Payment for Order Flow: How Robinhood Makes Money

The House Financial Services Committee will hold a hearing on the GameStop saga this Thursday. Reddit CEO Steve Huffman, Robinhood co-CEO Vlad Tenev, and Keith Gill (aka Roaring Kitty) are all expected to testify at “Game Stopped? Who Wins and Loses When Short Sellers, Social Media, and Retail Investors Collide.” Given the commentary leading up to this hearing, and its rather dramatic name, I’m sure the committee will try to paint RobinHood as the bad actor here that ‘stopped’ trading of GME just as the Reddit traders were putting the “short squeeze” on the hedge funds. As I wrote previously, RobinHood had to stop trading due to their Clearing House limiting their risk exposure. RobinHood’s failures are related to their poor communication and lack of operational preparedness but was not a conspiracy against the little guy. The Reddit mob are not blameless “little guys” in their actions either, and the SEC is taking a look at their activity.

As predicted, GME stock has come crashing back to earth. It is down from its near $500 frenzy peak to about $50 a share which means A) the ‘squeeze’ did not work in the long run and B) many folks certainly lost a lot of money. I wonder if congress will worry about all those “little guys” that got in at $200 to $300 a share only to end up losing most of their money while folks like Mark Cuban gave them the very misguided advice to hold on.

How does Robinhood make money? The true cost behind “Free”

One question that is sure to get scrutiny at the hearings is “how does the ‘free’ Robinhood App make its money?” In the wake of the recent events, many people were surprised and some were outraged to learn that Robinhood is selling their order data to industry market makers.

People accuse Robinhood of being a scheme created to make money for market makers so that they could all front-run the market. As usual lately, with this entire saga, these initial reactions are only partially informed and can lead to wildly inaccurate and dangerous accusations.

To understand what is really going on, we need to be familiar with several “inside baseball” financial market terms including:

That’s a mouthful of terms, but I’ll touch on the basics of each of these below as we go along, and you can follow the links for more in-depth explanations of each.

What is Payment For Order Flow?

When someone puts in an order to buy or sell a stock on Robinhood, that order (along with all the other retail orders from all the other Robinhood users) is sold to a market maker. The market maker pays Robinhood in the form of a rebate for those orders. This is called Payment for Order Flow (PFOF), and just about all the major online retail brokers (eTrade, Schwabb, Ameritrade) do it.

On a per order basis, the payment for orders from the market maker to the brokerage is a tiny fraction of a penny on a per order basis; from Robinhood’s own disclosure documents in 2019, it is $.00026 per dollar of executed trade value. Those tiny per dollar amounts add up over time however due to the high volume of transactions. In Q2 of 2020 for example, they totaled over $180 million dollars.

Robinhood doesn't try to hide the fact that they make money from market makers. If you Google ‘How does Robinhood make money,’ one of the first results is this article from Robinhood’s very own website which lists market maker rebates at the top. While the app itself is ‘free’, Robinhood is making a lot of money from PFOF and it doubled its PFOF revenue over the previous quarter with a good chunk coming from options trading.

Why sell orders to market makers, and what do the market makers do with all those orders?

It is true that Robinhood sells their orders to market makers. This however is a common practice in the industry. The next big question is why sell to market makers, and what do the market makers do with all those orders?

While certainly controversial, payment for order flow is legal, and is not necessarily a bad thing, as it provides liquidity. Liquidity is just a way of expressing how much activity is in any given market, and in practical terms, it translates to how quickly and likely your order is to be matched. For example, if you want to sell 100 shares of Disney’s stock at $190 per share, on a platform with a lot of liquidity, it is very likely you will be matched quickly and very near your selling offer price. If you were on a platform with low liquidity, then it's likely your offer would sit there for a while, and time is the enemy here. If you don't get filled quickly, your stock may go down in value which ultimately costs you money. So the market makers taking this order flow from Robinhood provide liquidity to Robinhood traders helping them to get their orders filled on a timely basis near their order prices.

Who are the Market Makers and what's in it for them?

