Following Robinhood’s lead many U.S. retail brokerage firms have not only cut brokerage fees to zero, but they are earning a growing share of their revenue from payment-for-order-flow (PFOF) strategies. In fact, PFOF has become very big business. More than 75% of Robinhood LLC’s firm revenue over the last five quarters came from PFOF, reaching $720m in 2020 and $341m in Q1 2021 alone. The 2020 figure includes $27 million in crypto “transaction rebates”, which Robinhood earned from select crypto exchanges after routing crypto trades to them. The crypto trading rebate grew to $88 million in Q1 2021 thanks in large measure to the crypto and dogecoin trading frenzy while boosting the contribution of cryptocurrency revenue to 21% of Robinhood’s overall total from 4% a year earlier.
This controversial practice in which some market makers like Citadel Securities pay brokerages like Robinhood lucrative fees to execute the trades has allowed these middleman firms to be the primary way to offer zero-cost trading. However, some successful brokerage firms like Fidelity and eToro have steered clear of this trend. Additionally, a rising tide of digital assets and blockchain-based alternatives are providing a new set of challenges to PFOF models.
Background on Payment for Order Flow
PFOF is legal in the United States if it gives the trader a price that is not worse than the prevailing National Best Bid and Offer (NBBO) at the time of the trade. But to fine tune brokers’ focus on the use of PFOF, the Financial Industry Regulatory Authority (FINRA) sent brokers a letter on Jun 23 in which it emphasized that their duty to clients requires them to direct to sources providing the most beneficial terms for their customers. The message – simply good is no longer good enough.
Here is an example of how it works. Say you want to buy ten shares of Tesla on a commission-free broker such as Robinhood at $649.26/share. You place the order and see the details pop up on your device, thinking that the transaction was just settled on an exchange. Your trade was confirmed at $649.26. Great! But behind the scenes the broker could have routed the trade to a market maker such as Citadel, Global Execution Brokers, or Virtu in exchange for a rebate equivalent to a few pennies/share. Add those pennies per share times millions of trades monthly, and the silent commissions add up.
Think of these half-dozen large firms as the Walmarts of Wall Street: They have huge order volume and beat the competition by making such a tiny margin on retail trading flow that the smaller stores in our analogy can’t quite compete.
It is worth noting that PFOF pre-dates Robinhood, but the fintech startup turbocharged the practice sometime after 2013 when it originated the zero-commission business model. Back then the prevailing brokerage industry charged clients $7 to $10 per trade. Since this inflection point, many companies attempted but ultimately failed to transition into this new era of zero-commission trading. One notable exception is Charles Schwab, who turned to PFOF to dramatically boost its brokerage revenue in 2020 to $621 million– a 350% increase over what the firm earned in 2018 or 2019.
The Hidden Cost of Free Commissions
That said, there is no such thing as a free lunch, or trade, and investors are just now finding this out when it comes to PFOF. First, it is hard to prove or disprove that one of these market makers offered (or didn’t offer) best execution in today’s convoluted U.S. market structure. This opacity in turn creates skepticism that gets directed towards this oligopoly of brokers and makes observers wonder if they are engaging in uncompetitive behaviors such as front-running client trades (since they know what trades are coming in and can theoretically exercise discretion in their ordering). Robinhood now discloses that its order routing procedures seek the best price for clients, but this only happened after a 2020 no-fault settlement with the Securities and Exchange Commission (SEC) where the regulator ordered Robinhood to pay $65m in penalties for not disclosing its PFOF practices to clients and not necessarily giving them best execution.
A PFOF Alternative – Internal Netting
One compelling alternative to PFOF is an approach called internal netting. Netting occurs when a large brokerage firm internally helps match buyers and sellers of a given stock, such as Tesla, to make money off its internally published spread, which in principle tracks the prevailing NBBO. In this process, the broker reduces the need of clients to have to procure external liquidity to satisfy a trade, i.e. PFOF. Additionally, whereas PFOF requires all trades to be sent to the public market, internal netting means that some trades will go to the interbank market (where financial service firms trade amongst each other). Netting will thus result in less potential information leakage and eliminate the chance that a trade order is rejected. The potential downside of a broker doing netting is if it lacks the sophistication to keep its books in order, it could cause havoc in the system or leave a particular firm financially vulnerable.
