Robinhood, the Fintech Discount Broker: Recent Developments and Concerns

Robinhood, the Fintech Discount Broker: Recent Developments and Concerns

October 8, 2020
Robinhood, the Fintech Discount Broker: Recent Developments
and Concerns
Founded in 2013, Robinhood is an online and phone app-
video games, including an explosion of screen confetti
based discount broker-dealer for retail customers with an
when a trader makes a trade. As reported in the Financial
interest in trading stocks, stock options, exchange traded
Times, one user, a Harvard University Ph.D. economics
funds (ETFs), and cryptocurrencies. It is part of a new
student observed that the “gamified” interface makes
breed of fintech firms—innovative, technology-focused
trading “so simple that it can be easy to make impulsive
firms offering financial products. The firm is seen by some
decisions.” The view is shared by various behaviorists, but
as “democratizing” access to retail securities trading; has
is rejected by firm officials.
been accompanied by industry consolidation; and has raised
various public policy and congressional concerns.
Trading in Stock Options
Like its online competitors (e.g., Schwab, TD Ameritrade,
The firm recently burst into the public eye for three major
E*TRADE), Robinhood witnessed an unprecedented surge
reasons: (1) it pioneered the now-widespread industry
in retail trading during early 2020. Alphacution, a research
practice of charging zero trading fees or commissions for
firm, found that compared with other retail brokers,
certain trades when the most inexpensive online brokers
Robinhood’s customers trade the riskiest products at the
were charging $5 to $8 per trade; (2) in March 2020, its
greatest frequencies. This is said to be especially true for
trading services shut down for more than a trading day in a
stock options—contracts that give investors the right to buy
period of market turmoil; and (3) in June 2020, a 20-year-
or sell shares at a specific price in the future. Robinhood
old college student, Alex Kearns, committed suicide after
reports options are traded by 12% of its active traders. In
his Robinhood app indicated that he had a negative balance
the aftermath of the Kearns suicide, stock option trading at
of $750,000 for sophisticated stock options trades, an
the firm has become a central focus. Mr. Kearns had been
amount that now appears to have been grossly overstated.
trading an advanced form of stock option.
Broker-dealers act as brokers when they execute securities
Analysts say that various advanced stock options can have
trades for their clients and as dealers when they trade their
substantial financial liability. A US News & World Report
own securities for their own benefits. Most broker-dealers
profile of stock option trading observed, “The statistics and
must register with the Securities and Exchange Commission
the horror stories of huge losses demonstrate how
(SEC) and generally must be members of and comply with
dangerous option buying can be, especially for
the rules and guidance of a self-regulatory organization
inexperienced traders.”
(SRO), the Financial Industry Regulatory Authority
(FINRA, an SEC-regulated nonprofit). In addition, broker-
FINRA’s generic broker rule, Rule 2090, the “know your
dealer sales personnel (also called registered
customer rule,” requires option traders to get a broker’s
representatives) register with their state.
permission to move to more advanced options trading tiers
based on broker-determined criteria. Depending on the
SEC-registered broker-dealers are largely regulated under
broker, the criteria may include client characteristics such
the Securities Exchange Act of 1934 (P.L. 73-291). Broker-
as options-trading experience, net worth, and age.
dealers, or simply brokers, have significant range in the
Robinhood, a member of FINRA, provides for increasingly
kinds of services they provide and generally divide into two
advanced and potentially more profitable but riskier levels
groups: full-service (who provide research and advice,
of options trading.
retirement planning, tax advice, etc.) and discount online
brokerage firms. Historically, discount online brokers, such
According to the Wall Street Journal, Robinhood has
as TD Ameritrade, E*TRADE, and Merrill Edge, have
imposed less rigorous hurdles to options trading than do its
charged lower trading fees than the full-service firms, but
various rivals. New clients reportedly take a questionnaire-
they have not provided individual investment advisory
based self-assessment, must acknowledge the trading risks
services.
involved, and promise to read the broker’s materials on
options trading. If clients say that they lack an options
Thanks in part to ads highlighting its zero trade
investing background, they cannot initially open an options
commissions, seemingly pitched largely at millennials, by
trading account. According to the New York Times, the
May 2020, Robinhood had reportedly attracted some 13
Robinhood app then subsequently tutors them “to change
million clients with a median age of 31. Of that total, 3
the answer to ‘not much’ experience, which opens the door
million were reportedly added during the first four months
for them to trade.”
of the year. As part of the firm’s appeal to its generally
youthful traders, observers cite that Robinhood’s phone
In June 2020, on the heels of the suicide, Robinhood’s
app’s trading interface has design elements similarly to
owners said that they had been plagued by shortfalls in
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Robinhood, the Fintech Discount Broker: Recent Developments and Concerns
customer service personnel, which they said were being
best execution violations stemming from PFOFs that
addressed. They also announced several safeguards. Among
occurred between October 2016 and November 2017. The
them are improvements to the user interface; the provision
company noted that the issues laid out in the settlement do
