Online brokerage Robinhood Markets (HOOD 1.57%) has seen no shortage of headlines and controversy since it burst onto the scene back in 2015, offering retail investors the ability to make trades with no commissions and a sleek, easy-to-use trading platform.
Now, the company is in the spotlight again, and this time it seems to be the target of new rules proposed by the Securities and Exchange Commission (SEC) that would significantly limit one of the main ways the company makes money. Here's what investors need to know.
Payment for order flow being targeted
The reason Robinhood is able to offer free trades to retail investors is because of payment for order flow, which is a key part of the online broker's business model, as well as others in the space that offer zero-commission trading.
Robinhood is a popular retail brokerage with 11.4 million monthly active users. The company is able to source a lot of stock orders, but doesn't actually execute those trades on its own. Instead, it sells those orders to market makers such as Citadel Securities, which pays Robinhood a fee for directing the order flow their way.
Image source: Getty Images.
Companies like Citadel make money by then selling the orders they get from brokerages like Robinhood to other investors, ideally at a profit. This is called the bid-ask spread and it may only be for a couple of pennies per share at a time.
But keep in mind that Citadel is doing this through high-frequency trading and in huge volumes; the more volume, the more profits. Market makers can get higher bid-ask spreads on options orders, so these are more profitable for players like Robinhood and Citadel. But critics would argue that this very arrangement also incentivizes these firms to encourage retail investors to trade more often and make riskier options bets even though it may not be in the customers' best interest.
The big change the SEC is proposing is that instead of order flow being sent to a single wholesaler of choice, orders would be sent to auctions where the market maker offering the best price for a trade (highest for sell orders and lowest for buy orders) would win the bid. Now, online brokers already must perform "reasonable diligence" on behalf of their customers to make sure they are getting the best deal, but SEC Chair Gary Gensler believes payment for order flow creates a conflict of interest. Auctions would likely hurt the bid-ask spreads of market makers.
The SEC believes that more competition for order flow could help retail investors save an additional $1.5 billion per year by getting better prices on their orders.
How this would impact Robinhood
The SEC proposal does not outright prohibit payment for order flow, but it could reduce demand for order flow if market makers determine that they can't make enough money to justify the business. Robinhood would not want to be in a situation where it couldn't fill orders.
Another SEC proposal would essentially codify brokers' responsibility to get its customers the best possible price on trades and require them to search far and wide before selling order flow to one party. I suspect these requirements would be a drag on operating expenses.
In 2022, transaction-based revenue, which includes payment for order flow revenue, made up about 60% of Robinhood's total revenue, which is actually down from 77% in 2021. Robinhood has made efforts to diversify its revenue and did get a lift from higher interest rates this year, although the loss of payment for order flow would undeniably be a big hit to the company. The bulk of transaction-based revenue also comes from options orders.
Will the rules be adopted?
Robinhood's deputy general counsel Lucas Moskowitz told The Wall Street Journal in a recent interview that he could see the SEC taking a step back because these rules proposals came from a review that went into place right after the meme-stock frenzy involving GameStop.
"I've never seen a rule-making effort of this size and complexity and interconnectedness being done all at the same time, this quickly, with so little advance study and discussion," Moskowitz said.
When asked about the matter on Robinhood's recent earnings call, CEO Vlad Tenev said he thinks "investors have it great right now" with commission-free brokerages like Robinhood, and he doesn't think the SEC's proposed rules will pass in their current form, adding that they will take a long time to work through.
The loss of payment for order flow is certainly a big risk to Robinhood's business model, but the situation reminds me of the early days of ride-sharing. The cat is already out of the bag and people clearly like commission-free trading, so I find the SEC unlikely to pass rules that would end the practice.
