Robinhood is Nothing Like The Folklore

Issue 27

07.13.20 - Robinhood has been a frequent discussion as of late at Brookfield Brief since the tragic suicide of a 20-year student day trader this June after seeing a negative $730,000 account balance made in error.

The Silicon Valley company is now valued at over $8.6 Billion after raising another $320 Million, closing out its total Series F funding round at $600 Million. The financing round was led by Sequoia Capital, with participation from Ribbit Capital, NEA, 9Yards Capital, Unusual Ventures, TSG Consumer Partners and IVP.

For those of you who don’t know, Robinhood is an investment application that, in our opinion, has changed the dynamic of retail investing - a paradigm shift that the SEC has yet to adequately address.

Robinhood has issues. From its questionable business model, to its self-regulation of protecting its users from making dangerous investment decisions, the company allows amateur retail investors to trade options and use margin (make trades with credit). Two things, that I think most professional traders in good faith would advise retail investors not to play around with.

Robinhood is unique, because prior to Robinhood, online brokerages had complex clunky user interfaces and fees that were taken directly per individual trade. Robinhood built and investment App so easy a child could use it, and they do.

Robinhood also doesn’t collect fees per individual trade, at least a fee that isn’t apparent when you execute a trade. They make their money by selling order flow. This breaks down another barrier for retail investors to incentivize them to start trading.

Selling order flow - what does that mean? Well here is where it gets controversial, not illegal, but controversial: Robinhood is an intermediary. They aren’t a market maker on their own. Every trade or order that gets pushed through Robinhood in actuality is executed by a third party.

These third parties aren’t investment banks, and these trades aren’t being pushed through the NYSE or NASDAQ. They’re being made in what are called dark pools by high frequency trading firms - specifically Citadel and Two Sigma (just to name two). Securities law specifies brokers to give their clients best execution, the ambiguity of that regulation does not mean best price.

So, in short, Robinhood makes its money by taking massive fees for directing it’s 3 million+ users trades to high frequency traders where they aren’t getting the best price possible. Breaking down the nuances of high frequency trading and dark pools, is another article entirely.

Robinhood is profiting big off of the dumb money in a big way, and according to SEC filings, high frequency trading firms are paying Robinhood over 10X more in fees for their order flow as they are to other brokerages for the same volume. Hedge funds and market makers aren’t going to do that unless they are making more in trade execution than they’re paying back to Robinhood in fees.

Robinhood was fined $1.25M in 2019 by FINRA for pushing the limits of this regulatory gray area, an amount that’s not even worth calling a slap on the wrist. A fine that equates to less than 1% of the company’s 2018 revenue.

Unlike the folklore, Robinhood isn’t stealing from the rich to give to the poor. Robinhood is raking in massive fees from investment firms in exchange for letting them vacuum up fractions of each trade in massive volume so that Wall Street can further enrich themselves.

It is no longer shady, slick talking brokers in boiler room operations convincing unsuspecting elderly folks out of their pensions - it’s now tech bros behind MacBook’s sitting back and letting algorithms quietly do it for them.

Source: Brookfield Brief