of enhanced educational resources for options traders; and
not reflect how it currently operates. In September 2020,
the consideration of adopting more stringent eligibility
the Wall Street Journal reported that the SEC and
criteria for certain options trades.
Robinhood were negotiating a settlement based on the
firm’s alleged failure to fully disclose its PFOFs. Under
Zero Commissions and Payment for Order Flow
rules 606 and 607 of Reg NMS of the Securities Exchange
Like many of its rivals, Robinhood subsidizes its zero
Act of 1934, key aspects of PFOFs must be disclosed.
trading commissions through other cash generation
mechanisms. Among them, the firm collects interest on
In February 2020, FINRA announced that it had written to
margin loans and charges traders for professional research.
unidentified brokers who have adopted zero trading fee
Its principal cash generator is reportedly a practice called
policies. Among other things, the “sweep examination”
payment for order flow (PFOF). Often described as the
asked whether “changing to the zero-commission model
lifeblood of discount brokers, PFOFs are rebates given by
resulted in changes to a firm’s routing practices, execution
securities exchanges or market makers (firms that buy and
quality, regular and rigorous review policies or the level of
sell securities for themselves) to brokers for routing trade
trading rebates or payment for order flow.” Responses may
orders to the firms for execution. Robinhood earned $100
help inform future regulatory moves.
million from the payments in the first quarter of 2020.
Congressional Concerns
Major PFOF market makers are two high-frequency traders,
The Kearns’s suicide note reportedly read, “I was a 20-
Citadel Securities and Virtu Financial. Data from
year-old with no income able to be assigned almost a
Alphacution indicate that Robinhood receives much more
million dollars worth of leverage.… I had no clue what I
per share in PFOFs for its stock trades than do its online
was doing.... ” Various Members of Congress have been
competitors. Some observers say that market makers’
scrutinizing Robinhood in the tragedy’s aftermath.
willingness to pay such a premium stems from the fact that
the firm’s clients tend to make exceptionally “uninformed”
In July 2019, Representatives Brad Sherman, Bill Foster,
trades, which can create better profit-making opportunities
Lauren Underwood, and Sean Casten and Senators Richard
for the market makers.
Durbin and Tammy Duckworth wrote to Robinhood’s two
owners. The letter stated, “By seeking to cultivate a
Proponents of the controversial PFOFs argue that by
customer base of relatively inexperienced investors, you
incentivizing larger volume trades, economies of scale are
have also taken on an especially great responsibility to
generated. In turn, this is said to help generate trading
make sure your customers are protected and always
efficiencies that can translate into savings for investors (as
provided with clear and accurate information.” The firm
in the zero trading fees). Proponents also argue that PFOFs
was also asked if it assesses a client’s age and experience
are subject to a required FINRA trading protocol called best
before a client can trade complex stock options.
execution, whereby brokers must “use reasonable
diligence” in determining the best market for a given
Outside of Congress, some experts have similar concerns.
security that is being bought or sold and so that the
For example, Micah Hauptman, financial services counsel
resulting share price is as favorable to the client as market
at the consumer advocate, the Consumer Federation of
conditions allow. Critics, including former SEC Chair Mary
America (CFA), told the Wall Street Journal, that “firms
Jo White, have said that PFOFs may create potential
[such as Robinhood] are making it way too easy to trade
conflicts of interest between brokers and clients, possibly
options … making it seem very attractive or low-risk.”
undermining the quality of best execution. Representative
Sean Casten, a member of the House Financial Services
As reported in Roll Call, some Members of Congress,
Committee, argued to Barron’s that because Robinhood’s
including Chairman Brad Sherman and Representative Sean
profits disproportionately come from the payments, he
Casten, see Robinhood as failing to comply with existing
alleged that it had an incentive to motivate its clients to
broker regulatory rules, a view shared by the CFA’s
trade more often. Attempting to assuage such concerns,
Hauptman. To date, FINRA reports that there are no such
firm officials told Barron’s that over time, their clients tend
disciplinary actions against the firm.
to become longer-term “buy and hold” investors.
Potential Regulatory Lag
Robinhood’s owners have argued that because they receive
A problem often posed by fintech firms is that existing
the same rates from all market makers that they route to,
regulations may have some obsolete aspects in their
there are no conflicts of interest. A determining factor on
applicability to them or their innovative products, a
whether a broker fulfills the best execution mandate can be
phenomenon called regulatory lag. At a House Financial
whether it considers the opportunity for something called
Services Subcommittee hearing on June 25, 2020, SEC
price improvement, when a trading order is executed at a
Chair Jay Clayton said his agency and FINRA would be
better price than what is currently publicly quoted. Unlike
coordinating to improve unspecified disclosures in this area.
its competitors, Robinhood reportedly does not report this.
Gary Shorter, Specialist in Financial Economics
On December 19, 2019, FINRA announced that it had
reached a $1.25 million settlement with Robinhood over
IF11663
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Robinhood, the Fintech Discount Broker: Recent Developments and Concerns

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