Protocol | Fintech

Payment for order flow made Robinhood huge. Now everyone's arguing about it.

Market makers have been paying brokers rebates since the '90s. But the meme-stock controversy has made them freshly controversial.

Payment for order flow made Robinhood huge. Now everyone's arguing about it.
Image: CSA Images/Getty Images

Payment for order flow is the business model underlying the rapid growth of retail investing in recent years — as well as the meme-stock trading frenzy.

When Robinhood first proposed offering free stock trades eight years ago, getting paid for directing its volume of trades to market makers was just one of several notions co-founders Vlad Tenev and Baiju Bhatt threw out as ways their startup could make money.

As the app took off and rival startups mimicked it, payment for order flow — a rebate market makers pay brokers for executing a buy or sell order — looked more and more attractive. Traditional retail brokers like Schwab and TD Ameritrade moved to match the upstarts' zero-commission trading, and many also took up the payments to compensate for the lost commissions.

With Robinhood poised to go public, customers, competitors and regulators will get a better look at the business model through the startup's financials. Those revelations will likely accelerate the debate, not end it.

Companies that accept payment for order flow say it provides better prices for investors and has opened up new markets. But some consumer advocates and competitors criticize payment for order flow, arguing that it presents an inherent conflict of interest. (It's hardly encouraging when traders learn that the late Ponzi schemer Bernie Madoff was the pioneer of payment for order flow in the 1990s.)

In March, Robinhood rival Public.com loudly dropped payment for order flow, saying it wasn't in its customers' best interests. It now solicits tips from customers instead.

At a Congressional hearing in February on the runaway trading in GameStop, several members of Congress focused on payment for order flow, blaming it for some of the current market problems.

But it seems unlikely that any legislative or regulatory action on payment for order flow will come out of Washington in the current political season, said Bradley Tusk, founder of Tusk Ventures. "We could see more happen around disclosure," he said.

For now, brokerages will continue to determine whether payment for order flow or other business models such as subscriptions or trading fees win out. Some, like Public, may make their stance a key part of their pitch to new customers.

The argument for selling orders

Supporters of payment for order flow say all parties can win.

Here's how it works: A broker sends a commission-free retail trade to a wholesaler or market maker. It does this instead of sending trades to the traditional stock exchanges because market makers say they can provide better prices.

The market maker then matches buyers and sellers — or more often, buys or sells the shares itself in order to later buy or sell them to match orders.

Market makers say they can outperform the official National Best Bid and Offer. The SEC requires brokers to get NBBO prices on trades of 100 shares or more, but the NBBO only reflects prices for certain trades on major exchanges, which leaves room for improvement.

Å portion of the better price is passed back to the customer in the form of what's called price improvement, after the market maker takes its profit on the spread between the buy and sell prices. And some of that profit goes to the broker as a rebate for steering the order its way. That's the payment for order flow.

A conflict of interest?

Where things get complicated is exactly how the benefits of price improvement get divvied up: There's no real regulation of that split. A broker might well seek out a market maker that promises higher payment for an order and delivers less price improvement. As long as the market maker and broker are offering the retail investor NBBO pricing, it's within the bounds of current regulations.

As a result, payment for order flow is a conflict between the broker's best execution duty to customers and its obligation to shareholders for maximizing its own profits, said Better Markets, an advocacy group.

Brokers can negotiate a larger share of the cut of price improvement that market makers send back to customers, said Public COO Stephen Sikes, or they can select certain market makers that offer brokers better terms.

More generally, the business model incentivizes more active trading, which isn't necessarily good for investors, Sikes said.

Robinhood said market makers give better prices than exchanges, and that it earns a "fixed percentage of the bid-ask spread" — the same rate — across all its market makers, so it has no incentive to route orders to a specific market maker and thus, it argues, no conflict.

But it hasn't said exactly what it pays. And that seems to be a crucial question in figuring out the actual financial gain retail investors capture from payment for order flow — once you leave aside the obvious benefit of not paying trading commissions.

Some answers emerged in December when Robinhood reached a settlement with the SEC over charges it had misled investors about its payment for order flow. The SEC found that Robinhood had negotiated a payment rate that was "substantially higher" than what trading firms typically paid broker-dealers: Only a fifth of the payment would go to the customer in the form of price improvement, with four-fifths going to Robinhood. The SEC said another market maker sent 80% of the payment to the customer through improved pricing and 20% to the broker-dealer routing the order.

