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Comment by mattferderer | Hacker News Reader

I'm curious if anyone with knowledge can speak to how Robinhood sells data to high frequency traders?

This seems to result in a large percentage of their revenue which of course makes sense due to not having commission revenue.

I've also heard some people argue if you're investing a decent amount, you're better off with commissions over market orders on Robinhood. The arguments were the above & that orders can take a much longer time to process. Though I imagine most small investors are not to concerned with either.

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I'll add Matt Levine's insightful take here [0], which delves a bit into the "deal for order flow" controversy, and also makes the unique claim that for Robinhood to engage in this is very much in line with "taking from the rich and giving to the poor", because it does guarantee price improvement for RH users.

[0] https://www.bloomberg.com/opinion/articles/2018-10-16/carl-i...

Summary:

Retail generates uncorrelated order flows, perfect for the market maker.

Institutional generates highly correlated order flows, the nightmare of the market maker.

As paradoxical as it may sound this can actually result in price improvement for the retail trader.

This is one of those rare places in finance where being small is an advantage. Another is in finding value opportunities - the smaller you are the larger the pool of potential opportunities. Warren Buffett needs big and good opportunities. Retail investor needs just good opportunities. The word "big" restricts choices.

I disagree with this description.

Retail flow is primarily uninformed - "noise", not "signal" (i.e. "alpha" in finance speak). Retail traders might trade based on Twitter news, Reddit suggestions, weather, gut feeling, sudden money needs, ...

Institutional traders are big and slow and they have long-term alpha (if any), I don't think they'd generate much worry for HFTs/market makers... The real worry is other HFTs, small, short term (well-funded, more rational) traders that do have "alpha". There, you're faced with negative selection - by trading passive (market making), you should assume that your order is more likely to be filled when the counter-party has better information (more alpha/signal than you) so you'll lose in the short term.

That makes sense too (avoiding competition). But it's not what the quoted article says.

Institutional trading (like mutual funds) certainly is a problem for market makers:

> Sometimes, when a customer buys 100 shares at $100.01, it then buys another 100 shares at $100.02, and another 100 shares at $100.03, and keeps going until it has bought 10,000 shares and pushed the price up dramatically. The market maker who sold it the first 100 shares—and who is probably now short and needs to go out and buy those shares at a higher price—has been run over.

> This is a risk of being a market maker on the public stock exchanges: Sometimes you sell 100 shares to a small retail investor and it’s random noise; other times you sell 100 shares to Fidelity and you get run over. But if a market maker can guarantee that it will only interact with retail customers—if it can filter out big orders from institutional investors—then its risk of adverse selection goes way down.

Indeed, this isn't a comment on your summary (which I have no reason to not believe to be accurate). I'm commenting on the ideas behind the article itself.

Still, I disagree. Even a large order won't "move" the market by itself (unless you're the Fed). At best, it might trigger a flash crash (we've seen a few of these in the past few years), where liquidity temporarily dries up (HFT market makers remove their passive orders, until they figure out what the hell is going on, precisely because they already predict cases like this) but comes back as soon as human traders figure out that nothing is going on (and the price has no reason to move).

More likely, a large order might blow through a few layers of the order book, which is good for market makers - instead of selling it at $100.01 (which is the "best", i.e. "lowest" price), you're selling it at $100.02 (i.e. you're making more money than your fellow market makers). In general, if you're an "institutional" (or otherwise big & slow) trader trading "large" orders (relative to the standard market volume), you're trying hard to disguise your intents. If HFTs know that you will buy the next 100 shares, they'll just sell it to you for $100.09 or more!

This is not Japan, the FED is not trading equities.

And continuous movement of price in one direction is bad for market makers. Read the linked article, it explains why.

> Even a large order won't "move" the market by itself

Certainly, the market moves when two parties agree on a price, so one order doesn't move the market by itself; however, a large order in combination with normal market behaviors will result in the market moving higher.

When you buy the book, the market makers are going to replace their sell limit orders at higher prices. If you have a lot more shares to buy, you're going to buy out those too. If you've done a fair bit of buying this way, and market makers had been selling short, they're going to want to buy to cover, which adds to or sustains the price increase.

This price movement isn't great for the institution or the market makers.

Market makers would rather trade against retail investors -- they don't make a lot of large trades, so they don't move the markets very much, and there's not the same risk of getting run over.

Institutional investors would rather trade in ways they can get a fair price without influencing the price -- if they can find counterparties to trade with on a volume weighted average price basis, they prefer that -- or they try to structure their orders to avoid hitting the market all at once.

