(Extended) Thought of the Day

• Robinhood, the Menlo Park based trading startup, has pioneered commission free trading, facilitating the addition of over 3M new users YTD

• While the platform offers a paid subscription service that yields access to greater leverage and equity research reports, it derives almost all of its revenue from selling the order flow of its users to institutional market markers (explained below)

• This revenue model has since been ethically called into question

• Critics claim Robinhood takes advantage of its user base (mostly new, inexperienced market participants) given they don't understand truly how these financial systems work

• In reality, when an individual requests to buy stock or equity derivatives on Robinhood, the order data is sold to firms that use complex computers and algorithms (high frequency trading) to match buyers with sellers

• These trading firms (i.e. Citadel) profit on the difference (the spread) between what the buyer is willing to pay (the bid) and what the seller is asking for (the ask)

• Thus there exists a financial incentive for these market makers to not provide said users with the best possible price

• The greater the spread between the bid and the ask, the greater the profit

• In addition, receiving order flow prior to trade execution lends valuable insight into the direction a stock is heading

• This gives high frequency trading firms, who run miles of fiber optic cables directly to exchanges, a huge advantage

• From a physics perspective, this is because photons carry information in these optic infrastructures at the speed of light, while electrons in a legacy power grid are limited to the speed of electricity in metallic wires (~1/100 the former)

• This allows just enough time for market makers to execute their own trades before large swaths of retail orders bid up the price of a stock

• Robinhood is not directly involved in matching buyers with sellers, but they do control which trading firms receive their order data, and they have historically chosen firms which ethically questionable backgrounds

• In summary, there exists financial motive for Robinhood to target inexperienced users who are less likely to know they are essentially trading at a material disadvantage

The Bottom Lines

• Within finance & economics specifically, there is no such thing as free lunch

• While Robinhood offers commission free trading, users ought to be aware of exposure to relatively subpar execution prices as well as the ability for trading firms to legally front-run their orders