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The real way that ‘free trading’ app Robinhood makes money will surprise you

‘Rob from the rich’ puts poor on dangerous path

Robinhood

Robinhood (via Shutterstock)

Something didn’t sit right with HyperChangeTV’s Galileo Russell when he went over the Robinhood app’s 2018 fundamentals. He runs a YouTube channel teaching Millennials about investing. Robinhood advertises to small-dollar Millennial investors as the best fee-free way to by crypto and stocks without getting screwed by high-fee brokers. They now have $5 billion valuation and $4 million in “brokerage accounts.”

But their numbers didn’t quite add up. We noticed a similar problem when we went through the app. Buy and sell prices always differed in their favor. And crypto and stock “buys” couldn’t get moved to another wallet or portfolio. So how does the app make so much money off of “free” trades?

Robinhood positions themselves as this big company that wants to change the system. They cite Occupy Wall Street as their turning point. But Bloomberg found that they don’t even mention on LinkedIn that during Occupy, they were designing software for high frequency trading operations.

We asked Galileo Russell to walk us through it.

Modern Consensus: Your HyperChangeTV YouTube channel has a similar mission from Robinhood. So why should we trust you on this?

Galileo Russell: I’m an investor and I’m open sourcing my journey. I’ve constantly gotten questions and no one teaches stocks, no one teaches taxes. So I started HyperChange to open source my own diary of my investment decisions. I’ll just put all my investment online to inspire Millennials to get a hold of their finances.

There’s no possible way that these companies are just doing this out of the kindness of their hearts. “Free” trades cost money.

I’ve been investing for over 10 years and I used to do a lot of Level II day trading. From those early days, I’ve always noticed that market makers play these games where they never execute at market price. Then the second before your order goes through it goes to from 10 to 12 cents.

And Robinhood?

The more and more I looked into their business model, they were selling order flow. Forty to fifty percent of their revenue is selling order flow.

Break that down for us.

The don’t execute any trades themselves. They’ll put out a bid if you want access to Robinhood’s order flow a hedge fund will have to pay Robinhood to handle your transaction.

It sounds like they’re taking a fee. Who are these people?

The biggest ones are Citadel and Two Sigma, two of the largest hedge funds in New York City. So why are they paying hundreds  of millions of dollars to Robinhood? Because they are able to leverage it and make money off it it by not paying market price. These companies are executing these orders in a “dark pool” along with all their other orders, but there’s this law that says they have to do it at the market price. But Citadel was actually fined $22 million by the SEC for not filling at the market price.

And so after these hedge funds pay a fee they just handle all of Robinhood’s transactions out of the goodness of their heart?

Qui bono? I ask myself: Who benefits? What’s the benefit of the large hedge fund buying this orderflow? One of Wall Street’s highest trading firm is Robinhood’s biggest customer for their order flow.

But Robinhood founders always say that they wanted to do this to go against the big companies and their fees. They’re literally going to the biggest companies because they are paying them a fee.

The deeper you dig, the more interesting the story gets. What the founders left off their resumes is that they were coders building software for high frequency trading firms, likely Two Sigma and Citadel. But that’s not on their LinkedIn.

So if Robinhood users are early in their investing lives, they probably aren’t experts at handling trade data on their phone. The videos for Robinhood want you do execute these trades while you’re waiting for an elevator.

My audience noticed that orders on Robinhood are going slower and they noticed that they were not getting the market price.

How much money are we talking?

Robinhood is valued at $5 to $6 billion and they have 4 million in brokerage accounts. It makes sense. They have a great brand. These are people they can tell a ton of financials services in the future. That’s what’s so confusing to me. Robinhood should be playing the very long game in those customers. Not making a quick buck on their orderflow.

I’m guessing that’s why they were able to raise $500 million. But we look at it this way. Robinhood has 4 million “brokerage accounts” and a $4 billion valuation. Is each pizza delivery person who makes a few trades a year really worth $1,000?

It is to a certain kind of investor.