Does Robinhood sell data on various order types like limit, stop-loss, etc to High-Frequency Traders? That would allow the HFTs to extract profits out of Robinhood's users since this information does not appear to be non-public and hence can be used for front-running.

At the volume of retail though how impactful are those price improvements over the long run?

My gut tells me it can’t be much, but I have zero data to back that up on and would love to find some.

Not much, but it's not like trading is expensive these days. IBKR usually charges me 1 dollar per transaction, unless I trade many thousands USD worth of securities at a time. Improvements (of which there may be none) should be in the same ballpark.

http://archive.is/DzFOg

This is a great article from patio11 that explains the general process, though not for Robinhood specifically: https://www.kalzumeus.com/2019/6/26/how-brokerages-make-mone...

This recently posted article does a good job of explaining how Discount Brokerages make money.

tl;dr - order flow is $$$, but interest is even better.

1- Interest

2- Commissions

3- Asset Management

4- Securities Lending

5- Payment for Order Flow

https://news.ycombinator.com/item?id=20276551

https://www.kalzumeus.com/2019/6/26/how-brokerages-make-mone...

The only issue I have had with Robinhood is regarding tax planning, because they only support FIFO sell orders. There have been several instances where I would have preferred to sell shares purchased more recently, so that my older shares can pass the one year threshold for long term capital gains. The ability to specify lots when selling shares would be worth money to me.

This is the precise reason that I only use Robinhood as a toy trading account. Give me a 'maximize losses' tax basis, please!

If Robinhood were to roll this out they'd inevitably do it in a way that counted as tax advice, getting them in tons of legal hot water, because they wouldn't be able to help themselves on the marketing side. So it's actually rational for them not to bother building this incredibly obvious feature. /s

Can't you use whatever accounting method you wish, regardless of how they report it?

Yeah would love an answer here too

When you sell shares, cost basis is reported to the IRS by the brokerage. The parent comment suggests that RH always reports the FIFO cost basis, i.e. price of the first shares you bought as opposed to the last shares. There are places on tax forms where you can adjust your cost basis up or down from the one reported by your brokerage, but (without doing any research into it) I doubt that "I don't want to use my brokerage's cost basis method" is a valid reason to use those.

I really have no idea, but it's a VERY new thing that brokerages even report this information. The 1099-B can't be more than a decade old. You used to have to track it all yourself. I suspect you can use your own cost basis method. (subject to rules; of course you have to be consistent)

That said, this is definitely not tax advice, and even if it's legal/allowable, you're almost certainly more likely to be audited if your numbers don't agree with what the brokerage reports.

This is why Form 8949 (column (f)) exists.

Aren't the shares fungible?

Robinhood sells their order flow to the likes of Citadel, Virtu, etc.. These are called "internalizers" and they will often "Pay for Order Flow" or pfof. pfof flow is certainly profitable, because its "retail" and bi-directional. But it's not THAT profitable. For the big guys, it might be a few $10s of millions of dollars in revenue/years. But that revenue is significantly defrayed by the cost to purchase the flow - which is easily in the $10s of millions/year as well. Net net, its still a drop in the bucket compared to money being made in other strategies.

Typically, these pfof arrangements require price improvement from the bid-ask. So the retail guy benefits a negligible amount on their trade (1/10th of a penny for example). This may be good for the retail guys in aggregate. There is also some immediacy to an order getting filled (also a requirement) that may not be there if the internalizers didnt exist.

Robinhood's valuation comes from the net interest (borrowing short and lending long) and from the upsell of services.

https://news.ycombinator.com/item?id=20276551 << refer to the excellent article and discussion here about how brokerages make money.

Where attention should be turned is whether RobinHood is investing or gambling. More money is lost punting on the markets than through any arrangements to hi-freq guys.

> I'm curious if anyone with knowledge can speak to how Robinhood sells data to high frequency traders?

They don't sell the data. They sell the trade.

> I've also heard some people argue if you're investing a decent amount, you're better off with commissions over market orders on Robinhood.

Potentially, although if you have to ask, it's unlikely to really matter for you.

(Robinhood, as is required by law, gives you the best publicly available price, and no fees. They can do this because, as above, they're selling your order flow, and their are people willing to privately offer better-than-best prices to certain types of orders. That value can be split a number of ways between the broker and the customer, and Robinhood as opted to keep the money, use it to fund their operations, and offer zero commissions. But you could imagine a different broker who charges "normal" commissions and passes the price improvements on instead. For some customers, that might end up being a better deal...or not.)