Market Makers are typically Banks, hedge funds, and other and major institutions. In this case, one of the primary Market Makers in the Robinhood scandal is Citadel. Market makers make a market for a given stock by providing a ‘bid’ and ‘offer. The bid (or buy) is slightly less than the actual market buy price, while the offer (sell) is actually more than the market sell price. These slight differences are called the spread and this is how a market maker makes money.

From Investopedia:

Market makers charge a spread on the buy and sell price, and transact on both sides of the market. Market makers establish quotes for the bid and ask prices, or buy and sell prices. Investors who want to sell a security would get the bid price, which would be slightly lower than the actual price. If an investor wanted to buy a security, they would get charged the ask price, which is set slightly higher than the market price. The spreads between the price investors receive and the market prices are the profits for the market makers.

So let's take an example using ABNB stock. Let's say the market price for ABNB is 200 and 200.05. So the actual market price has a spread of 5 cents. Citadel could make the market at 199.99 and 200.06. You can see that in this case, the bid is 1 cent less than the market and the offer is 1 cent more than the market. Citadel will buy at 199.99 and sell at 200.06 and they will make 1 cent on every buy and sell. Do this enough times (millions of times a day), and it adds up to serious cash.

This might sound like good and easy free money, but the market maker is providing a service here and is also taking on some risk if it can’t find a buyer or seller for the other side of the deal.

Here is another example from this excellent article describing the role of market makers:

When an entity is willing to buy or sell shares at any time, it adds a lot of risk to that institution's operations. For example, a market maker could buy your shares of common stock in IBM just before IBM's stock price begins to fall. The market maker could fail to find a willing buyer and, therefore, they would take a loss. That's why market makers want compensation for creating markets. They earn their compensation by maintaining a spread on each stock they cover.

For example, consider a hypothetical trade of IBM shares. A market maker may be willing to purchase your shares of IBM from you for $100 each—this is the bid price. The market maker may then decide to impose a $0.05 spread and sell them at $100.05—this is the ask price. The difference between the ask and bid price is only $0.05, but the average daily trading volume for IBM is more than 6 million shares. If a single market maker covered all those trades and made $0.05 off each one, they'd earn more than $300,000 every day.

You can see here that the market maker is providing a service to the retail trader by providing liquidity, and it's also taking on some risk in the process. For both of those things, it is getting paid by making money on the spread.

Pennies from Heaven

I want to pause here and make a point. We saw earlier how Robinhood gets paid fractions of a penny via rebates for order flow it sends to market makers, and now we are seeing how market makers make money pennies at a time. This is important to understanding today’s markets. Market makers are making money by making these small micro profits that translate to pennies at a time, but they are doing it tens of thousands of times a day. It's important to understand this concept, because when you realize how the ‘big boys’ make money, you also realize how you as an individual long-term buy and hold investor is not going to get scammed. You see if you buy IBM or ABNB or any stock for 100.00 a share and someone else got it for 99.95 as a market maker, this won't matter a hill of beans to you 15 years from now when you sell ABNB for $2,000 a share to pay for your house, kids college, retirement, etc. I’ll get into that further when I cover algorithmic trading in coming weeks.

NBBO and Odd Lots

By law, the SEC requires that brokers like Robinhood, eTrade, and others guarantee their customers the best available bid and ask prices in the market. The best available prices are collectively known as the National Best Bid and Offer (NBBO). NBBO is the best available (lowest) ask price and best available (highest) bid price available to customers from multiple exchanges. NBBO is put together in what is known as the “consolidated tape by the NYSE”. This requirement to fill orders at the NBBO is also a requirement for the market makers. Once order flow is moved to a market maker, it is the responsibility of the market maker to get the best price for those orders. This regulatory requirement is also known as ‘best execution.'

You are probably wondering if market makers must fill the orders at the NBBO, then how are they able to make money on the spread. The catch is that the SEC’s “best execution” requirement only applies to “standard” lot sizes or orders in increments of 100 shares. Anything below 100 shares is considered an “odd lot”. Odd lots are not tied to the NBBO fill requirement, and are thus susceptible to the spread fill.

