#71 - Robinhood Update: The Lawsuit, Payment for Order Flow & the IPO
Updated: Mar 5, 2022
-FINRA Penalties Assessed on Robinhood -Robinhood’s IPO Details -Payment for Order Flow (PFOF) -How Payment For Order Flow is Transacted -The Pioneer of PFOF That You May Have Guessed
New York (CNN Business) Robinhood has settled a wrongful death lawsuit filed by the family of a 20-year-old trader who died by suicide after seeing a negative account balance of $730,000.
The controversial trading app disclosed the settlement on in its IPO filing. Terms of the agreement were not disclosed.
The family of Alex Kearns, a college student who traded options on Robinhood, accused the startup in a February lawsuit of luring inexperienced investors to take big risks in sophisticated financial instruments without providing the necessary customer support and investment guidance.
The lawsuit accused Robinhood of wrongful death, negligent infliction of emotional stress and unfair business practices.
Kearns' death was cited by Wall Street's self-regulator in a record-setting penalty imposed on Robinhood on Wednesday for harming investors.
FINRA Penalties Assessed on Robinhood
The Financial Industrial Regulatory Authority (FINRA) accused Robinhood of "systemic supervisory failures" and giving customers "false or misleading information." FINRA said that since late 2017, Robinhood "failed to exercise due diligence" before approving customers to trade options.
Robinhood relied on algorithms that "often" approved customers to trade options based on "inconsistent or illogical information," the regulator said.
FINRA ordered Robinhood to pay about $70 million in fines and restitution to harmed customers, the largest penalty ever handed down by the regulator. Robinhood neither admitted nor denied the charges.
Robinhood’s IPO Details
The initial public offering (IPO) is slated for 7/29/21 with a proposed price per share at $38 - $42 with an estimated valuation of $35 billion dollars.
The offering bears some similarity to recent IPOs such as Coinbase Global and Rocket Cos., which made their debut in the midst of crypto and mortgage booms, respectively. Investors had the challenge of trying to chart out a normalized earnings and revenue path. So far, neither of those prior examples have worked out for initial public investors.
Robinhood derives the vast majority of its revenue from trading by its customers, including in cryptocurrencies like Dogecoin. Its primary trading revenue source is payment for order flow, one of the most hotly debated topics in finance and in Washington.
Payment for Order Flow (PFOF)
When brokerage clients place their trade orders, the broker in theory should try to take the trading traffic via the most optimal path so that the trade is executed in the quickest manner with the most efficient fill / trade being placed.
This sounds great; however, your broker may have an arrangement with a third-party processor to reach the destination to place a trade.
The result in any scenario is that the third party pays the broker for sending trading traffic to them. Since they benefit, the broker will receive compensation.
Here’s a loose example of how it works:
-The retail customer place an order for one share of Microsoft
-This order get passed to a wholesale market maker
-The wholesale market maker places an order on NASDAQ market exchange
How Payment for Order Flow is Transacted
-The retail customer places a trade request for the “ask” price of $100
-On the other end there is an “bid” price. This price is what the wholesaler is going to execute the trade at. Let’s say $98.
-So this means there is a two-dollar difference. So the wholesaler takes $1 and gives the other dollar back to the broker
-Now the broker can say . . . we were able to execute your trade at $99.50; so this nice because the price came in lower
-Then the broker keeps the remaining 50 cents as part of doing business
This process is a highly contested one as there is a middleman involved and between the two parties, they negotiate the profit which some argue hurts the trader.
FYI - it is illegal to front-run which means that trades can be deferred or jumped over another meaning they have to be processed in the order they are received.
The Pioneer of PFOF That You May Have Guessed
PFOF was pioneered by Bernie Madoff, ( from Wikipedia) although it was not a factor in the Madoff investment scandal. In a 2000 interview, he described it as a way for market makers to outsource the task of finding orders to fulfill, and compared it to retail arrangements in which a supplier pays for the rack on which its products are displayed.
"No one tells a firm how they can advertise. If I want to hire salesmen to generate order flow, no one is going to object. I don’t have them. So if I want to use Fidelity's salesmen and pay part of my trading profits in the form of a rebate, why shouldn’t I be allowed to do it?
It was characterized as this bribe and kickback and something sinister, which was very easy to do. But if your girlfriend goes to buy stockings at a supermarket, the racks that display those stockings are usually paid for by the company that manufactured the stockings. Order flow is an issue that attracts a lot of attention but is grossly overrated."