Robinhood Exposed: Why Retail Investors Should Find a New Broker
Don’t listen to what they say, watch what they do.
That’s the best advice we have for Robinhood traders right now.
Robinhood is, publicly at least, in full damage control.
Privately, however, it is continuing its core business of selling out its clients to literally the highest bidder.
And Robinhood is doing this in a far sneakier way than just restricting retail investors from buying GameStop and a few other stocks.
Here’s what we mean.
Robinhood: New Mayor Of Kickback City
Robinhood started out on the basic idea that stock traders hate commission, and a “no commission” trading service would attract a large client base quickly.
The company’s founders were right about that.
Robinhood was founded in 2013 and has grown steadily, to the point where it has become one of the largest discount brokerages in the United States in less than eight years.
However, those “no commission” trades are anything but “free” when all is said and done.
And as a result, Robinhood has become one of the most relatively valuable discount brokerages in the world.
Our analysis below shows how Robinhood is comparatively worth 27X to 34X more than E*Trade and TD Ameritrade, respectively.
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Here’s how it works.
Robinhood doesn’t charge a direct fee to clients for trades.
Instead, it charges the middle-men on the other side of the trade for the trade.
These fees, called Payment For Order Flow (PFOF), go directly to Robinhood from the middle man.
In Robinhood’s case, Citadel Securities (an affiliate of Citadel LLC, a hedge fund) is one of the middle men that pays Robinhood for order flow.
In return, Robinhood lets Citadel Securities see what orders are coming in, a few milliseconds before they’re filled.
High frequency traders (bots) can use these extra milliseconds to make advantageous trades.
So to recap, Citadel Securities gets to see the orders that come through Robinhood before anyone else. It can use this information to front-run the market, and pocket the spread.
They can also use this information to determine the next over-leveraged fund that’s going to get squeezed. To think that they couldn’t do anything to influence this squeeze would be naive.
If you’ve ever read the book Flash Boys, by Michael Lewis (and in light of all this, we recommend that you do), you know that those extra few milliseconds can make all the difference to hedge funds that use high frequency trading algorithms – it’s why in the earlier days of online trading, hedge funds were literally moving their physical offices to areas where the internet bandwidth was milliseconds faster than the competition. In trading, a few milliseconds can make all the difference.
Obviously, this operation was extremely lucrative for Citadel. And Robinhood was completely complicit.
But firms like Robinhood have rightly concluded that customers don’t care too much about PFOF fees, poor trade execution, and losing a few extra bucks on each trade, as long as the costs are unseen.
Here at Dear Retail though, we have the receipts.
And the numbers say Robinhood is the most effective major discount brokerage… at selling out its clients through PFOF.
Here’s a table from CNBC that breaks down PFOF and how particularly outstanding Robinhood is at selling out its clients:
The table shows the PFOF in the first half of 2020, from the four major discount brokers.
If you look at the Q2 numbers, you’ll see that Robinhood beats out every major competitor on the PFOF rates it receives by sending its customers orders to a middle man.
Robinhood is anywhere from 20% to 40% higher in PFOF than its major competitors.
And that ability (or more like willingness) to take the high kickback-style PFOF has made Robinhood’s founders and early investors fortunes.
Just look at how much more valuable Robinhood is compared to its competitors.
Thanks, Retail: Robinhood Is Now The Most Valuable Discount Broker
Robinhood is now, on a relative basis, the most valuable of the “Big Four” discount brokerages in the United States.
We say relatively, because Robinhood is still small.
But it is so good at turning its clients into revenues for itself, it is worth so much more than its more established competitors.
Let’s break down the numbers.
The most important number to any broker is Assets Under Management (AUM).
AUM is the measure of how much clients’ money a brokerage has.
For example, TD Ameritrade, before it was bought out by Charles Schwab (SCHW), had $1.3 trillion in assets under management.
Robinhood, meanwhile, has an estimated $20 billion.
The difference between the two is massive.
So there’s no way Robinhood is worth more than TD Ameritrade was.
However, we can compare apples to apples with a ratio.
In this case we’ll use a Market Value/AUM ratio to determine how valuable a firm is relative to its AUM, or simply MV/AUM.
This ratio allows us to compare the largest discount brokers and see how insanely valuable Robinhood has become by turning its clients into its own cash.
We’ll start with TD Ameritrade.
It has $1.3 trillion in AUM and was recently acquired for $22 billion.
That means TD Ameritrade was worth 1.69 cents for every dollar of AUM.
E*Trade is similar.
E*Trade had $600 billion in AUM and was recently bought out by Morgan Stanley for $13 billion.
That means E*Trade was worth 2.17 cents for every dollar of AUM.
Robinhood, meanwhile, has an estimated $20 billion in AUM.
And although we don’t have a market price for Robinhood as it’s a private company, we do know that:
Robinhood completed a $660 million capital raise at a valuation of $11.7 billion, according to reporting from Coindesk.
That means it is worth $11.7 billion (almost as much as E*Trade!) even though it has only $20 billion in AUM.
If we look at the ratio, that’s 58.5 cents for every dollar of AUM.
So on a comparative basis, Robinhood is valued at 27X more than E*Trade, and 34X more than TD Ameritrade.
What could explain the vast difference?
Well, the most obvious is that Robinhood is best at turning its clients into its own revenues.
And that revenue is coming, in one way or another, from its clients.
Three Strikes And Robinhood Should Be Out
In the end, this all amounts to why Robinhood is one of the worst possible discount brokerage options for retail investors.
Robinhood offers a limited range of stocks that its clients can trade. Retail investors using Robinhood can’t tap into many of the best and brightest small-cap stocks in the world because of this.
The high PFOF earned by Robinhood by selling its clients orders to the highest bidder puts its corporate interests far ahead of its clients’ interests.
The GameStop fiasco has exposed that Robinhood doesn’t really care about what’s best for its clients.
If it did, it would never have imposed trading restrictions on GameStop and the other stocks the Redditors were colluding on to push higher.
We don’t mind brokers making money.
But when Robinhood becomes worth 27X to 34X more than its competitors (on a relative basis), you should realize you are paying too high a price to use the platform.
Watch what they do, not what they say.
Ditch Robinhood and find a discount brokerage with lower fees (both direct and indirect fees like PFOF) that gives you access to all the small-cap stocks with the greatest growth potential.
Until then, wishing you many happy returns,
Dear Retail Editorial Team