I’m okay with all of this until you get to the part of offering margin trading. You shared a Reddit post from someone who had negative $55,000 in his account.

Robinhood Gold. Users can pay a flat fee per month for access to margin trades. Basically trading on credit.

That’s where you start to get into dicey territory. It’s like Apple moving into “company services” over products.  I don’t want Netlflix for investing. But here it is.

It’s worse than that, especially in a slick, addictive app. If you pay $5 to $10 a month, you can incentivise people to use that leverage. It’s the sunk-cost fallacy. You think, well, I already lost $5 this month paying the fee. So maybe I can make it back if I leverage my account. And Robinhood is incentivised to use that leverage to make money.

Ooof. I did that the first time I went to a casino in college. I thought, oh no, I lost $100. I better go to the ATM and get out another $100 to win it back. And I was studying economics!

Haha. I would consider myself a seasoned investor over the last decade but I would never use leverage. That’s another way they make money. It’s not illegal, but I don’t like it. Instead of learning from my mistakes, I could have gone bankrupt many times if I’d used leverage.

We see this problem in crypto all the time. All of the people who bought last year on credit or who mortgaged their house for bitcoin are now very, very sorry. And there are few resources to help you in a bear market.

None of the services in Robinhood will prepare their users for the bear market.

What do you think their books look like?

They are probably doing $250 million in revenue and losing $200 million. If they’re valued at $5.6 billion, they have to have some big revenue.

A lot of it doesn’t pass the smell test. When they first came out, we could email Lavinia [Chirico, communications at Robinhood] anytime and talk to her about developments. Now they never get back to anyone.

In transparency that investors need. I’ve tried to contact Robinhood. I have relationships with other companies in the investment space. And Robinhood won’t reply to me at all, which is ironic because I communicate with a lot of investors, young investors who trade stocks. I just don’t get what their MO is.

Walk me through what really happens with a Robinhood trade.

Okay. I’m a young investor and I’m impressed by Tesla. I press buy Tesla at $330/share. You put a market order. Robinhood doesn’t touch that order. They send that order to one of the two high frequency trading firms. Let’s call it Citadel, their biggest customer in Q4. Citadel runs it through their own exchange, which is called a “dark pool.” In theory, they can meet the match without paying fees. In theory, it’s a lot more.

So within the “dark pool” inside the hedge fund it’s not even a real trade. It’s like paying your friend in PayPal from your PayPal balance.

Yes. And this is what Citadel got in trouble for, in my opinion. You look at your screen and it said $330.50. You know at Citadel, you’re going to buy Tesla in their dark pool for $330 and sell it at $330.50. These are just very theoretical examples.

So a “market order” at $330 isn’t exactly that.

Right. Think of it as a lobbed pass. It’s just moving very slow. I toss my trade through the dark pool and anyone can snatch it up. And they don’t have time restrictions. There’s no parameters. It’s up to these hedge funds in the grey area. If Tesla is at $330 and my trade says “sell at the market price” and then flip it immediately to you at $330.50. They’re cutting in front of your order and skimming off the top. It could be in fractions of cents and it moves so quickly.

But that’s not what they’re selling you as a service.

All in all, the total cost of trading on Robinhood could be cheaper. Like, okay, I didn’t pay $10 per trade, I just lost $0.50 per transaction. But you can’t tell how much it was and Robinhood won’t tell you. The best way I can say is why are Citadel and Two Sigma continually making high bids for Robinhood’s order flow.

What does Robinhood get?

Robinhood is collecting 2.6 cents per $100. That’s what Robinhood collects by selling your order flow. So if it’s that low, then Citadel wouldn’t take your order, but you can imagine how much they would have to add to your trade to make any money. Citadel would have to make that money back to break even. These firms never have a down month or a down year.

That’s where the numbers get weird. Even someone making a $1,000 order gets them $0.26. But the banking fees to get $1,000 into Robinhood is more than $0.26.

And then the hedge funds are making at least $0.026.

