JARED DILLIAN: Robinhood not really a friend of Average Joe

Robinhood Markets has been at the forefront of the democratisation of finance, which is the idea that an Average Joe can play in the stock market alongside the professionals. And back in January, they did, nuking a bunch of hedge funds betting against GameStop in one of the greatest short squeezes of all time. Hollywood is full of Average Joe underdog stories, but is it true in real life? Not, at least, in the markets, where retail trading of “meme stocks” is, on balance, just a massive transfer of wealth from the unsophisticated to the sophisticated.

At issue is the long-standing practice in the equity markets known as payment-for-order flow. Brokerages don’t actually execute orders to buy and sell stocks any more; they send them to market-making firms for execution in exchange for a small payment. This allows brokers to offer zero-commission trades. Market-making firms like this arrangement, especially when it involves orders for retail investors because they are typically wrong and are profitable to trade against. So market-makers will pay brokers for the privilege of receiving these orders, on the idea that even though they are small individually, in the aggregate they are profitable. Robinhood earned about 75% of its $958.8m in revenue from payment-for-order flow in 2020.

An outsider might view this practice, which has been going on for a few decades, as a conflict of interest. The broker isn’t guaranteeing that its customers will get the best price on a trade, but instead is sending orders to the market-making firm that pays it the most, where execution quality may not be the best. The real issue is about how Robinhood’s messaging about democratisation is inconsistent with its execution practices. Also, under the current arrangement, the costs of trading are hidden. With zero commissions, the client of the brokerage firm does not pay commissions directly, but does so indirectly through payment for order-flow arrangements. New US Securities and Exchange Commission chair Gary Gensler has identified payment-for-order flow as a potential conflict.

To be fair, besides a few insiders, no-one really knows how market-makers operate any more. In the old days when stocks were quoted in fractions, it was as simple as creating a bid-offer spread on a stock, and buying on the bid and selling on the offer. Then 2002 brought decimalisation, and things got a bit tougher. The mathematics behind market-making today is incredibly sophisticated, and I imagine it takes into account correlations with different stocks and sectors, and I suspect that quants have programmed the algorithms to take into account the information value of a trade and whether the trade is likely to be right or wrong in the short term. (Some of my newsletter subscribers are employed by market-makers.)

That’s even before taking into account the explosion in options trading, from 2-million contracts a day across exchanges 20 years ago to tens of millions of contracts today. Some of the meme stocks have experienced wild options trading, with options prices warping and deforming in ways that had never been seen before. Of course, this happened with Robinhood’s own stock — as soon as the options were listed, retail traders scooped up short-term call options, sending the stock higher. It just so happens that many of the quants who started their careers in complex, exotic options are moving to listed options to try to mathematically model the volatility under the explosion of retail options trading.

The optics of this business are terrible. The Average Joe opens an account at Robinhood, deposits $250, buys one options contract that is swallowed up by some computer leviathan programmed by some of the smartest mathematicians in the world. I can tell you who is winning here, and it is not the Average Joe. I’m not saying that Robinhood’s order flow should be routed to dumb market-makers; I’m saying that their populist appeal is slightly misplaced.

This shouldn’t be interpreted as an attack on the business of market-making. It’s grown much more efficient and sophisticated over the years, which translates into billions of dollars of savings for retail investors in terms of execution quality. The increased mathematical sophistication allows market-making firms to maintain tight bid-offer spreads in stocks undergoing an explosion in volatility. I haven’t seen any comprehensive surveys of retail investor losses in meme stocks, but we can see the profits of the market-making firms, and they are enormous. Bloomberg Intelligence said in May that order-flow payments from wholesalers jumped 39% in the first quarter to $1.16bn from the final three months of 2020, and it expects the total for the year to rise 61% to $4.6bn.  

I’m not against payment for order-flow arrangements in principle. The arrangements evolved out of natural market forces and it is hard to make the argument that investors are being harmed in terms of execution speed or price. The problem is that costs are not explicit, and since online trading is perceived to be free, it causes retail investors to overconsume the product — in this case, trading.

If execution costs were made explicit, and investors were able to see the cost of their executions, they might be incentivised to trade less frequently, which would probably result in better returns. But the more investors trade, the more money Robinhood makes. This isn’t really what democratising investing is all about.

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