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the 2011 Occupy Wall Street movement materialized as a protest of bailouts on Wall Street and foreclosures on Main Street, one of Tenev and Bhatt’s friends accused them of profiteering from an unequal system. Soul searching led the pair in 2012 to conceive Robinhood, a trading app with a name that was an explicit reference to leveling the playing field. The most obvious—and disruptive—innovation: no commissions and no minimum balances, at a time when even low-cost rivals like E-Trade and TD Ameritrade made billions on such fees.
Initially, Tenev and Bhatt used the allure of exclusivity to capture interest. For their 2013 launch, they restricted access, building up a 50,000-person waiting list. Then they turned the velvet rope into a game, telling prospective users they could move up the waitlist by referring friends. By the time they launched on Apple’s App Store in 2014, Robinhood had a waitlist of 1 million users. They had spent virtually nothing on marketing.
Bhatt focused maniacally on app design, trying to make Robinhood “dead simple” to use. iPhones flashed with animations and vibrated when users bought stocks. Every time Bhatt came up with a new feature, he’d run across the street with staffers from Robinhood’s Palo Alto office to Stanford’s campus, cornering random students, asking for feedback. The app won an Apple Design award in 2015, a prize given to just 12 apps that year. Millennial customers started downloading it in droves.
By the fall of 2019, Robinhood had raised nearly $1 billion in funding and swelled to a $7.6 billion valuation, with 500 employees and 6 million users. Tenev and Bhatt, both minority owners of Robinhood with estimated 10%-plus stakes, were rich.
Then, in September 2019, Goliath bowed low to David. Over a 48-hour span, E-Trade, Schwab and TD Ameritrade, industry giants many times Robinhood’s size, cut commissions to $0. A few months later, Merrill Lynch and Wells Fargo’s brokerage unit followed suit. As this source of revenue evaporated, brokerage stocks plunged, and TD Ameritrade soon entered a shotgun marriage with Schwab, while E-Trade ran into the arms of Morgan Stanley.
Two Millennials had done something that discount giants like Vanguard and Fidelity could never accomplish. They had dealt the final blow to the easy-money trading commissions that had fed generations of stockbrokers and formed the financial foundation of Wall Street brokerage firms.
The secret sauce of Robinhood’s success is something its founders are loath to publicize: From the beginning, Robinhood staked its profitability on something known as “payment for order flow,” or PFOF. Instead of taking fees on the front end in the form of commissions, Tenev and Bhatt would make money behind the scenes, selling their trades to so-called market makers— large, sophisticated quantitative-trading firms like Citadel, Two Sigma, Susquehanna International Group and Virtu Financial. The big firms would feed Robinhood customer orders into their algorithms and seek to profit executing the trades by shaving small fractions off bid and offer prices.
Robinhood didn’t invent this selling of orders—E-Trade, for example, earned about $200 million in 2019 through the practice. Unlike most of its competitors, though, Robinhood charges the quants a percentage of the spread on each trade it sells, versus a fixed amount. So when there is a large gap between the bid and asked price, everyone wins—except the customer. Moreover, since Robinhood’s customers tend to trade small quantities of stocks, they are less likely to move markets and are thus lower-risk for the big quants running their models. In the first quarter of 2020, 70% of the firm’s $130 million in revenue was derived from selling its order flow. In the second quarter, Robinhood’s PFOF doubled to $180 million.
Given Tenev and Bhatt’s history in the high-frequency trading business, it’s no surprise that they cleverly built their firm around attracting the type of account that would be most desirable to their Wall Street trading-firm clients. What kind of traders make the most saleable chum for giant sharks? Those who chase volatile momentum stocks, caring little about the size of spreads, and those who speculate with options. So Robinhood’s app was designed to appeal to the video-game generation of young, inexperienced investors.
Besides being given one share of a lowpriced stock to start you on your investing journey, one of the first things you notice when you begin trading stocks on Robinhood and are authorized to trade options is that the bright orange button right above BUY on your phone screen says TRADE OPTIONS.
Options trades also happen to be prime steak for Robinhood’s real customers, the algorithmic quant traders. According to a recent report by Piper Sandler, Robinhood gets paid—by the quants—58 cents per 100 shares for options contracts versus only 17 cents per 100 for equities. Options are less liquid than stocks and tend to trade at higher spreads. Selling options trades accounted for 62% of Robinhood’s order-flow revenues in the first half of 2020.
