlpha story is true) $260/$1mm traded, or $2.60.
3. Executor takes the order and immediately sends 900 shares to the market, lifting the offers. Now best offer is $10.10
4. Executor facilitates the tail of the order, 100 shares, at $10.10. So they are short -100 shares here - or they can give a de minimis price improvement (like 10.0985) to meet their contractual obligations.
5. Temporary market impact attenuates and offer mean reverts to $10.05
6. Executor still has risk on their books - but their paper mark-to-market profit is $5.00.
7. Risk can be mitigated by waiting for crossing order or waiting for more favorable offers to close out the short.
So roughly speaking they paid $2.60 to get the order, but made $5 on it...
You could have saved the hypothetical $2.40 had you traded differently, albeit slower, and caused less market impact with your order. Of course, trading slower comes with its own slippage risk or opportunity cost that the market moves out of your favor. But it could also move in your favor... However, if you let a greedy HFT use your order to impact the market - it will always be out of your favor.
For a small retail guy, you are powerless unless there is a RobinHood 2.0 that decides to offer comm-free trades + does not sell your orders + makes money doing something else ... stock loan maybe?
EDIT: Also the HFTs hate limit orders because it reduces the amount they can internalize. They also generally have a contractual obligation to always execute your order. So you can always use a limit at or inside the offer if youre buying, and potentially save on that cost.
This is why I asked for specificity. Yes, we agree, internalizers pay for order flow because they can make money on it. The question is: can you make that money on your own order flow, or is the allocation of orders to internalizers Pareto-optimal?
It is possible to build one, but it would look so different from existing markets that it would be an uphill battle to get people to adopt it.
The flow I explained in one way these guys make money. It's certainly exaggerated. At the one place I worked we ran a $0.5bn book of this stuff. You don't always get chances to get out. So risk management is key. Your book turns over every few days.
And it's not like a lot of internalizers are going around with prospectuses saying "we're gonna purposefully move markets to give your customers worse prices", so the SEC isn't going to have much trouble fining them if they decide to (assuming this is actually happening all the time).
Yeah I don't really care about the semantics here, it is commissionless. My strategies aren't materially affected by some broker-level BS, I am satisfied with the fills I get on Robinhood vs what I can see on the order books using other tools.
> ... according to three people with knowledge of the matter, who asked not to be identified because the details are private...
Then, the end of the article mentions 3 VCs:
> Two venture capitalists, speaking on condition of anonymity because the discussions were private, expressed concern that Robinhood's ties to high-frequency traders might undermine its image and stymie expansion plans. A third said it was the reason he didn't invest.
I wonder if this article is the product of some VC sour grapes.
Is that a wrong assumption? If not, seems like maybe RH is just taking advantage of the rebate for not much benefit to Citadel?
On the other hand if you're trading against a hedge fund... You don't know what info they have. You also don't know when they'll stop buying or selling. Their orders could come across multiple days. You don't want to touch that stuff
This is incorrect. Retail volumes are smaller. (This also makes them less risky to fill and offload.) But spreads are wider.
I worked on an algorithmic derivatives desk many years ago. We paid a well-known national broker lots of money to get their options flow. Their customers were notorious for forgetting to exercise slightly in-the-money options, putting in misplaced limit orders, putting in market orders for illiquid names, et cetera.
Robinhood has its hands on the money of a generation that was too young to lose money in the last crisis.
> Equity options $0.01 or more in the money will be automatically exercised for you unless you instruct us not to exercise them.
https://www.bloomberg.com/news/articles/2013-10-23/e-trade-s...
Their 'default' order price is a market order that they promise will not clear until after hours or the next day.
https://freetrade.io/order-execution/
This is quite possibly the worst way a retail investor could send in an order.
Isn't this only true for the non-paying users, who are not subscribers of their premium plan? That's probably their entire (freemium) business model. It's the same with Revolut: free users might lose more money in foreign exchange and withdrawal fees, which pushes them to upgrade[1].
Robinhood seems like a better deal.
https://freetrade.io/order-execution/
In the US they would be required to disclose how much they are being compensated for that. I don't know if that is a requirement for the UK so have been unable to magic search term my way to their disclosures.
https://www.fca.org.uk/publication/thematic-reviews/tr14-13....
So for as long as freetrade is UK only I think you can probably assume they aren't receiving payment for order flow.
When people in the industry talk about 'dumb money' they aren't talking about how informed or intelligent the order flow is. They are talking about how likely the order relates to market structure.
An individual investor who has looked at their portfolio and decided that the best move for their investment horizon is to move a big component out of equities and into bonds is still 'dumb money'. Even though that might be the most intelligent option.
A bot that has a terribly performing algorithm that takes market structure into account is not dumb money though.
What do you mean by "market structure?"
In reality for most trade-able instruments there are a variety of exchanges all operating at once. Further in each exchange there isn't a single price. There is a collection of buy and sell orders that combined together form the 'book'. For instance if you had 10 buy orders at $1 and 2000 sell orders at $1.10 what is the 'price' of that thing? The structure of the book and how all the exchanges relate (and Reg NMS in the US equities space) are all the 'market structure'.
HFT will take that bet on the other side of every retail investor they can get their hands on, including those with very sophisticated trading terminals. For that matter they will take the other side for very sophisticated non-retail investors so long as its non-directional flow.
For example buying a LIMIT says the highest price I am willing to pay per share is X. So you can be confident you'll get a price at least equal to or below the limit price.
> the share price is meaningless to me
??? Confused. Do you like buying high and selling low?
For retail order sizes and holding periods, that's probably fine as long as you place orders close to the current price.
Regardless, I’ve traded for decades and on high-volume stocks (which are the ones you’re likely to trade), putting limit orders in is a waste of effort. For some folks, it’s important to save a few cents. For you, not so much. Different story on penny stock or < 100K/day in volume, but if you’re buying AAPL just put a market order in.