As I strolled into class, one of my students, Ricky, was checking his portfolio. He had a frown on his face as the stock he had been following was purchased, but at a higher price than expected. Jim, a classmate, was following the same stock and purchased it virtually at the same time, but for a better price.
The difference wasn’t a huge amount, but it got Ricky to ask questions. Why is it that a company can be purchased at the same time, but at different prices?
In this particular case, Ricky was trading on the Robinhood platform. Robinhood is very popular with younger people who are new to investing. Often, they are inexperienced and naïve.
As I asked Ricky why he used Robinhood, he said it was fun and offered “free” trades. When he places a trade there is a graphic popping a streamer telling him “Congratulations!” He added it was a lot like a videogame.
Comparatively, Jim’s account was held at a traditional discount brokerage. The platform was his father’s platform. It was very matter-of-fact and a bit clunky. As such, it was functional, but not necessarily fun.
Ricky and Jim asked why, if the same trade was placed simultaneously, was it executed at two different prices?
The difference is due to “payment for order flow.”
In this particular case, Robinhood has agreements with “market makers.” A market maker coordinates investors wanting to buy and sell different securities throughout the day. Assume one person wants to buy Coca-Cola and another wants to sell it simultaneously. The market marker coordinates the transaction between the buyer and seller and charges a small fee called a “spread.”
Some brokers have arrangements to get the best pricing possible for their customers. Others, like Robinhood, have a different agreement. In Robinhood’s payment for order flow they agree they will send trades through a specific market maker. The market maker charges their spread and then rebates part of the fee to Robinhood.
Although this makes Robinhood look “free,” it is not. Furthermore, it incentivizes the market maker to be more expensive in how it connects buyers and sellers.
The conflict of interest from payment for order flow is so large that it has been banned in the U.K., Canada and Australia.
Payment for order flow schemes are highly lucrative as they recently accounted for more than 75% of Robinhood’s revenue’s.
Robinhood’s transaction-based revenues increased nearly 350% from March of 2020 and March 2021. At the same time, Robinhood users grew from 5.1 million in 2019 to 22 million at the end of June 2021.
What can be learned from this?
Nothing is free. If you are not paying for a product or service, then you are the product. Or, in this case, your trade is the product as it is being over-charged. You never see the excess fee, but your investment performance suffers.
When high frequency traders or market makers trade and process hundreds of millions of trades per day, the incentive to increase the spread and trading costs are enormous.
The higher the kickback or rebate from the market maker or high frequency trader to Robinhood, the more you suffer.
A stock is not a random ticker symbol. It is a business. Know what you should pay for a business and then use limit orders to make sure you pay the right price.
The gamification of the financial markets has stolen a page out of the Las Vegas playbook. Stock trading on platforms like Robinhood look more like a slot machine with vivid graphics, bells, whistles and congratulatory pats on the back. This is designed to give you a hit of dopamine and make you trade more. The more you trade, the more brokers have the opportunity to manipulate you and make money in the process.
Successful investing is won by people with long-term vision and discipline. Videogame like trading platforms are designed to induce short-term behavior. However, long-term success is what matters. Furthermore, the longer you can hold your positions, the greater your tax-efficiency.
Gamified trading platforms like Robinhood offer nothing special, except for inferior returns. Don’t get sucked in.