During onein February, Rep. Alexandra Ocasio-Cortez tore in and grills the Silicon Valley manager about how his royalty-free trading app makes money.
When Tenev appeared before the House Financial Services Committee via Zoom, the New York Democratic member of Congress was focused on “paying for the flow of orders.” It’s a financially shaky term for a controversial practice in the trading world that allows large investment firms to pay brokers like Robinhood to forward traffic to them. Then the companies do business on Robinhood’s behalf.
Critics say the practice is detrimental because it encourages a company like Robinhood to push its users into ever more trades and to encourage reckless investing. Ocasio-Cortez wanted Tenev to commit to paying those revenues to the users of the app rather than keeping them to himself.
“If removing the income you get from paying for the order flow resulted in the removal of free commissions, doesn’t that mean trading with Robinhood isn’t free initially?” Said Ocasio-Cortez. “Because you’re just hiding the cost.”
The hearing was sparked by a bizarre saga that rocked Wall Street a month earlier. Traders on Reddit had joined forces on the r / wallstreetbets subreddit, bringing the stock of the ailing video game retailer GameStop to an 800% increase. Robinhood, the app of choice for Redditors making their stakes, was at the center of the noise. And now that Robinhood is getting closer to going public on one of the most anticipated tech IPOs of the year, the company is back in the limelight. With the fanfare, however, comes a renewed review of the business model.
The Ocasio-Cortez survey highlights a common concern about Robinhood: users aren’t exactly sure what’s going on or what they’re really getting into. It’s not the only company monetizing its users. Google and Facebook, through their massive digital advertising businesses, are soaking up the data of people using their services so marketers can target consumers more accurately. The notion that “if it’s free, you are the product” takes on another level when the business model focuses not only on users’ time and attention, but also on their life savings.
The royalty-free app company was founded in 2013.
In addition to reviewing Robinhood for how it makes money, critics have criticized the company for promoting a reckless attitude towards investing. They say the app takes advantage of its users and turns trading into a mobile game with animation and dopamine hits. And due to Robinhood’s success, more traditional competitors have been pushed to adopt some of their practices.
“Everything they do is incredibly intentional,” said Tara Falcone, founder of financial education company ReisUp. “And that scares me.”
Robinhood is defending its business model, saying it opened trade to people who would otherwise not invest. “There will always be people who reject change. There will always be naysayers who say that new ideas cannot work,” a company spokeswoman said in a statement. “Robinhood refuses to accept the status quo because if we stayed the same we would accept a future where barriers to investment persist and where only a handful of people have the potential for financial freedom. The system did not contain millions.” from people who are investing now for the first time – we are honored to serve them. ”
Payment for order flow
Founded in 2013 by Tenev and his former Stanford University roommate, Baiju Bhatt, Robinhood was a pioneer in commission-free online trading. The product was specially tailored to the stated mission of “democratizing finances” and appeals to people with little experience in the stock market. The service allows traders to receive notifications and read market news. They swipe to confirm stock purchases that critics deride as an occasional opportunity to make important financial decisions.
Robinhood didn’t invent payment for the flow of orders. The practice has been around for decades, pioneered by Bernie Madoff, the notorious Ponzi program investor who passed away last month. Under the model, a broker like Robinhood makes money by referring deals to investment firms called “market makers” who pay Robinhood fees for real-time information about stocks they buy and sell.
The order flow fees are low but add up. In the first half of 2020, the company generated more than $ 270 million from incoming orders, according to regulatory filings. Robinhood’s largest partner in this area is Chicago-based market maker Citadel Securities. Other partners are the investment firms Two Sigma and Wolverine.
Robinhood denies criticism that encouraging high volume trading leads to reckless investing. The company cited an internal survey in which half of the users who answered the questionnaire said the app motivates them to save money. Robinhood also said it introduced new educational resources to the app, such as a course on defining individual financial goals, as well as phone support for users.
At the February hearing, Tenev responded to criticism of the use of order flow payment by emphasizing that Robinhood was a “for-profit business.” The company has a similar message on a page titled How Robinhood Makes Money on their website. “By generating income, we can offer you a range of financial products and services at low cost, including commission-free trading.”
“Who is your client really? There’s a deep lack of clarity.”
Rachel Robasciotti, CEO of Adasina Social Capital
Rachel Robasciotti, CEO of Adasina Social Capital, criticized the payment for the flow of orders in a Senate committee hearing on the GameStop saga in March that was separated from the House’s procedure. She couldn’t specifically comment on Robinhood during an interview, but when she talked about royalty-free apps in general, she said that such apps ultimately harm small merchants because the companies don’t protect them. “Who is really your customer? She said, “There is a deep lack of clarity. ”
Robasciotti said all the attention around paying for the order flow from the GameStop drama is ultimately bad for toll-free apps. The business model works best when consumers don’t know how the company makes money, she said, but now that more people know, some level of trust has been broken. “It really jeopardizes long-term relationships with consumers,” said Robasciotti. “That’s the essence of running a business.”
In fact, the model rubs some users in the wrong direction. O’Neil Thomas, a 23-year-old New Jersey actor, started Robinhood about a week after the GameStop saga. He had no idea about the payment for the order flow model. After CNET explained it to him last week, he called it “seedy”.
“I feel like they aren’t really vocal about signing up with them,” he said. “Especially when it comes to trading stocks, you want to be as transparent as possible.”
“Treat this like a game”
The app’s critics also say that Robinhood uses emotion pulling mechanisms and features similar to video games to get people excited about the service. The app showered the screen for certain milestones like a user’s first digital confetti trade, but the company changed the design of its digital celebrations in March. When they register, new members receive a free portfolio of the company’s choice. The danger, however, is that investing is complicated. It’s about real money and critics say Robinhood is not doing enough to make users aware of the consequences.
In the worst case, tragedy has struck. In June 2020, student Alexander Kearns killed himself after seeing a negative balance of more than $ 700,000 on his Robinhood account despite some of his deals being incomplete. In a suicide note, Kearns mentioned Robinhood and asked how it is possible for a beginner to get into this position.
“How could a 20 year old with no income get nearly a million dollars worth of leverage?” the note read. “It wasn’t intended to take that much risk.”
Rep. Sean Casten, a Democrat representing the Illinois District of Kearns, told the chairman of the Securities and Exchange Commission in June that the app’s documentation was inadequate to explain the risks involved in trading. Robinhood later paid $ 65 million to come to terms with the SEC for failing to adequately disclose its sources of income.
In December, Massachusetts securities regulators sued Robinhood for its playful qualities. “Not only is it unethical to treat this like a game and get young and inexperienced customers to do more and more business,” said then-Commonwealth Secretary William Galvin, “but it also falls far short of the standards we set in Massachusetts. ” Last month, the state attempted to revoke Robinhood’s broker-dealer license and asked the company to invalidate the lawsuit.
As Robinhood’s IPO approaches, Falcone fears that problems with Robinhood’s business model will only get worse. She fears that if the app tries to increase trading volume as a public company, it will become even more aggressive as it seeks to reward shareholders with growth.
“They are motivated to take their users to action and take action often,” she said. “They don’t care if their users are actually making money or losing money.”