Why Robinhood’s Payment for Order Flow System Is an Issue for Users

Scott Galloway is a bestselling writer and professor of selling at NYU Stern.
The following is a latest weblog submit, republished with permission, that initially ran on his weblog, “No Mercy / No Malice.”
In it, Galloway calls the cost for order circulation (PFOF) system that Robinhood makes use of “affiliate marketing online” for funds.

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Robinhood went public on Thursday, the old style approach — by way of an IPO with underwriters after a roadshow. The IPO priced at $38 per share, yielding a valuation of $32 billion, and closed its first day of buying and selling down 8.4%. The buying and selling firm’s debut is the worst on report among the many 51 US corporations which have raised as a lot money as Robinhood. (Disclosure: I’m an investor in Public.com.)So what is going to $30 billion purchase? At first look, Robinhood is a roaring success. In 2020 it registered income of $959 million, a 245% enhance from 2019. RH boasted 18 million month-to-month lively customers in March 2021, up from 7 million a 12 months prior. And in line with the corporate’s thesis, “to democratize finance for all,” feminine customers tripled over the previous 12 months and greater than 25% of customers at the moment are folks of coloration, considerably greater than on the incumbent brokerage homes.However … I’ve written earlier than concerning the problematic facets of Robinhood’s gamification of investing. The firm preys on human weak point, specifically younger males’s susceptibility to playing dependancy. That’s nonetheless true, and RH’s IPO warrants a deeper dive into the agency’s enterprise mannequin.What is Robinhood?The firm operates a cell app that allows shoppers to commerce shares, choices, and crypto. These orders are the corporate’s stock, which it sells to “market makers” — massive monetary establishments that pare (execute) the trades available in the market. As with Google or Facebook, Robinhood’s customers will not be its prospects, however its provide.

Scott Galloway

This means Robinhood is incentivized to maintain its customers buying and selling … lots. The aim: make inventory buying and selling as addictive as social media scrolling. RH has loved success right here. The proportion of customers who test it every day rivals these of Twitter, Snapchat, and Facebook.Various monetary merchandise drive the corporate’s income, however one is particularly profitable: choices. RH makes at the least twice as a lot per choices commerce than it does on a inventory commerce. Why? Because market makers pay extra for choices than shares. Options buying and selling is much less liquid than inventory buying and selling, which interprets to better bid/ask spreads for the market makers. RH depends on market makers, and market makers love choices. The transitive property tells us the corporate depends on choices, as evidenced by its income combine. Despite making up solely 3% of RH’s property underneath custody, choices drive 46% of whole income.

Scott Galloway

FYI: Options do not present any precise fairness in an organization. They solely allow you to purchase or promote a inventory at a given value inside a finite interval. Put one other approach, they’re 1) extremely speculative and a pair of) dangerous. RH is extra gaming app than funding app. Keep in thoughts, 43% of its customers have FICO scores beneath 650.Payment for order circulation (PFOF)Robinhood’s incentive to drive traders towards day buying and selling choices will not be the one fissure between customers’ pursuits and its personal.

The transaction on the coronary heart of the corporate’s mannequin is “Payment for Order Flow” or PFOF. Because RH generates its income by promoting orders to market makers, it does not cost commissions to its shopper customers. But this additionally creates a battle of curiosity for the corporate, which is motivated to promote orders to the market maker that gives the very best cost for the commerce fairly than the perfect value. It’s like affiliate marketing online, however for your monetary future.PFOF goes again to the Nineteen Eighties, when it was pioneered by, wait for it … Bernie Madoff. Madoff relied on the observe to make his agency one of many main market makers of its day, and when regulators raised questions on whether or not it offered a battle of curiosity, he used his place because the chairperson of Nasdaq to stop restrictions. (PFOF is unlawful within the UK) There was no battle of curiosity, Madoff assured his colleagues, as a result of “there are very strict guidelines that I might assume most corporations adjust to.”Regulatory overrunRobinhood is the newest instance of an growing development: tech firms for whom illegality is a function, not a bug. Uber is an $86 billion gypsy cab firm. Facebook and Google have acquired so many fines, it is doubtless the businesses internally classify them as a price of doing enterprise. This is tantamount to changing civics programs with jail coaching, as a result of … nicely … that is how we roll.For its half, RH has racked up: a $70 million settlement with FINRA, a $65 million SEC high-quality (for failing to correctly disclose PFOF), and a separate $1.25 million FINRA high-quality. And on Wednesday, on the eve of pricing its IPO, the corporate disclosed that its senior executives are underneath investigation by FINRA for failing to accumulate broker-dealer licenses. In addition, one other inquiry is underneath approach into the likelihood that RH workers made unlawful insider trades throughout the GameStop frenzy early this 12 months.

Once, that sort of disclosure would have dismembered an IPO. Instead, 48 hours after it made the disclosure, Robinhood was publicly buying and selling at $32 billion. Telling level: The firm paid its chief authorized officer, Daniel Gallagher, greater than $30 million in 2020, although it employed him midway by the 12 months. From 2011 to 2015, Gallagher was an SEC Commissioner. Our enterprise setting has morphed from capitalism, which depends upon the principles of truthful play, into cronyism.

