When Robinhood filed its S-1 to go public, it also revealed just how much better it is than its long-established competitors at making money from retail trading.

The company famously doesn't charge commissions. But it's also a powerful illustration of the maxim that if you're not paying for something, you're not the customer, you're the product. Robinhood is far better at selling that product than Schwab, E-Trade or Ameritrade, according to a new report by Alphacution Research Conservatory.

Robinhood's retail trading business, which relies on payment for order flow, is much more lucrative per dollar held in its users' accounts than its competitors. Payment for order flow, the system in which market makers pay brokers for sending them retail orders to execute, dates back to the 1990s, and Robinhood isn't the only one using it. It's just better at it, the data shows.

Brokers and market makers say these payments provide better prices for retail investors as well as fee-free trading, while critics say that brokers and market makers are grabbing the lion's share of benefit from these trades when they could be getting better pricing elsewhere. The sums in question are typically fractions of a penny a share, making it hard to see the harm — except when, as Robinhood has in filing to go public, the overall numbers become visible.

The online brokerage game has long been defined by gathering more and more assets under management. The accumulation of wealth provides more opportunities for charging fees and cross-selling products. Trading became an afterthought.

Robinhood changed that. Its assets under custody as of the end of March 2020 were $19.2 billion across 8.6 million users, according to its S-1. That's an average account value of $2,235, compared to an average account value of $97,214 for TD Ameritrade, $86,131 for E-Trade and $274,568 for Schwab. As an asset manager, Robinhood looks like a pipsqueak. (Alphacution looked at Q1 2020 because consolidation in the sector made later comparisons difficult: In October, Charles Schwab closed its acquisition of TD Ameritrade and Morgan Stanley completed its acquisition of E-Trade.)

The data shows how Robinhood makes much more from its users' trades than competitors do. Alphacution compared the firms' total order routing revenue, which includes payment for order flow, to its average account value. That calculation is a proxy for a broker's efficiency in extracting value from the accounts it holds.

For Robinhood, the ratio of its order routing revenue to average account value was 40,683, compared to 2,079 for TD Ameritrade, 891 for E-Trade, and 195 for Schwab, Alphacution found.

Robinhood's order routing bonanza has only increased since then. Robinhood generated $331 million in order routing revenue for equities and options in Q1 2021, up 263% from $91 million a year ago. And assets under custody for the quarter ending March 31 spiked to $80.9 billion across 17.7 million accounts, for an average account value of $4,572. Robinhood's order revenue to average account size ratio was 72,432, almost doubling in a year.

Inside the machine

So how can Robinhood make orders of magnitude more from each customer's dollar than its competitors?

The biggest reason, according to Alphacution: Robinhood's customers trade much more than those using other brokers. That's largely because of "the mobile-first, social media-infused design," said Paul Rowady, founder of Alphacution. Robinhood traders trade at one or sometimes even two orders of magnitude the velocity of other brokers, he added.

Robinhood's users often look to trade in and out of hot names — the GameStop phenomenon is the clearest example of that — and Robinhood's product supports that, Rowady said.

Robinhood declined to comment. In defending payment for order flow, it has said it "earned an average of $0.0023 per equity share traded in the fourth quarter of 2020. That's two-tenths of a penny for every share you buy or sell."

That disclosure may be accurate in the specifics, but it is misleadingly incomplete. Note the carefully parsed wording: "share," "buy" and "sell." It doesn't include what Robinhood makes off of options, which are much more profitable, and it doesn't break out which kinds of equity trades give the company the most profit. And Alphacution's data suggests Robinhood actually made about 0.5% of its customers assets in order routing revenue — nearly 2% annualized. That's nearly 30 times what TD and E-Trade made and more than 300 times what Schwab made.

Whether trading more actually generates better outcomes for investors is hotly debated. But it's clear that Robinhood's customers trade more and that Robinhood benefits from that.

And whether Robinhood is, as it claims, getting better prices for its traders than they could have without payment for order flow is another point of debate, since those figures aren't captured in the order routing revenue or asset numbers. Some experts argue that putting trades on exchanges would give better prices than Robinhood's price improvement. Price improvement, after all, is what's left after a market maker takes its profit on a trade and pays the broker its cut for order flow. In December, Robinhood paid $65 million to settle SEC charges that it had misled investors about such payments and trade prices, with the agency saying inferior trade pricing had cost investors $34.1 million.

The app effect

Retail investors can be influenced by brokers to make trades in certain investments, or brokers can attract investors likely to make such trades, which is another possible reason Robinhood is paid so well for its order flow, Rowady said.

"This young, green, new, highly impressionable demographic is susceptible to suggestion to trade options or thinly-traded names that are likely highly volatile," Rowady said. Those are often more profitable for market makers.

Options are rarely discussed in payment for order flow, but they represented 64.1% of Robinhood's order flow revenue in Q1 2020, Alphacution found. Options also generated far more revenue per dollar of assets under custody — 144.4 — than equities — 2.5 — in the quarter, according to Rowady's analysis.

"It takes very little money at the 'table of greater fools' to trade options on the Robinhood app," Rowady writes in his report.

In January 2020, Robinhood was No. 3 in options volume behind TD Ameritrade and E-Trade, but by December 2020, Robinhood had leapfrogged E-Trade, doing double the more established online broker's options trades, and was not far behind TD Ameritrade, according to Rowady.

Options are generally less liquid than equities and more volatile. As a result, spreads on options are generally higher than on equities, Rowady said. They're also more risky than trading regular equities because an investor has to time options trades to make money. That increases trading volume, which generates more revenue for Robinhood. The difference between Robinhood and Schwab in trading velocity is greatest for options, Rowady found.

Actual rates of payment for order flow played a smaller role than trading volume in giving Robinhood an edge. But Robinhood got paid more per trade, on average, from payment for order flow than most competitors in 2020, Rowady found in an analysis of SEC filings. For trades in S&P 500 stocks, which are generally more liquid, Robinhood made significantly more than competitors. But Robinhood is also near the top in average order flow pricing for non-S&P stocks — a favorite of meme stock buyers — and in options.

In market orders for S&P stocks in December 2020, Robinhood's payment per share was about 4 times Schwab's rate. In market orders for non-S&P stocks in December, Robinhood's payment was almost triple Schwab's. In options, Robinhood's payment per contract for market order options was almost double Schwab's payment in December 2020.

Why does Robinhood get paid more than other brokers? Robinhood and market makers don't talk about how they set these prices. Robinhood has said it gets a "fixed percentage of the bid-ask spread" and that it does not select market makers based on pricing since "[a]ll market makers we route to pay us at the same rate for equities, ETFs and options." But Rowady believes Robinhood's contracts with market makers pay Robinhood more when volatility is higher, whereas other brokers' agreements may not have such features. Market makers can make more money when volatility is higher.

Gary Gensler, the new SEC chair, has criticized payment for order flow, suggesting it poses an inherent conflict of interest. The Alphacution data highlights just how extreme Robinhood's conflicts might be compared to other brokers.

"All facets of [Robinhood's] business model are designed to maximize order routing revenue," Rowady said. "It's the most aggressive version of the retail brokerage (payment for order flow) model that facilitates this level of trading activity."