New filing shows Robinhood brought in close to $100 million by offloading order flow in the first quarter

As tumult gripped the global market and retail investors flocked to stock and options platforms, Robinhood cashed in big time. The retail brokerage raked in tens of millions of dollars from offloading customer order flow to high-frequency trading firms, according to a regulatory filing by the company. 

According to a new report filed by the California-based firm in May, electronic market making firms like Citadel Securities and Virtu Financial paid the company $91 million in fees in exchange for various types of orders in the first quarter of 2020.

Brokerages like Robinhood are required to file information about their order routing activity each quarter in what is called a 606 report. However, a change to Rule 606 implemented in early 2020 by the Securities and Exchange Commission (SEC) now requires brokers to file even more information, revealing for the first time exactly how much trading firms are paying them in fees. 

Robinhood has drawn the ire of financial media and commentators for one of the main ways it makes money: It routes customer orders to wholesale brokers and high-frequency trading shops for execution — a process known as "payment for order flow." In fact, most retail brokerages do this.

Firms like Citadel Securities can either execute them internally or route them to other exchanges and venues. Retail brokers get better execution for their clients, whereas large brokers get additional volumes that can help lure larger traders.

The new 606a report illustrates the net payment paid by various firms for market orders, marketable limit orders, non-marketable limit orders and all other orders on the platform for non-S&P 500 stocks, S&P 500 stocks and options. The 606a covers most retail orders. 

Net payments made to Robinhood increased from $19.4 million in January to $45.4 million in March. The increase in payments mirrors the spike in market activity as the COVID-19 pandemic swept markets. Indeed, financial media has been abuzz recently about the possible impact of new retail traders pouring into equity markets via platforms like Robinhood.

For its part, Robinhood added 3 million new customers in the first quarter, the company said. The more established players benefited as well. As reported by The Wall Street Journal at the end of April, TD Ameritrade saw retail clients open a record 608,000 new funded accounts in the first quarter. E*Trade and Charles Schwab also set company records with 363,000 and 609,000 new accounts, respectively.

Options growth

As for Robinhood, payments for options flows accounted for the lion's share of all fees in the first quarter. 

That shouldn't come as a surprise. The options market has been red-hot amidst the ongoing economic and health crisis due to COVID-19. Options have apparently found new appeal among retail traders who are both bored and hungry for outsized returns.

"There's no sports to bet on so people are betting on whether Tesla will break $1,000 using options," one former options market maker said of the current market environment.

Average daily options volumes have surged in 2020, increasing from around 19 million contracts traded in all of 2019 to more than 27 million in 2020 to date, according to The Journal.

As for Robinhood's 606, the rates trading firms paid Robinhood for non-marketable options orders increased from February to March. Those rates are set by Robinhood. Making markets in options offers more opportunity for profit due to the volatile nature of such contracts, which translates into wider spreads.

Too concentrated?

Meanwhile, the data indicates that a large percentage of Robinhood's order flow are sent to just a handful of firms.

More than 55% of all market orders are routed to Citadel Securities for S&P 500 stocks. Robinhood also routes 67% of market orders for options to Citadel. In total, Citadel is behind 43% of payments across assets and order types to Robinhood.

In a sense, this indicates how big of a player Citadel is in the market making space. In another sense, it shows how concentrated Robinhood's flows are, according to Joe Saluzzi, co-founder of Themis Trading. 

"That much concentration between two brokers should raise best-execution concerns," Saluzzi said, referring to the obligation that retail brokers have to route orders to venues where they will be executed at market price or better.

Unlike rival Fidelity, which routes S&P 500 orders to 10 venues — including stock exchanges like Nasdaq and NYSE — Robinhood only routes to five. It doesn't route any orders directly to exchanges. 

Furthermore, a lower number of venues relative to rivals might lead to issues pertaining to best-execution, according to Saluzzi. 

Robinhood already has a history here. FINRA fined Robinhood $1.25 million for failures in 2016 and 2017 related to best-execution. The agency noted its "supervisory system was not reasonably designed to achieve compliance with its best execution obligations."

To be sure, Robinhood has addressed these best-execution concerns, noting that its routing systems automatically send client orders to "the market maker among these that’s most likely to give you the best execution, based on historical performance."

PFOF, what is it good for?

Payment for order flow is a thorny subject. While detractors say it can lead to conflicts of interest, advocates say the practice has improved market structure and improved pricing for retail clients. 

Orders routed to market makers can be executed at a tighter spread than on an exchange. That difference translates into not only a payment for the broker but also price improvement which is offered to the end client. According to Citadel Securities, the firm provided 10 times more in price improvement than PFOF for marketable equity orders in the first quarter of 2020.

"While the world of payment for order flow sounds murky, it really is not — and the alternatives have problems," as market structure specialist Larry Tabb noted in an op-ed for The Financial Times. "The system as it is provides both individual investors and their brokers with the surety of best execution in a market dominated by faster, larger and more sophisticated investors."

Editor's Note: Clarification in the year of the Rule 606 change. It is 2020, not 2019.