Two firms that have found a way to use netting to successfully compete with the PFOF model are Fidelity and Israeli-based eToro. As the largest brokerage firm in the world, Fidelity has scale to do things differently than its competition. Fidelity does internal netting for stocks and it regularly sends trades to the same market makers as Robinhood or Schwab, but it refuses to accept payment for order flow. However, that does not always mean that its practices are beyond debate. Additionally, PFOF’s gravity can sometimes be too hard to resist. In a public spat between Fidelity and Charles Schwab, Schwab CEO Walt Bettinger II noted that Fidelity accepted payments for flow for options orders and that one of its units (presumably Fidelity’s National Financial Services, or NFS) acts as a principal and makes money matching retail flow against institutional orders. A Forbes review of Q1 2021 routing reports under SEC Rule 606(a) for the relevant brokerage firms confirms that unlike its peers Fidelity does not receive payment for order flow in equities trades, but does so for options trading. Rule 606 mandates US brokers to reveal details of how customer traders are routed and who, if anyone, paid for that order flow.
eToro in turn is a brokerage firm regulated in four continents that added bitcoin in 2014 – a very early time for any firm. eToro plans to list its shares on Nasdaq in late 2021 as part of a $10 billion Special Purpose Acquisition Company (SPAC) merger. The firm derives most of its revenue from Europe but is in the process of broadening its international footprint with expansion in the United States. The firm offers spot cryptocurrency, commodity securities like crude oil and gold, popular stocks and indices, and novel products that allow investors to copy the trades of vetted trade leaders. eToro reports having more than 20 million registered users and more than 1.5 million funded accounts in its investment network.
I first spoke to eToro CEO Yoni Assia in 2011 when his firm was then a fast-evolving, tech-heavy brokerage firm with little regulatory oversight and a focus on gamification of investing and “copy trading” of leveraged products.
The firm’s early revenue model was based on having an above-average price on tradable products on its trading platform, partly because the service was aimed at young audiences completely new to investing. This practice was not particularly sustainable in the long run because it contributed to faster instances of client attrition and poorer investment outcomes. eToro experienced a major change of heart in recent years, as it lowered spreads (the difference between the price at which eToro transacts with buyers and sellers) and simultaneously broadened its appeal to cash (unlevered) clients wanting to hold individual stocks and indices.
A burning question I had for Mr. Assia in researching this report dealt with how the company made money in a world where the competition does not charge a commission.
“We generally make all our money by aggregating all of the data flow ourselves” he indicated, adding details of how they’ve grown in sophistication to manage both their risk and ability to turn client flow into revenue without revealing client positions to liquidity providers. “Our head of quantitative trading comes from a high frequency trading firm, from Virtu.”
In a simplified example, Mr. Assia illustrated how eToro supports the trading activity of 1.5 million funded account holders, some of which are buyers of Facebook stock and others are sellers. While eToro clients don’t pay a commission, they incur a small spread cost for the stock they buy or sell. eToro pays that same spread to banks like JPMorgan Chase that provide liquidity, akin to broker agents who transfer to clients an industry cost. As buyers and sellers for the same stock carry out their transactions, eToro fills client orders by matching buyers and sellers within its vast social network as much as possible, capturing in the process a 1% spread of all that is traded. That 1% is actually a pretty large haircut in today’s market, but eToro’s equity business hasn’t operated in the U.S. where the NBBO offers a benchmark spread of how much a client should pay. Since there is no perfect correlation between buyers and sellers at any given time, there is a net amount that a brokerage firm needs to hedge. Ultimately, eToro algorithms determine whether one or more trades are needed to hedge the Facebook exposure in our example.
Assia summarizes: “We internalize that flow in an algorithmic, real time, market making basis” and adds “We are giving pure stock spread and no commission stock trading.”
Time Running Out for PFOF?
As retail trading of both the crypto and traditional variety exploded during the pandemic, additional scrutiny has fallen on the business models of companies like Robinhood and eToro, when it comes to the fine print that comes with commission-free or low-cost trading. In light of the GameStop fiasco this has also become a hot topic for the U.S. Securities and Exchange Commission (SEC) and Congress.
During recent testimony before a Congressional panel, the SEC chairman Gary Gensler noted that he asked his staff to revisit the regulations governing a variety of areas including PFOF, casting a dark shadow over Robinhood’s business model. Robinhood itself disclosed in its S-1 filing that should the practice of PFOF be banned, it would “require us to make significant changes to our revenue model, and such changes may not be successful.”
