Following the trading restrictions of my broker in the context of the stock market chaos caused by the Reddit chats, I was interested in the main American broker involved and offering supposedly free trades: Robinhood.
Upon accessing their site, I immediately received the following message “Sorry! We’re not currently able to accept applications from outside the United States. The question of using their services from Europe or Switzerland is therefore not practical at the moment. However, it is interesting to look at Robinhood’s business model.
Robinhood is a company founded in Silicon Valley in 2013, and has more similarities to Facebook than to Wells Fargo. The app is meant to be very intuitive and fun, and appears to be free as no commissions on securities transactions are charged. Despite its free trading app, however, Robinhood generated nearly $700 million in revenue in 2020. The source of these funds immediately provides insight into Robinhood’s business model: Its revenue sources are Citadel Securities, a leader in high-frequency trading (a controversial stock market phenomenon that will be the subject of a future article), as well as Wolverine Securities, Virtu Financial, Two Sigma Securities and Morgan Stanley. Robinhood provides them with information for a fee about private investors’ orders to trade options contracts and company stocks.
The first business of Robinhood’s founders, Vladimir Tenev and Baiju Bhatt, was dedicated to high frequency trading. Among the clients buying this information are companies with which the founders had already done business in the past.
The success of Robinhood is simple: It is hidden commissions under the guise of free services to investors. The company sells client orders to market makers (who actually use them for profit) and financial service providers. Unlike the medieval hero, Robin Hood, Robinhood takes information from the poor retail investor, before the trade is made, and sells it to powerful hedge funds, who profit from the information. The SEC recently fined Robinhood $65 million for this lack of transparency, but its practices remain unchanged.
As J. Bogle said, a service provider cannot serve two masters, and Robin Hood is in just that situation. Retail customers receive a free service, but their information is used to serve its other, more profitable customers, who are the buyers of that information. In conclusion, a good retail investor should avoid any broker that is linked to high frequency trading partners. As a matter of principle, an order should be executed at the best price and not monetized to third parties for profit, however small. As in other segments of the digital economy, free services are not always beneficial to their direct users.
It is therefore recommended to fully understand the business model of a financial service provider before engaging with them.