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According to Wall Street Journal, “Robinhood Markets Inc. faces a civil fraud investigation over its early failure to fully disclose its practice of selling clients orders to high speed trading firms.” Here’s what that means in plain english.
When Robinhood launched in 2013, it changed the way people in their 20s invest, including myself. There were no such thing as buying and selling stocks without paying a commission. That left a lot of people wondering how exactly was this new unheard of app called Robinhood making its money? If you went to their website, they wrote a page called “How Robinhood Makes Money”.
There were two main ways that were listed: #1: the interest that their brokerage collected from all the money that you and I deposit in the app and #2 they made money from the fees from margin trading accounts.
If you’re unfamiliar with Margin Trading, it’s when you buy and sell stocks with “leveraged money” or money you don’t actually have but money that you borrow and is considered “collateralized” which means, if you lose money on margin, not only do you lose your borrowed money, you also are forced to sell any stocks and cash you had in your brokerage to pay for those losses, and this strategy is a very risky way of investing. It turns out, Robinhood had a third way they made money that was not disclosed to investors. #3 Payment for order flow.
Robinhood does not execute its own trades like some brokers do, it outsources them to someone else. Market makers are usually very large companies that provide liquidity to the market. That’s because Robinhood doesn’t actually sell or buy us the stocks we want to invest in, all they do, is match a buyer with a seller. That order then goes to a market maker which is the actual company that holds the stocks, which then sells it to the client. The difference in price for what the market maker sells and buys the stock for, is called the bid and ask spread. They make fractions of a penny per share.
The reason these middle man are important to trading is a few reasons. They provide liquidity which means we can invest in stocks instantly without having to wait, we can invest in stocks at a more accurate price point, and they (the market makers) take all the risk for holding on to the stock while they wait for the orders.
Robinhood has been receiving payments from these market makers for routing our trades to them. There’s nothing illegal in this practice. In 2018, Robinhood made half of its profit from these rebates. In 2020 they made $126 million from Citadel Securities, $75 million from Susquehanna, $37 million from Wolverine, $20 million from Virtu, $9.7 million from Two Sigma, and $1.6 million from Morgan Stanley.
What’s wrong with what they did, is not telling you and I about how they made their money before we placed our trades because it creates a potential conflict of interest. Now, they are now in a civil fraud investigation by the SEC. Ultimately, this doesn’t affect us much. Especially if you’re someone who’s a long term investor, in the grand scheme of things, over paying by 1/8th’s of a penny per share isn’t going to make any difference to how your money grows if you’re investing for retirement.
If you’re super concerned still, a good solution is just to set a limit order for what you think the stock is worth and for what you want to buy it at, and the problem is solved.
*None of this is meant to be construed as investment advice, it’s for entertainment purposes only. Links above include affiliate commission or referrals. I’m part of an affiliate network and I receive compensation from partnering websites. The video is accurate as of the posting date but may not be accurate in the future.
SEC Report (Payment For Order Flow): https://www.sec.gov/files/Algo_Trading_Report_2020.pdf
WSJ Article: https://www.wsj.com/articles/robinhood-faces-sec-probe-related-to-deals-with-high-speed-traders-11599074891