Robinhood Failed to Disclose True Cost of Commission-Free Trades to Customers. The bill for “commission-free” trading is coming due for broker-dealers. Robinhood Financial, LLC (“Robinhood”) had to pay the price when the SEC fined the firm $65 million for misleading customers about revenue sources and failing to satisfy its duty to seek best execution. Established in 2013, Robinhood was one of the first retail broker-dealers to offer commission-free trading to its customers. The big issue in this case was “payment for order flow.” Here’s how it works: Instead of sending customer orders directly to national exchanges, “Robinhood, like other retail broker-dealers, routed its orders to other broker-dealers (often referred to as “principal trading firms” or “electronic market makers”) to either execute those orders or route them to other market centers,” according to the SEC’s order. The market makers paid Robinhood for the right to execute customer trades. SEC rules permit brokers to receive payment for their order flow, as long as the payments do not interfere with their efforts to obtain best execution. Broker-dealers must disclose payments for order flow arrangements on quarterly reports filed under Rule 606 of Regulation NMS.
The SEC noted that many retail broker-dealers can get better prices (“price improvement”) than those that are publicly available, so the practice can benefit retail investors. There is, however, a trade-off, as Robinhood learned during its negotiations with principal trading firms. Charging more for order flow means less money is available for price improvement. Nonetheless, Robinhood charged principal trading firms four times the going rate for order flow, which ultimately ate into the price improvement investors might have realized on their trades. The SEC found that Robinhood customers lost $34 million due to poor execution compared to competing broker-dealers, even after netting out the approximately $5 per order commissions charged by those brokers at the time.
To add insult to injury, Robinhood was not benchmarking its order execution quality to its competitors until October, 2018. At that point, the data showed that Robinhood’s execution quality lagged behind other retail brokerages by a wide margin. At the same time, the firm’s FAQs on its website claimed that its execution quality matched or beat that of its competitors. Even worse, Robinhood appeared to deliberately hide the fact that it received a significant portion of its revenue from payment for order flow.
The takeaways from this case are that the SEC will continue to look at payments for order flow and how they impact best execution. Broker-dealers and investment advisers should review Rule 606 reports and ask questions about how the routing arrangements might be impacting the execution quality of trades. Contributed by Jaqueline M. Hummel, Partner and Managing Director.
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