So if someone wants to buy 100 shares of ABNB - the current price is $212.68 - then they will be covered by the NBBO requirement. However, 100 shares of ABNB is $21,268. Not a small trade. A beginner trader on Robinhood might want to only purchase 5 shares or $1,060 worth. That trader would not be covered by the best execution law and thus a market maker could fill that order at different prices and make money on the spread.

On Robinhood’s own website they say that 93% of orders are executed at NBBO or better. They go on to say:

Most orders placed on Robinhood are executed at the nationally published quote—also known as at NBBO, or better. This means the vast majority of our customers are receiving, at a minimum, the best available bid or ask price.

When you consider that Robinhood is a relatively new app that attracted many new traders with free trading and a beginner friendly design, then it stands to reason that many of these trades will be small - ie odd lots and so a good deal of them will fall below the NBBO best execution requirements making it an overall attractive place to be for market makers looking to make money on the spread.

Here is an excellent article that covers just this point: Odd lots on the rise; could cost you more.

The Bottom Line

What does all of this mean to the average person trying to invest and make money for their future goals? What is the cost of your orders being sold to market makers, and what is the extra cost to you if you end up falling outside of the best execution price? Let's take an example. Say you want to buy 50 shares of Netflix stock and for simplicity, we will say the best sale price is $100 per share. You place your order on Robinhood or some other online broker, and your order gets sold to a market maker, and because it's an odd lot (under 100 shares), it does not get the best execution preference and you actually get it at $100.02. The extra 2 cents goes to the market maker as payment for them making the market. Like a good investor, not a casino gambler, you hold these shares for 10 years. In 10 years those shares are now worth $1,000 a share, and you decide to sell. Again since it's an odd lot, you don't get the best price, but instead, sell for $999.98 - a two-cent spread penalty that again goes to the market maker. Your total gain on this deal is $44,998. If you would have bought and sold at the best execution prices your gain would have been $45,000. So you lost (really paid) $2 for the benefit of that $44,998 gain. Not bad considering if you did this trade on Robinhood, it was free of a trading commission. Consider that not very long ago, just the commission on these transactions to make the trade would be $20 to $45+ on average for each buy and sell.

The bottom line to all of this is that If you are a buy and hold investor, you are fine. The costs of these market makers are really negligible in the long run. If you are trying to game the market on speed or day trade, etc, then you are up against a very high-powered and sophisticated arsenal of institutions and likely won't win very often. The former can be as rewarding as it always has been. The latter is a high-stakes gamble so be ready to lose everything - just please don't claim the markets are rigged.

Is Robinhood really just a good guy playing by conventional rules?

While PFOF is common, and market makers are providing a service via liquidity, Robinhood does get higher rebate revenue than the other brokerages. Since the market makers are paying for the spread difference, this could be due to the fact that Robinhood order flow has a larger spread which is probably due to the lack of experience and sophistication of the average Robinhood traders. This is particularly true on options trades where Robinhood is making the bulk of its PFOF payments.

It is also true that the SEC did investigate Robinhood’s activity between 2015 and 2018, and fined them for NOT getting their traders the best prices during that time period. So there is a history of some sketchy activity. While this does not mean that what is happening now is illegal, recent events of course are bringing those past transgressions into greater focus.

If you use Robinhood, and all of this still makes you uncomfortable about their services, consider switching to one of these many good alternatives.

As I have said before, I’m not defending Robinhood, Citadel, or any other players in the financial markets. What I do want to do is inform people on how the financial markets actually work and squash the populist notion that the markets are rigged. There are good and bad actors in all areas. There are certainly some unscrupulous market makers out there, but just like short-sellers, market makers generally provide a valuable service to the overall health and function of the markets.

I’ll be writing more about this topic and others related to financial markets, technology, and entrepreneurship. I plan to cover high speed algorithmic trading next.

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Payment for Order Flow: How Robinhood sustains its ‘free’ trading app