Part 2: What this reveals about the business model issues of free trading on RobinHood.

When RobinHood first appeared in 2015, DailyFintech wrote RobinHood Freemium could enable a lot of new Low Cost Active Alpha services. We focussed on the free part of the story and guessed at the business model as RobinHood was not being transparent about this. We guessed wrong although now that RobinHood’s business model is in the spotlight and they are in trouble, it might be that our a suggestion was a more sustainable business model than what they actually adopted.

When Robinhood blocked customers from buying GameStop shares, there was no shortage of outrage.It became a media and political food fight. The easy story is that “if it is free you are the product”. There is truth in this. Robinhood, like most brokerages and exchanges does sell its users’ order flow. This enables front running, which is legal (today). Front running means I see your order for $10 and make a risk free return by buying at $9.90.   Politicians from both extremes (Sen. Ted Cruz and Rep. Alexandria Ocasio-Cortez) seized on this aspect of the story as did most media outlets. Maybe front running should be illegal.

However the reality is a) it is legal and b) most brokerages and exchanges make money selling order flow to enable front running. Robinhood was only following standard Wall Street practice.

However dig a bit deeper and we get the story of the Ferrari and the Donkey. We measure trading in fractions of a second. That is the race car. Then we climb out of that speed machine and get onto the old grey donkey to do settlement which takes 2 or 3 days (T+2/3 Securities Settlement).Before we do Settlement we have to do Clearing. So the sequence is:

  • Trade = what a broker like Robin Hood does.
  • Clearing = the accounting process where the clearing house (such as DTCC) updates the databases by matching the buyer and seller of the transaction thereby confirming that both parties are in agreement to the terms of trade.
  • Settlement = where a seller gets cash from the buyer. Transaction is now complete.

Clearing houses attempt “netting” = setting off the buy and sell orders so that only a few transactions will actually have to be settled. RobinHood uses free trading to get network effects so that they can do a lot of netting internally without using clearing houses (such as DTCC).

Here is the problem. Until RobinHood get that level of dominance, they still need to use a clearing house. When volatility strikes and shares move up and down over those two settling days, that process has lot of risk/cost, so clearing houses demand more collateral from the broker. That led to a cash crunch at RobinHood, leading to them raising $ billions (at great cost to existing shareholders as their reputation/brand had also taken a hammering).

All of this will change when we move to Real Time Settlement or to be more technically accurate – Concurrent Delivery Versus Payment (DVP). This is happening in the crypto markets. Meanwhile back in the real world, RobinHood has to find the money to fund the time going from the Ferrari to the donkey.

See first post in this 4-parter.

Next week we will look at this from the perspective of those reviled Hedge Funds in shorting can be a valuable price discovery mechanism

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