There's gold in them there smartphones. This CNBC article on the new breed of mobile brokerages, especially Robinhood, might as well have that quote as its lede.
When I started in the Equity Research department at Lehman Brothers in 1992, we had analysts with many industry plaudits, including industrials analyst Bob Cornell, who used to describe an equity analyst's job as "professional cynic." So, why, in the very same industry, is there so little cynicism when it comes to Robinhood and this generation's crop of commission-free online brokerages?
Well, Robinhood and others have built a better mousetrap, not surprisingly for themselves, not for "the greater good." The steady and often price-inelastic demand for trades that Robinhood sees is an absolute gold mine for larger brokerage operations that actually execute those trades.
As noted in the CNBC article, larger operations like Citadel, Virtu (VIRT) , Wolverine, G1X and Two Sigma pay Robinhood for the right to execute your trades. Why? Because if you knew where the order flow was going to be because you are handling it, you could decide when and to where it would actually flow. Thus, you would have a huge advantage on other market participants.
Ken Griffin at Citadel is the master of this. According to this article in the bible of institutional research, Institutional Investor, Citadel is taking a whopping 65.5% of Robinhood's order flow, as per the company's most recent filing with the Securities and Exchange Commission. In the second quarter of 2020, according to CNBC's research, Robinhood earned an average of 17 cents per equity trade in payment for order flow and an astounding 58 cents per options contract traded. The payment for order flow will always be higher on options trades owing to the much lower liquidity of the contracts and the multiplicative factor therein. As a frequent options trader -- I do not use Robinhood for my or my firm's accounts -- I find the notion that some entity is making 58 cents per options contract traded to be an obscene one.
When I was at Lehman Brothers (Bob Cornell was one of our most highly-rated analysts) we used to call the institutional share-trading business "the six cents-a-share business." That was a common commission rate for large, institutional clients. That six became five, and then people stopped talking about the numbers completely, presumably because the spreads had narrowed so much. That was 28 years ago.
If you are using Robinhood today, you are paying approximately 3-times what the big boys paid a generation ago. You are also paying multiples compared to what those very same big boys are paying in today's electronically-dominated world of stock trading. Why? Are you getting something for that? It's not better execution, believe me. These trades are routed algorithmically; it's all done by computers. Your trade matters no more or less than one done by Mister J.P. Morgan (JPM) . That's an old Wall Street saying, since Mr. Morgan actually died on March 31, 1913, but it makes my point.
Apps like Robinhood make trading so darn easy, and that is ultimately what their users are paying for. A few clicks on the touch screen of your smartphone, and you are done. Are you being ripped off in return of that convenience? Seriously? Of course you are.
There's an economic concept called a zero-sum game, and payment-for-order-flow scenarios like Robinhood's often rely on market participants' lack of knowledge of the true economic benefits of any transaction. That's exactly what happens with stock trading. The actual sum is much higher than one might assume, because the value of knowing when and what price orders will be placed is very difficult to quantify, but certainly more than zero.
Remember that the next time you whip out your smartphone to make a trade. Why are these online brokers, not just Robinhood, making it so easy for you to do it? Not because they love your account balance, but because they depend on it for profitability. Be careful when and with whom you trade. Gordon Gekko taught Bud Fox the value of information in 1987's "Wall Street," but sometimes it seems like no one learned the lessons from Oliver Stone's great film.
Pay attention. As TheStreet's founder Jim Cramer likes to say "Stop trading." It's good advice these days.