How Robinhood Exploits Its Traders After Hours

Online brokerage firms are in an arms race to provide more tools to investors. It seems counterintuitive, yet when it comes to trade execution less is often more.

Executives at Robinhood Markets (HOOD) announced on Tuesday that customers are now able to trade securities from 7 a.m. to 8 p.m. ET. Eventually, trade execution will be available 24/7.

It is a great development for Robinhood shareholders, clients not so much.

Robinhood has been derided by traditionalists, regulators and even some users for gamifying investing. The platform almost makes it too easy to get in and out of stocks and options.

Founders Vlad Tenev and Baiju Bhatt had the genius idea in 2013 to merge social media, smartphones and online investing. Then the Stanford students schemed up a way to let investors seamlessly purchases odd lots of stocks for free, sort of.

Trading on Robinhood is not really free.

Eliminating the commission that is normally billed to customers means collecting it elsewhere. And that’s where the business gets a bit sketchy. Robinhood racks up fees from market makers in exchange for routing client buy and sell orders their way for execution. This means client accounts at Robinhood are the product. The true customer is the stable of market makers competing for client orders.

According to the S-1 filing with the Securities and Exchange Commission only a few of these financial firms now make up 75% of Robinhood’s revenues. Market maker Citadel Securities accounted for 34% of sales, Susquehanna International Group contributed 18%, and Wolverine Holdings made up 10%. Worse, the contribution from market makers to the overall business at Robinhood is growing, up from 62% a year ago.

Keep in mind, market makers are on the other side of every retail transaction at Robinhood. Their profit is a direct function of the spread between the bid price and the ask. The bigger the spread, the better the profit. And a system called “payment for order flow” kicks back a portion of that windfall to Robinhood.

A lengthy study by BestEx Research argues these spreads could be narrowed by 25% if they were properly routed to an exchange.

Customer trading at Robinhood isn’t free. The fees are simply hidden in hefty spreads.

Those spreads, and the inherent dangers of relying on market makers, became apparent in February 2021 during the GameStop
GME
(GME) trading frenzy. The so-called meme stock zoomed from $17 to a high of $483 as short sellers were forced to buy back rising shares. The frenetic pace of the advance led to ultrawide spreads, windfall profits for market makers and a slew of trading outages for Robinhood customers.

The financial industry regulation authority deemed those outages did significant harm to customers. FINA announced last June that Robinhood agreed to pay nearly $70 million to settle customer complaints. It was the largest penalty ever ordered, according to a CNBC report.

The business model at Robinhood is fraught with problems in what should be orderly markets with plenty of buyers and sellers. Now imagine what happens to retail orders when they are exposed to chronically illiquid premarket and afterhours trading.

This is an undoubtedly a positive development for Robinhood shareholders. The firm is about collect even bigger fees from market makers. This also explains why shares jumped on Tuesday to $15.91, a gain of 24%. Unfortunately, it is Robinhood clients who will pay the price for trading in thin markets.

I have never recommended Robinhood shares. I don’t have a problem with the ethics of the business model. All is fully disclosed. The company does not pretend that its services are free. My issue has always been churn, the idea that too many customers will ultimately be close their accounts as they lose money, or interest in investing. As a business, this is unsustainable.

At a share price of $15.91, Robinhood stock trades at 6.4x sales. The business is currently unprofitable, and the return on investment in 2021 was -22.5%.

Shares could rally as high as $22 in the next rally, which would be a good place to sell if you have them.

Investors should close existing long positions into a rally toward $22.

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