Robinhood makes hundreds of millions from selling customer orders. That business model is about to come into focus.


A major portion of Robinhood's business model that relies on handling a high volume of trading is once again getting attention, and it comes at a critical junction for the fintech, which had reportedly been hoping to go public as soon as this quarter.

Robinhood made its name by offering users free stock and options trading. Instead of generating revenue from trading commissions, as brokerages had done in the past, Robinhood led the charge in making money from what's called payment for order flow (PFOF). Robinhood sells its customers' buy and sell orders directly to market-making firms, such as Citadel Securities, Virtu, and Two Sigma, as opposed to going to a trading venue. 

While the practice is common amongst brokerages across the industry, and a key piece of their ability to offer commission-free trading, Robinhood has relied on it more heavily than others. 

The attention the startup has received as a result of the Reddit-fueled GameStop trading frenzy of recent days is bringing the practice back into the spotlight.

In a series of tweets on Sunday, high-profile VC investor Bill Gurley called on the US Securities and Exchange Commission to ban PFOF, describing it as the key issue in the so-called plumbing of the financial markets.

Many say $GME/RH situation is a "problem in the plumbing," implicating the structural integrity/complexity of our financial systems. If the SEC/government wants to "fix the plumbing" the number one thing they should do is ban Payment for Order Flow. [more] https://t.co/lyNAypAHME

— Bill Gurley (@bgurley) January 31, 2021

Outspoken tech investor Chamath Palihapitiya alluded to issues with PFOF in a tweet on Thursday, in which he said Robinhood is no different from Facebook, a company he previously worked at.

"They both trick you into thinking you are the customer. But, in fact, you are the product and your data is the asset," he tweeted. "These assets are then sold to their true customers who pay them money and always at your expense."

In the fourth quarter of 2020, Robinhood received more than $221 million in PFOF for equities and options flow, according to data collected by Piper Sandler from regulatory filings. The amount was larger than competitors E-Trade ($107 million) and Charles Schwab ($63 million), trailing only TD Ameritrade ($322 million), which sold more than twice as much volume to market makers. 

While larger brokerages have the benefit of scale and a more diversified business that includes other investing and wealth management offerings that drive revenue, Robinhood was largely built, and remains, a brokerage focused on free trading. 

If regulators were to go as far as put restrictions — or outright ban PFOF — Robinhood's business model would be challenged, according to industry watchers.

"If you remove payment for order flow, there is a possibility that then the brokers can't provide the zero commission. Especially a guy like Robinhood I don't think can," said Richard Repetto, managing director of equity research at Piper Sandler, told Insider. "That would be the issue. Is there enough for the brokers to live on?"

A Robinhood spokesperson did not return a request for comment in time for publication.

A key part of Robinhood's business model has always been PFOF

It wasn't until a report from Bloomberg in October 2018 that stated more than 40% of Robinhood's revenue came from PFOF that the startup acknowledged it received payment for client orders. 

Twice Robinhood has been been fined by regulators tied to issues around disclosures of the practice. In December 2019, the Financial Industry Regulatory Authority (FINRA) hit Robinhood with a $1.25 million fine over best execution violations.

That was followed in December 2020 by Robinhood paying $65 million to settle charges from the Securities and Exchange Commission (SEC) for an investigation between 2015 and late 2018. The SEC alleged Robinhood had "misleading statements and omissions" about PFOF, and determined customers missed out on $34.1 million as a result of poorer execution qualities due to the practice, in a release announcing the charges.

Robinhood has garnered a higher price for its flow than other brokerages.

Brokers are generally required to set a standard fee for flow with all market makers to avoid incentives to shop around customer orders for the best price. Brokerages have a legal obligation to route to the market makers that can provide the best execution quality.

While most brokers charge a flat rate per share, Robinhood has a unique approach. 

The fintech charges a fixed percentage of the spread between the national best bid and offer of the security at the time of execution. In short, the wider a spread, the more money Robinhood makes. 

The result is Robinhood's order flow generating more revenue than its competitors. In the fourth quarter of 2020, Robinhood was paid $0.0039 per share, higher than TD Ameritrade ($0.0026), E-Trade ($0.0026), and Charles Schwab ($0.0019).