Robinhood paid a $65 million civil penalty to the SEC for not telling its customers over a number of years that it was using payment for order flow and for not giving best execution on orders. But the provisions of the settlement didn't address the cut Robinhood took.

Robinhood earned an average of $0.0023 per equity share traded in the fourth quarter of 2020. It's not clear how much that might have changed if it took a smaller cut. Robinhood declined to discuss its current rate.

"The settlement relates to historical practices that do not reflect Robinhood today. We recognize the responsibility that comes with having helped millions of investors make their first investments, and we're committed to continuing to evolve Robinhood as we grow to meet our customers' needs," said Dan Gallagher, chief legal officer at Robinhood, in a statement.

Room for improvement

One of the biggest benefits of payment for order flow for retail investors is price improvement, many brokers say. Without it, liquidity for trades would decrease and spreads would increase, which could mean worse pricing for retail investors, said Bob Cortright, CEO at DriveWealth, which provides trading software for fintech.

Investors saved $3.7 billion from price improvement last year, according to Bloomberg Intelligence.

But in the U.K., which effectively banned payment for order flow in 2012, the proportion of retail trades executed at "best quoted prices" have increased from 65% to 90% from 2010 to 2014, according to a study by Sviatoslav Rosov and the CFA Institute.

The question is whether retail investors save more from the elimination of trading fees than they might lose in price improvement. Cortright believes they're getting the best of both worlds now — no commissions and better prices via market makers.

Robinhood said 94.5% of orders are filled at NBBO prices or better, while Schwab said 98.8% of S&P 500 stock orders between 100 and 499 shares are filled at better than NBBO prices.

The NBBO rule only applies for trades of 100 shares or more — so-called "odd lots" of less than 100 shares are not reported on most public data feeds and not included in NBBO. That means many retail trades — many of which are odd lots — may not get the best price through payment for order flow, Sikes added.

Price improvement at Robinhood was not as good as at other brokers, Better Markets pointed out, citing the SEC order. The SEC wrote in December: "Robinhood's execution quality and price improvement metrics were substantially worse than other retail broker-dealers' in many respects, and senior Robinhood personnel were aware of this analysis."

Robinhood said it had "significantly improved our best execution processes."

Transparency in question

Some have speculated that market makers somehow use the orders they pay for to front-run retail investors. Experts doubt that's actually happening. For one, it's illegal. It would also be hard to carry off such a scheme, since market makers generally give better prices than the public market prices. And it's not clear it would work: Retail investors generally are less well-informed than institutional investors, so trading on the knowledge of their moves would bring little benefit.

The lack of disclosure of payment for order flow arrangements still casts a pall over the business. Market makers do have other businesses where they could in theory benefit from this order flow, Sikes said: It's unclear how or if retail customers are hurt by this, but no one knows how the data is being used.

It's clear that payment for order flow has turbocharged Robinhood's growth, and left others racing to imitate it. Tenev said in February that more than half of Robinhood's revenue comes from payment for order flow. Robinhood made more than $600 million from it last year, and $200 million in the fourth quarter of 2020 alone.

But is payment for order flow the only viable alternative business model to commission-free trading? Without payment for order flow, brokers would still send trades to market makers, but without a split of the spread, they'd have to charge retail investors somehow, some argue. Public has adopted a system of voluntary tipping, but Sikes said that's not his company's only possible business model: It could charge for data, content or other features.

Traditional brokers such as Schwab also benefit from payment for order flow, but make more money with other products such as banking, ETFs and advisory services. Schwab made 25.8% of its revenue from trading — of which payment for order flow is only a portion — in its most recent quarter.

Fidelity is the one major U.S. retail brokerage that doesn't use payment for order flow for equities, though it still takes payment for options orders. Fidelity and Schwab have publicly sparred over the issue.

Even with payment for order flow, Robinhood, like Schwab and others, will likely also eventually offer other financial products or seek other means to generate revenue.

Still, even if strict, U.K.-style regulation isn't forthcoming, you're likely to keep hearing about payment for order flow. Brokers are in fierce competition for new customers. With some brokers, like Public and Fidelity, making it a part of their marketing pitch, the conversation in the marketplace may be shifting from eliminating trading commissions to a focus on execution quality. If that message resonates with customers, they'll vote with their portfolios.

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