Scott Galloway

Flouting the legislation is now a sign to traders {that a} agency is “disruptive.” Established firms, which consider they’ve an excessive amount of to lose, have spent years investing in a tradition of compliance to guard themselves. Disrupters, with entry to low cost capital and few legacy property, haven’t any such constraints. In Robinhood’s case, no much less an institution bulwark than Goldman Sachs has blessed its strategy to enterprise by taking the lead on the corporate’s IPO. Forget orange — criminality with out consequence is the brand new black.The soul of the brand new machineRobinhood made its “prospects” really feel particular by reserving a 3rd of the providing for them. But the deeper into the insider circle (early traders and workers) you go, the extra particular (and rich) it will get.In February, RH issued $2.55 billion in tranche 1 convertible notes, that are to be exercised at 70% of the IPO value: That’s $26.60 a share vs. $38. This means the convert consumers noticed an instantaneous and assured 43% achieve once they awoke yesterday morning. There’s additionally $1.03 billion in tranche 2 converts that get the identical deal. In addition, 27.8 million shares are reserved for future stock-based worker compensation. That’s greater than $1 billion reserved, once more, for the actual insiders.

As for the RH customers who have been trying to capitalize on their “head begin,” the instant 8% loss will sting. But that is what occurs when your IPO values you at 33x annual income. By distinction, Charles Schwab is value 11x income, regardless of yielding income 3x better than Robinhood’s income.Pocket on line casinoIn observe, Robinhood’s actions look extra just like the dispersion of monetary threat than the “democratization of finance” — form of like if a for-profit jail claimed to be “democratizing housing.” As each an app and as an funding, RH makes extra sense within the context of playing than investing. Its enterprise mannequin depends upon lively merchants, however analysis exhibits the extra lively merchants are, the extra money they lose. Likewise, the on line casino is not making a lot off the blackjack participant who sits on the $5 desk cadging free drinks, nevertheless it hopes the lure of simple cash (and the lubrication of these free drinks) will loosen his pockets ultimately.

Scott Galloway

Greater playing entry is changing into a development. The unlawful sports activities betting market, estimated at $150 billion a 12 months, is quickly transferring to authorized on-line boards. You can now place a sports activities wager out of your sofa in 20 states and counting, and cell playing apps are reaping the rewards. Since its

itemizing in April 2020, DraftKings’ inventory is up 160%. I haven’t got an issue with this, as these corporations state what they’re made for: playing.Another market that is benefited from our insatiable urge for food for threat? Crypto. Robinhood caught that development early and launched crypto buying and selling to its platform in February 2018. Since then, the worldwide crypto market has grown from $450 billion to $1.9 trillion. In the primary three months of 2021, 6% of RH’s income got here from Dogecoin trades. If that appears like an unstable enterprise mannequin, belief your instincts.

RemediesHere’s what we’re saddled with: A development of firms that prey on our monetary naiveté, with no regard for legislation or morality and infinite quantities of capital. What can we do?First, it is gone time for the rule of legislation to reassert itself. Five years in the past, admissions to elite universities have been awash in bribery and fraud. Then the feds put some rich legal professionals, traders, and tv stars in jail. Did it work? I’d enterprise that if any guardian receives an supply of a “aspect door” for their child to get into an elite college as we speak, the guardian hangs up, crisply.Second, we have to arm ourselves, and significantly our younger folks, with monetary literacy. Everyone needs to be fluent within the fundamentals of markets and methods to construct monetary safety. My NYU colleague Aswath Damodaran believes the perfect regulation is life classes. Perhaps fundamental classes in finance (e.g., to not commerce on an app that harvests its orders for income) would reduce the ache of those classes. If we will supply laptop science and Mandarin in faculties, we must always supply programs in monetary literacy. The English-as-a-second language course in any capitalist society must be in cash.In November 2017, Wisconsin handed a legislation requiring that non-public finance courses be integrated in Ok-12 curriculum. In 2019, New Jersey adopted go well with: Financial literacy schooling is now required yearly of center college. A begin.

But based on PwC, solely 24% of millennials have fundamental monetary literacy. Meanwhile, the median age of the Robinhood consumer is 31. The firm is masking its bases with an investing schooling web site, Robinhood Learn, however that does little to nullify the toxicity of its platform.

Scott Galloway

The federal authorities hasn’t performed sufficient both. The finest the Financial Literacy and Education Commission may give you was … one other web site. Its flagship schooling product, MyCash.gov, acquired a whopping 700k web page views in 2020 — lower than a tenth the variety of every day Robinhood customers.We’ve carried out insurance policies within the US which have resulted in a halving of the wealth of Americans underneath the age of 40 (as a share of family wealth) over the previous three a long time. With a lot much less to lose, as we speak’s younger Americans are justifiably wanting for new asset courses and embracing volatility. Put one other approach, there may be trigger for a rebel. The meals industrial complicated needs you to be fats, social media needs you to be divided, and RH needs you to consider you will get wealthy fast by day buying and selling. Rebel.Life is so wealthy,


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