The Robinhood statement that it now routes orders keeping investors’ best execution in mind is somewhat reassuring, as is the fact that their efforts to go public suggest that the company will be on good behavior. That said, best execution can be hard to execute, even for Robinhood. Not all brokerage firms possess the sophistication to route trades properly or police their liquidity providers, and firms like Robinhood may sometimes find themselves in uncomfortable situations where they feel pressure to route a trade to a key partner. One can make the case that there is a condition of dependence for a PFOF broker relative to its few major liquidity providers that creates conflicts of interest.
Crypto Crashing the Party Through a Third Door?
As we try to predict the future of these platforms and business models, it is also critical to understand what crypto and blockchain can offer to the discussion. After all, eToro, Robinhood, and countless other brokers have seen their bottom lines go up dramatically due to unprecedented interest in the space.
Digital assets (native crypto assets or tokenized versions of stocks/bonds/etc) and blockchain-based settlement mechanisms might provide a compelling alternative to internal netting or PFOF while preserving the low-cost trading models that have become so popular. Consider the following advantages that it can offer:
- Moving money around faster. Today the capital investors use to buy stocks, or futures, or crypto is segregated and requires investors to liquidate investments and convert to US dollars or other fiat currency before sending that capital from one broker to another – a process that is tedious, costs money, and takes days. Soon, investors can own digital forms of their favorite asset class (i.e., tokenized stocks, tokenized indices, cryptocurrencies, tokenized futures contracts) in universal wallets and portfolios, which will have the following benefits:
- Settlement of digital assets occurs in seconds, minutes, or hours, compared to today’s norm of T+1, which stands for ‘next day’ settlement; not only will it be faster, but it will require little or no reconciliation and handling trade exceptions by hand – two aspects in today’s way of doing things that add costs that investors must pay indirectly
- Investors custody their own investments. Right now, if an investor has any traditional investments, they are kept by some custodian and rarely do they hold any type of bearable instrument. With digital assets, investors have the option but not the obligation to custody bearable instruments of their portfolio in the wallet of their choosing.
While this may seem far-fetched, blockchain-based trading is closer than you may think. For instance, FTX, a crypto exchange offering a variety of spot and derivatives crypto securities, partnered with Switzerland-based Digital Assets AG to tokenize popular stocks like Apple and Tesla so that a fully collateralized stock token can trade on the FTX platform alongside cryptocurrencies. One of most novel aspects of this approach is that Digital Assets AG used the Solana blockchain to develop a broker-agnostic wallet service so that investors custody their own investments and change brokers or trading platform, as needed, without the assets having to move from wallet to wallet or from wallet to fiat back to wallet. That said, Binance, the world’s largest cryptocurrency exchange, had to recently abandon a similar offering due to regulatory pressures, so it appears that tokenized stocks will have to account for both regulatory and technological challenges as it moves forward.
Additionally, before all of this goes mainstream crypto trading will need to going through a similar transformation to a low-cost world. Because of its novelty, crypto trading is one of the most lucrative and expensive brokerage businesses in the world today. Exchanges can charge fees equivalent to 5% of the transaction amount if the purchase was made through a credit card, and 1.5% if it was made by fiat currency. These huge spreads allow crypto exchanges to pay brokers like Robinhood what it calls transaction rebates.
Industry insiders and exchange executives recognize that they will also need to adapt to this lower cost environment. Right now, many centralized exchanges use a process akin to internal netting as a way to avoid blockchain transaction fees, which can rise to $50-$60 dollars during times of high use. Decentralized exchanges that do not exist on blockchains do not have that option. All products at a novel stage command a higher cost which falls over time as it becomes commoditized. Crypto exchanges have a limited amount of time to:
- Figure out how else they can add value to a customer before fee compression and higher regulatory costs cause a profitability squeeze to weed out the weaker ones.
- Identify opportunities to lower costs such as adding support for faster and cheaper blockchain-based payment rails such as the lightning network on Bitcoin
The world still needs brokerages to be able to make money to fund the breaking down of barriers that keeps investor capital tied up in antiquated silos. In my opinion, internal netting is likely to prevail over PFOF as the primary business model for traditional brokers. The world needs both brokers and crypto exchanges to be highly sophisticated using the latest technology to give traders best execution and they need capital to pay for the higher regulatory costs which in turn give more peace of mind to retail investors. However, both PFOF and netting face similar threats in the form of cryptocurrency exchanges and brokers that have tokenized assets and blockchain-based settlement infrastructure based into their DNA.
 A security’s NBBO price originates from an industry body that calculates it using prevailing prices from multiple exchanges and trading venues and constitutes the tightest bid-ask spread.