"Robinhood's been very efficient at it," said Repetto of the firms ability to maximize the revenue it receives from PFOF.

Robinhood also generates revenue from its premium subscription service, securities lending, and interchange fees from its cash management offering, among other things. 

PFOF has remained a hot topic in the industry

While payment for order flow has existed for decades, questions around the merits of PFOF are likely to once again get pushed into the national spotlight.

The topic cropped up again in the fall of 2019 after traditional brokerages announced their shift to commission-free trading, a move that was largely forced by the success of Robinhood. 

Brett Redfearn, the then-director of the SEC's trading and markets division, said that while it's always good to see competition bring down prices, "there is still a best execution obligation to customer order," while speaking at a conference in October 2019.

Execution quality of trades sits at the core of the debate around PFOF.

Market makers have long said that by executing orders through them, as opposed to a brokerage going directly to the market, is actually better for retail investors. 

"Citadel Securities has been a driving force in reducing the costs of trading for retail investors. Last year alone, we provided $1.3 billion dollars of price improvement that went directly into the pockets of retail investors," a spokesperson for the market maker said. 

Others, however, say that investors would be better off trading with the wider market.

Alexander Gerko, founder and CEO of London-based algorithmic trading firm XTX Markets, said in a LinkedIn post on Friday that PFOF is "horrible."

"The way to get actual price improvement is to put retail flow on exchange where multiple trading firms and institutional investors and other retail orders would compete for it," he wrote

As a result, some markets have banned the practice. Such is the case in the UK and Canada, where PFOF arrangements are not permitted.

In 2016, the CFA Institute, a not-for-profit that handles the exam for chartered financial analysts (CFAs) — published a report examining the impact of PFOF in the UK, which banned it in 2012. The report found that from 2010 to 2014 the percentage of retail-sized trades that were executed at the best quoted price jumped from 65% to 90%. 

In January 2021, former US senator Carl Levin, a Michigan Democrat, wrote an op-ed in the Financial Times calling on the incoming administration to ban PFOF. In the op-ed, Levin called PFOF a "conflicted practice that siphons billions out of US investors' funds each year."

"Millions of American families and businesses are still paying the price for their brokers' conflicts of interest," Levin wrote.

As Robinhood gets more attention, its business model will come into focus

Now, in the wake of the recent trading frenzy, Robinhood is likely to take center stage.

Rep. Alexandria Ocasio-Cortez of New York has already said in a tweet it was "unacceptable" the startup halted trading on GME. Sen. Ted Cruz voiced his support, tweeting "Fully agree."

Meanwhile, Rep. Jeff Duncan is leading a bipartisan group of lawmakers calling on the SEC to investigate Robinhood and other financial firms for "their unprecedented and harmful actions against individual investors," the South Carolina republican tweeted Thursday

Other politicians who have called for the SEC to look into the trading saga include Sen. Elizabeth Warren and Senate Majority Leader Chuck Schumer.

Robinhood CEO and cofounder Vlad Tenev will reportedly testify before a House committee on February 18 about the recent trading frenzy and the startup's involvement in it, according to Politico.

To be sure, there's no guarantee lawmakers will push the issue. And Gary Gensler, who is President Joseph Biden's pick to serve as chair of the Securities and Exchange Commission and previously led the Commodity Futures Trading Commission, has given no indication PFOF is a topic he plans on targeting.  

And if the time comes for Robinhood to defend it's business model to regulators, it'll be well prepared with a staff that includes SEC veterans and former Goldman Sachs in-house counsel.

But even if regulators don't push the issue, PFOF will come up when the company attempts to go public, which it reportedly is preparing to do this year.

All companies planning to go public are required to disclose in greater detail their business model and major risks posed to it. PFOF would likely be a major focus of any regulatory filing from Robinhood. 

Still, investors seem sanguine. Robinhood has raised $3.4 billion from previous investors in less than a week, signaling confidence in the company. And Repetto said the startup can still pivot away from PFOF if it has to. Much in the same way Amazon started off selling books and then broadened its focus, so too can Robinhood.

"I think they are thinking, there's gonna be other ways to make revenue since you've got all these customers," Repetto said. "You've got the eyeballs and control of them just like Amazon built out the model well beyond just books."