Ok, Elon Musk was right
Robinhood has always had to thread the needle between a populous mission to upend the establishment ($0 trades for everyone!) and running a real business (enough revenue and growth to successfully take the company public).
So what’s the answer? Unfortunately, it’s what Elon Musk was alluding to on Sunday night on Clubhouse when he asked Vlad Tenev, Robinhood’s CEO: “Did you sell your clients down the river or did you have no choice?”
It looks like the answer was “yes” to both.
Selling Clients Down the River
Unfortunately for its customers, Robinhood has misaligned incentives between their customers and their revenues – that have been structurally in place since the company’s early days.
This is summarized in one simple chart:
(Source: CNBC. Full article here)
According to this data, Robinhood is generating an annual run rate of nearly a billion dollars through order flow (an amount I’d venture to guess is even higher now). Furthermore, they’ve chosen to accept higher margins than most of their competitors. Clearly, customer frustration this week was warranted.
(Source: Business Insider. Full article here.)
If this sounds unjust to you, well, that’s because it is. They’ve settled a lawsuit on this topic already, but the structural misalignment of incentives continues.
Robinhood did, in fact, have no choice
In many ways, the Robinhood team really did have no choice as well.
The NSCC capital requirement – part proprietary value-at-risk calculation, part discretion – was indeed a genuine requirement for Robinhood to operate. To their credit, the Robinhood team renegotiated the amount down quickly, and Robinhood’s CEO is right for arguing that the T-2 settlement system is in large part to blame, and trading should occur in real-time.
However, Robinhood is also now implicitly beholden to the hand(s) that feed it. More specifically, market makers (like Citadel) that provide a significant portion of Robinhood’s revenue are the same firms that make billions in profit annually while shaping the NSCC’s rules.
I shudder whenever I hear PR reps from firms like Citadel explaining their work and mention the ‘social good’ they do and the ‘small profit’ they’re required to take (like this one from Citadel explaining what a market maker is) – the combination of which leads to billions in profits every year.
It’s not hard to see that a few large players are acting much like an oligopoly and using their structural advantage to extract excessive rents from the masses.
In short – they’re ripping a lot of people off.
How markets should ideally work – hello, blockchain and updated regs
In an ideal world, trades should be able to happen directly between buyers and sellers – with market makers serving as a secondary/backup option, driven by buyer and seller preferences.
More specifically, a buyer and seller could specify the parameters for a sale (buy and sell price) along with how long they’re willing to wait, and a trade could be cleared directly between parties – a la digital barter.
If a market for a security is less liquid or someone wanted to trade in real time, they could specify that, work with a market maker up front and pay a clear and pre-agreed on fee for this.
Ideally, regulators would require brokers (in conjunction with market makers) to make this fee transparent (before each trade, not buried deep in brokerage disclosures), and educate customers about better trading options.
In terms of implementation – while I generally believe blockchain is hyped up and is more often than not a shiny technology in search of a use case, this might be a great use case for it.
I’m sharing this in broad brush strokes, and I know many companies and startups have already started chipping away at the edges here, but it feels like we are still in the early innings.
Customers have a right to be angry.
Robinhood has a right to make money, but should do so transparently.
Regulators need to step in to fix structural misalignments, and keep consumers informed of ways they are paying more than they need to.
And while we’re at it, let’s see if blockchain can support this use case on a wider scale, and build a direct trading Robinhood with true alignment between its customers and shareholders.