Now this is like when Facebook testified in Congress that their settings allow you to get around this. I hate when tech companies advertise themselves as easy to set up when their “User Agreement” is two hours of reading and their features are hidden. Robinhood can come back and just say that you can make a limit order.

I get this all the time. In the comments people would say, “you can make a limit order.” Okay, so you set a limit so the “dark pool” can’t do $330.50. But that $330 order won’t get executed when the market has slippage. They will have to get it to $329.50. And you’ll watch the markets and wonder why your order didn’t get filled. You might not see that price again in the market.

And in their defense, the whole order rarely gets filled at the exact price.

There has to be some slippage±your market order doesn’t execute exactly—and they are capturing that slippage. This is all speculation, not that they are selling order flow.

Robinhood said big firms pay almost nothing for trades.

Citadel has so many orders to process that they built their own dark pool. They trade for free after setting up the expensive dark pool, but then it becomes a profit center.

The SEC fined them for slippage?

Citadel got fined for this. It doesn’t say slippage, but that’s how I’d put it.

Is the data itself of any interest? Does a hedge fund want to know “Millennials are buying this?”

No. I don’t know who could benefit from that data. I can’t think of a way that a Citadel could be interested in that. Robinhood is the dumbest money you can get. You make money on order flow. It’s not like somebody at Citadel is like, “Whoa, guys on Robinhood are buying Tesla! We better act!”

A “Dark Pool” isn’t what we think of when we imagine stock trading. It’s not exactly the floor of the NY Stock Exchange.

The book “Flash Boys” by Michael Lewis goes into this. These huge hedge funds had everyone so pissed because they noticed the slippage. Even billion dollar funds bound together to work something out. Somebody who worked at RBC noticed the problem and built IEX with fully transparent prices. He’s the main character in “Flash Boys”. Robinhood should just partner with the good guys and be the actual good guys.

This is our problem with a lot of crypto platforms. But another one is that the real “slippage” of a system is the fees. You put $10 on your Venmo and send it to a friend and they put that in their bank account and Venmo loses money. But would I pay the fees myself to make Venmo “more transparent?” Hell no.

The way that Robinhood makes money now is the opposite of Robin Hood. They are taking money from small dollar investors and giving it to the largest high frequency trading firms in exchange for a fee.

And yet…the problem with finance it has a high barrier to entry. We savaged them in our review and then ended up saying it would be better to let a kid lose their allowance learning about investing than it would to buy some video game.

There is an argument to be made that it’s cheaper than $10 you would pay to trade somewhere else. Even if they’re getting screwed on slippage, that’s where I give it to Robinhood. That, to me, is the great part of Robinhood. It seems like there is a much better way for them to do all of this. I do think they are the most disruptive company in Fintech.

So you don’t use Robinhood?

I get 25 free trades with Vanguard per year. They have it in their terms of service that they won’t sell your order flow. I trust Vanguard because they’re not going to go bankrupt. I don’t want to have my life savings held up in Tesla stock with Robinhood. I also trade really weird securities and such. Robinhood can’t handle that.

It’s such a tough call. I would recommend it to a young person. Trade or hold your way into having getting a couple hundred bucks and then get into a Vanguard.

I think the margin thing is the only place where people can get in trouble. I’m assuming they’ve had big margin calls on Robinhood before. I think about the amount of dumb things I’ve done investing, I can’t imagine how much bigger and dumber things I could have done on margin. It would have made my biggest mistakes worse. I could have gone bankrupt. But that could be what happens to Robinhood if all their customers go bankrupt.

That poor guy on Reddit, though…

I don’t know how they get it back but that’s how it works. The psychological incentive of paying for a monthly access to debt makes you want to use the debt. It’s like people shop on Amazon prime more because they paid their $99. That could be doing more harm to young investors than good.

Brendan Sullivan is a writer, producer, and author of the memoir Rivington Was Ours: Lady Gaga, the Lower East Side, and the Prime of Our Lives. Disclosure: he owns cryptocurrencies. Follow him on Twitter.

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