The most delectable of these options trades, according to Paul Rowady of Alphacution, may very well be so-called “Stop Loss Limit Orders,” which give buyers the opportunity to set automatic price triggers that close their positions in an effort either to protect profits or limit losses. In October 2019, Robinhood gleefully announced to its customers, “Options Stop Limit Orders Are Here,” a nifty feature which essentially puts trading on autopilot.
“That [stop limit] order is immediately sold to a highspeed trader who now knows where your intention is, where you would sell,” says one former high-speed trader. “It’s like you’re writing a secret on a piece of paper and handing it to
OPTIONS TRADES ARE PRIME STEAK FOR ROBINHOOD’S REAL CUSTOMERS, THE ALGORITHMIC QUANT TRADERS.
your broker, who sells it to someone who has an interest to trade against you.”
Robinhood refutes the notion that its model preys on inexperienced investors. “Receipt of payment for order flow is a common, legal and regulated industry business practice,” says a Robinhood spokesperson who insists the firm’s trade executions saved customers $1 billion this year. “We are focused on providing a platform that makes finance accessible and approachable and where people can make thoughtful, informed investing decisions.”
Billionaire competitor Thomas Peterffy, the founder of Interactive Brokers, says stop limit orders are the most valuable orders a sophisticated trader can buy. “If people send you orders, you see what they are. You can plot them up along a price axis and see how many buy and sell orders you have at each of those prices,” he says.
For instance, if a buyer sees sell orders bunched up around a certain price, it means that if the stock or option hits that price, the market is going to fall hard. “If you are a trader, it’s good for you if you can trigger the stop—you can go short and trigger the stop, and then cover much lower,” Peterffy says. “It’s an old technique.”
In a sense, Covid-19 has been both a blessing and a curse for Robinhood.
The pandemic forced millions of future Robinhood customers home to shelter in place, free from diversions like sports and armed with fast internet connections and free money from the government. The stock market, meanwhile, provided edge-of-your-seat excitement as it plunged and then soared, propelling superstars like Amazon and reviving walkingdead stocks like Chesapeake Energy. The result was unprecedented growth for the upstart brokerage. Robinhood now has more than 13 million registered customer accounts, nearly as many as venerable Charles Schwab, which after 49 years has 14 million funded accounts, and more than twice as many as E-Trade, with 6 million accounts.
The company has also been a game changer for some of its clients. Taylor Hamilton, 23, an IT worker who graduated from the University of Pennsylvania in 2018, opened a Robinhood account and began trading in March. He began buying put options against plummeting travel-industry stocks like Delta and Uber, and later bought calls on Boeing and other beaten-down companies, correctly figuring that they would benefit from the government’s de facto bailout via the bond market.
After four months and 300 trades, Hamilton has netted nearly $100,000 and paid down his $15,000 in student loans. “It felt like a once-in-a-lifetime opportunity,” says Hamilton, who reports that he has transferred most of his profits to his bank account to eliminate the temptation to trade away his gains.
The pandemic has also exposed Robinhood’s warts. During the market’s 5% one-day swoon and subsequent rebound in early March, Robinhood’s customers were completely shut off from their accounts for nearly two days as the brokerage firm’s technology systems crumpled under the weight of a tenfold jump in order volume. Angry customers lashed out against Robinhood on social media, and more than a dozen lawsuits were filed against the company.
In the last few months, Robinhood has quietly been restructuring. Tenev says it’s making major technology investments to increase capacity and add redundancy. A sizable chunk of its $800 million in fresh venture capital is going toward upgrades and adding engineers to the 300 already on staff.
In the wake of the Kearns tragedy, Robinhood’s optionstrading interface is also being overhauled. The company has pledged to help educate its customers on the highly speculative nature of the trades. That includes hiring an “Options Education Specialist” and “rolling out improvements to in-app messages and emails” that it sends to customers about their complex options trades. In August, the brokerage app said it would hire hundreds of new customer-service representatives in its Texas and Arizona offices by the end of 2020.
According to insiders, there’s a sense of urgency at the company these days. For two years, Robinhood has been speaking publicly about an IPO. With interest rates near zero and the stock market roaring, the public-offering window is wide open, but it won’t be forever.
A better option—especially considering Robinhood’s current problems—might be a quick sale to a full-service firm such as Goldman Sachs, UBS or Merrill Lynch. Such a sale would surely provide billiondollar windfalls for its young founders, Tenev and Bhatt. And as any good trader knows, it’s much better to sell when you can than when you have to.
No one loves Robinhood trades more than Wall Street’s billionaire quants. Citadel, owned by Ken Griffin (above), No. 34 on The Forbes 400, is the biggest buyer. Billionaires in Sherwood Forest