Re the 1st question, the article gringoDan posted will explain it, but I think the important thing to clarify that can get lost in the detail is that "payment for order flow" doesn't mean what it sounds like it means. They don't sell data in the way we usually think of in tech. Payment for order flow means Robinhood sells HFTs the opportunity to execute RH's transactions.

The other commenters answered your first question about the sale of flow to HFT firms.

Regarding your second question, I wouldn't recommend trading a lot of size on Robinhood, or using market order in general, but brokerages that charge commissions do not necessarily offer better execution than Robinhood, many of them still route your flow to an HFT firm or have less than stellar order routing systems.

Execution price is governed by SEC and clients must get the best price. HFT doesn’t really work on retail investors who’s sells and buys can be covered with one order. You can’t front run one order trades. Institutional investors are the prey for most HFTs since they do large stock trades and they need to hide to prevent front running.

The top of book liquidity on most equity stocks is light enough that a single retail investor can absolutely submit orders which must hit multiple exchanges, especially if they do so at non-peak hours. The NBBO doesn't help you if every market maker retreats before your broker can hit the next exchange.

There was a post on Reddit just a month ago where a small investment club did just that. https://imgur.com/gallery/qMBAzoQ

This is not 1994. Catching a market order with volume is winning a Power Ball. It will be a limit and if it is not IOC/FOK order, should it clear top of the book and not be filled it would simply become a new national best.

Its not really clear who you are arguing against, the GP mentioned large market orders, I simply made the point that most brokers have worse order routing than the HFT firms and Robinhood is probably not much worse than anything else out there. Using limit IOC orders is a tool that more savvy retail traders can use to prevent bad execution, but if they are trading size the commission they pay to the broker won't make much of a difference.

I would also point out that having your IOC order not fully filled is also bad execution. If you want to get a certain size done, repeatedly IOCing the market with manual click trades is not ideal.

GP is confused. The market orders from retail investors are measured in hundreds to thousand share, mostly 100s rather than 1000, with 100x100 or 200x200 being a typical live quote on a 1000x1000 As soon as the retail investor starts throwing more than 1k orders they become limits.

All the talk about RH being a bogey man with it selling order flow is b.s. peddled by those who either suck the teat of the retail investors directly or those that live off the spoils from those that such those teats. Wall St is terrified that tech is coming to eat its margins -- that's why we get all this.

P.S. I'm not a fan of RH at all - 99% of the people who use it should buy an ETF with a 0.01-0.03% expense ratio and be done but if a random college jock that does not have a PhD in math can make $200k/year first year out of college in a Wall St firm, Wall St needs to get a haircut.

They are selling order flow to the market makers. Market makers want retail orders and not hedge fund orders since assumption is hedge funds may be operating on more knowledge than the market maker. Eg: satellite pictures of parking lots to predict earnings report for retailers

So this isn't about moving the market itself with the orders. There are numerous exchanges on which shares are bought and sold. They aren't just traded on the NYSE and NASDAQ. In fact most large investor institutions have their own Dark Pool exchanges.

What Robin Hood does is sell the orders to high frequency traders, which then front run these orders and can great a small incremental disparity per trade. It's not even .01 per trade.

However, the benefit is that every trade is done at a profit to the high frequency trader, because they are simply fulfilling an order, and not holding the stock.

And to the regular small investor, the price movement is inperceptible.

The actual work of high frequency traders was discovered by large institutions because their order volumes were much higher and because they were much more price sensitive, and they saw a much larger swing in their price from which they were closing transactions.

This was all detailed in Michael Lewis' book "Flash Boys". So if you liked "The Big Short", this one is a must read as well. So in this case they are giving from the poor to the rich, but it's really a small imperceptible amount and because of the vagueness of what's happening most retail investors are completely unaware nor that much interested in what's happening here.

You are getting a zero commission trade, which may cost you $7 somewhere else, do you really care if someone tacks on a $0.50 cent charge? You are still up $6.50.

I disagree with a lot of this comment, but the largest most glaring mistake is around the perception that robinhood is without fees. Robinhood takes their cut by creating a larger than normal bid/ask spread. I promise you their cut is more than $.50 and most likely > $7 (at least in Crypto land where I have witnessed this behavior). To think that HFT firms are using this data to only front run orders also feels pretty naive to me, but I'm no expert.

