Robinhood’s Deals With Wholesale Market Makers

During their recent interview on The Acquirers Podcast with Tobias, Dr Richard Smith, PhD in Systems Science discussed Robinhood’s Deals With Wholesale Market Makers. Here’s an excerpt from the interview:

Tobias: What’s wrong with that?

Dr. Richard: What’s wrong with that? It incentivizes Robinhood to put their novice customers into illiquid widespread trades like options for example. I do think that’s a very risky way to proceed for novice investors, and I think it creates a bit of a conflict of interest between Robinhood and its users.

Tobias: How does Robinhood’s approach to investing differ from some of the more established brokers that are out there, and why is their behavior, why does that necessitate a regulatory response?

Dr. Richard: Again, Robinhood has brought many small accounts and facilitated engagement in the markets, and versus somebody like Schwab for example. I think the average count in Schwab is maybe $250,000, and the average count at Robinhood is $2500. Ballpark figures. I don’t think I’m off by an order of magnitude. Traditionally, the SEC has look to protect smaller retail investors. I think that’s what you have at Robinhood. There’s also an element of what are the wholesale market makers doing with the data that they get from the Robinhood users and other retail traders. So, I believe that Robinhood really has taken the Silicon Valley user as product business model that the Facebook’s, the Google’s, etc., and has imported that into retail finance, and that is done in collaboration with the market makers.

Instead of, Google and Facebook might have advertisers that pay to get the attention of the users of the platform, and Google and Facebook are incentivized to nudge behavior in the direction of their paid customers. They’re paying customers, which are the advertisers. I think that Robinhood is incentivized to nudge behavior in the direction of its paying customers, which right now are the wholesale market makers. So, I think that we don’t really get to see what the wholesale market makers do with that data, how they use it to make intelligent decisions in the markets. They’re really in the business of risk management.

But I think they’re getting value out of that data, and that’s why they’re paying for it. So, I do think that sets up a conflict of interest with Robinhood’s users potentially. I would love to just see more transparency around all this. If it’s so great for retail investors such a great deal, let’s see all the data. Let’s see what are the assets that are really driving transaction fees at Robinhood, and is that ending up being profitable for its customers? What are the wholesale market makers able to do with this data, and how is it profiting them and their other sister businesses?

I think all those questions are really unclear, and it would be great to see more transparency. The SEC actually made a rule change a couple years ago that required broker dealers to disclose the relationship of payment for order flow with wholesale market makers. That wasn’t happening before two years ago. That’s why payment for order flow is a household word today, household phrase, I guess. Because the SEC required that disclosure, and before that Robinhood didn’t tell anybody that it was making money on payment for order flow, and they actually even pretended that they weren’t. So, more of those kinds of actions by the SEC, I think, even on the wholesale market maker side, more transparency, more disclosure, I think some things would come to light that in the end, it could help us all make better markets.

It’s such an incredible generational opportunity right now to engage a new generation of investors in the capital markets hopefully for decades, and not just up to a flame out like we had in March of 2000. I’m personally concerned, is an elevated risk right now. So, I would love to see all these young investors learn to love capitalism, learn to love capital markets, not have this just be a war against Wall Street. But I think we all got to work together to do that, and I think that everybody wants a better future, and especially for the markets, everybody wants the markets to succeed. We only have ourselves to look at to solve this problem and I’m hopeful that we [crosstalk] something about it.

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