I don't know about crypto but on stocks they're legally not allowed to execute a transaction outside the NBBO. See https://en.wikipedia.org/wiki/National_best_bid_and_offer

It’s sctually the opposite: retail orders have no information about direction of market, so the profitable thing is not to “front run”, but to trade in the opposite direction of the retail order. If the retail order is selling the bid price, you want to buy the bid because you know on average those retail orders don’t indicate that market is going in any direction

What you're describing is illegal in most regulated markets around the world and certainly illegal on U.S. markets [1]. Brokers are legally required as per Reg NMS to offer the best quote to their customers.

https://en.wikipedia.org/wiki/Regulation_NMS

> I promise you their cut is more than $.50 and most likely > $7

For stocks? Absolutely not. You get the National Best Bid or Offer (NBBO), as required by law, ie, the best spread available on the public stock markets.

> at least in Crypto land

Well, maybe there's your mistake.

> To think that HFT firms are using this data to only front run orders

They're not using it to front run orders. Not only is that illegal, but it's also in this case impossible by definition. You front run an order that might move the market by trading in advance of it, but in this case the internalisers are paying for retail order flow because it won't move the market. That's the only reason it has value to them. And because it won't move the market, you (obviously) can't get out in front of that market movement.

I'd suggest doing a bit more research.

Internalisers do not "front run" retail orders. That's not even a thing you can do; the idea of front running is to get ahead of a trade that will move the market, but the internalisers are buying retail order flow because it won't. If the order isn't moving the market, you can't "get in front of it".

If front running happens at all (and by strict definitions, it really doesn't), it certainly isn't happening to Robinhood customers (or the custoemrs of any other discount brokerage).

Its market makers generally rather than HFT. Essentially they (market makers) agree to buy stock that you want to sell than they sell it to someone else. Problem is if the market moves against them, you could be a hedge fund manager that knows something they don't.

Robin hood customers don't really know anything, their trading is fairly random, so a market maker can be confident that if they buy the shares, the Robin hood customer doesn't know something they don't, that is worth something to them, and allows them to offer tighter spreads.

TLDR; question answer: An HFT makes money because they see you want to buy 100 shares of Apple. Their servers are located in the exchanges, so they can buy the 100 shares of Apple for $99.99 each quickly, then flip them to you for $100 each, effectively giving them a risk free profit of $1. The HFT then gives Robinhood a small reward for sending them the order data. Multiply that times millions of trades a day.

If you are curious where the average broker routes orders to, they all file Rule 606 documents with the SEC.

Here is Robinhoods for Q1 2019: https://d2ue93q3u507c2.cloudfront.net/assets/robinhood/legal...

These filings show exactly how much each HFT, aka market maker, got routed by robinhood.

Here is Schwabs: https://www.schwab.com/public/schwab/nn/legal_compliance/imp...

What you will notice is that both have roughly similar distribution across execution venues, and the same can be said about many retail brokerage firms (Fidelity, Etrade, and the like). The difference is that Robinhood makes quite a bit more money from Payment for Order Flow than the typical brokerage.

Back in 2016 when Robinhood was gaining traction, I was pretty suspicious that they were either directly front-running their own users, or they were selling order flow to HFT's. Back in that day, both of the founders still had a LinkedIn that showed that they both worked at an HFT! before starting Robinhood. Since then they have removed that history from their profiles, but it's definitely not a good look if you are saying you are commission free! Selling order flow is the norm in the industry, but there is certainly a special relationship between Robinhood and their execution venues that isn't completely clear.

Overall, I am in the boat that Robinhood should at least be required to say that they aren't perfectly commission free. It seems that the commission most users pay is just indirectly being paid to an HFT, then kicked back to Robinhood.

With all of that being said, unless you are making huge block (100's of shares) trades, it's probably still cheaper to use Robinhood than a retail firm.

My hypothesis is that Robinhood gets higher kick backs because:

1) The user base is typically not financially savvy.

2) Users are more likely to do "market" orders leading to more profit for HFT's

3) Since there is no commission fee, users feel like they can buy or sell with 0 friction meaning the average user will end up in and out of positions much more frequently.

All of those things mean more profit margins for HFT's to kick back to Robinhood.

Robinhood certainly is "free", but the issue is that without friction, e.g. $10 trade fee, you as an investor will hop in and out of positions quickly, meaning more profit for the HFT, and indirectly, Robinhood. However, for most of us Robinhood is still cheaper than a brokerage even with this hidden tax.

I recommend avoiding options, penny stocks, and cheap-per-share stocks if you want to avoid paying a higher hidden tax to HFT's.

No. Front running is illegal, that's not what RH does. What RH sell is uncorrelated orders, and the users actually get better prices from this too.

> Their servers are located in the exchanges, so they can buy the 100 shares of Apple for $99.99 each quickly, then flip them to you for $100 each, effectively giving them a risk free profit of $1.

I don't know a lot about trading US equities, but this sounds wrong. Brokers are required by law to give their customers the best price ($99.99 in your example).

https://en.wikipedia.org/wiki/National_best_bid_and_offer

Brokers are required to, yes. But Robinhood doesn’t submit orders directly to exchanges, it always passes through a middle man who has to collect some fee for their service.

No, they're not (if my understanding is correct) passing their orders through a middle man, they're passing their orders to a market maker. Market makers don't get "fees" and don't perform arbitrage (they can't, they need to match the best bid/offer). They make money by trading the spread (the difference between offer and bid). They buy at $100.01 (best bid) and sell at $100.02 (best offer) and pocket the difference ($0.01). This of course relies on statistics, law of large numbers (doing this often enough) and avoiding risk (a single large move can wipe out your profits from 1000s of trades). The reason they like trading with Robin Hood (and other retail traders) is that the chances of a large move following a retail trade is much smaller (retail traders are "uninformed", i.e. noise).

I'm pretty confident we are talking about the same thing. I was referring to market makers as the middle men because they are not the stock exchange. Call it whatever you want, but trading the spread is arbitrage, i.e. a price mismatch with opportunity to profit.

It's unlikely that we're talking about the same thing. Based purely on your reply I reckon you have your concepts all mixed up.

(1) The exchange is the middle man. The market maker is your counterparty, i.e. the person you actually trade with. The exchange facilitates the trades (often, not always - e.g. you might also trade off exchange, e.g. in dark pools (but you wouldn't do that unless you thought you were getting better prices) or by trading directly with market makers - in which case the US law protects retail customers from being "scammed") and also does clearing which means that it "guarantees" the trades - but that might not really work because an exchange cannot print money and so can go bankrupt itself - recent example in Norway:

https://www.bloomberg.com/news/articles/2018-09-14/nordic-po...

> The loss for Nasdaq’s default fund, that helps guarantee trades, amounts to 107 million euros ($125 million) and the exchange has issued a “replenishment contribution request” to cover the default losses. Current trading members will have to contribute in relation to their size and this is the kind of event the default fund was designed to handle, a company spokesman said.

(2) If you really want to call market-making "arbitrage", sure, go ahead - but it's time arbitrage, not price arbitrage. Similar to how your bank is (or was) doing time arbitrage by connecting short-term deposits with long-term loans (and earning a fee in the process). Without market makers, if you wanted to sell 1 share of AAPL (Apple), you'd have to wait until someone came along wanting to buy 1 share, and then you'd have to agree on a price. Market-makers facilitate trading by continuously providing bid-ask quotes, so that you can sell immediately at a known price, and then 1 hour later someone can buy immediately at a known price (minus the "fee" (spread) that marker makers earn).

All in all, I don't think you even need to use brokers. You can just find buyers yourself and sell directly to them, avoiding the "evil arbitraging market makers" in the process.

Thank you for clarifying my misunderstanding.

Robinhood is a broker dealer.

> Brokers are required to, yes.

Correct. And Robinhood is a broker, so it is also required to.

> Robinhood doesn’t submit orders directly to exchanges

Correct, but irrelevent.

> it always passes through a middle man

Correct.

> who has to collect some fee for their service.

Incorrect. They are not charging Robinhood (or their customers) a fee.

Robinhood's clients get the NBBO, as required by law, full stop. There's no trick here.

What you're describing is illegal activity and no brokerage engages in anything remotely close to it.

It's quite frustrating since I actually work for an HFT firm and the amount of misinformation about it in this comment thread is absolutely overwhelming. I don't even know where to start to debunk so many of the claims being made about front-running, or how paying for order flow works... all I can say is that reading through these comments really reinforces the point that plenty of people without any experience or background in a topic will talk about it as if they are experts in that field and there's no way to know who is and isn't knowledgeable on certain technically sophisticated topics.

Basically, take a topic that you're an expert in, find a discussion about that topic on the Internet and see just how much misinformation there is out there about it. Now consider all the topics you're not an expert in but read about on Internet discussion forums and you have to conclude that most of what people say is basically conjecture, speculation, and rumors with no sensible way to discern who is who.

It's kind of depressing.

I appreciate your comment. Can you clarify how Robinhood gets compensated for Payment for Order flow?

Additionally why is it that they get a better rate than most retail brokerage houses with much more volume?

This is the best article I've seen on this issue (by patio11): https://www.kalzumeus.com/2019/6/26/how-brokerages-make-mone...

> I've also heard some people argue if you're investing a decent amount, you're better off with commissions over market orders on Robinhood.

If you're investing a decent amount, you're better off using limit orders. No real debate to be had there.

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