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As Robinhood (HOOD) prepares for its IPO on July 29 in a bid for a $35 billion valuation, some analysts warn that the company's business model — specifically its reliance on payment for order flow (PFOF) — is an unseemly practice that won't last.
“This IPO is effectively selling investors on exploiting other investors,” David Trainer, CEO of New Constructs, said on Yahoo Finance Live (video above). "The whole payment-for-order-flow business model is probably not going to be long for this world... it's a legalized version of front-running."
Founded in 2013, Robinhood democratized investing for retail traders by offering zero-commission trading, a practice that was subsequently adopted by other brokerages. (There are roughly 18 million accounts on the platform, with a majority of those users being first-time investors.)
And instead of relying on commissions, Robinhood primarily generates revenue through PFOF — that is, by routing trades through third-party trading firms instead of stock exchanges.
The practice is controversial given the potential for those third-party trading firms to leverage the transaction data provided by brokerages like Robinhood to make their own trades based on that information, an illegal practice known as front-running.
“Payment for order flow raises a number of important questions,” SEC Chairman Gary Gensler said in June. “Do broker-dealers have inherent conflicts of interest? If so, are customers getting the best execution in the context of that conflict?”
In addition to Robinhood, some major brokerages use the practice: TD Ameritrade, E-Trade, and Charles Schwab saw revenues from PFOF triple in 2020.
That said, Robinhood is singularly dependent on the practice: In 2020, according to the company's S-1 filing, Robinhood derived 75% of its $959 million revenue in 2020 from PFOF.
“Some of the larger players that do take payment for order flow are able to probably get away or be able to run their business without that revenue because they have so much more scale in terms of assets and the ability to generate revenue from other sources, which Robinhood does not have,” Trainer said.
Robinhood retail investors 'selling away their trading intentions'
Trainer questioned how long PFOF, which is banned by the U.K. financial regulatory body, will remain legal in the U.S.
“There are some businesses out there... like M1 and Public, who are very outspoken about not taking payment for order flow and really standing up for doing what's right for investors and not really sort of selling away their trading intentions to Wall Street insiders,” Trainer said.
“And they are finding a way to make their business model work that way,” he continued. “So I think there is a way to make the online brokerage business work with a little more integrity and without the conflicts of interest we see at Robinhood.”
"I don't believe that regulators can crack down on payment for order flow because payment for order flow has been going on at Wall Street for 200 years," Interactive Brokers' Thomas Peterffy told Yahoo Finance.
Trainer argued that while Robinhood's lobbying efforts may stave off regulators for now, investors may be less forgiving as time goes on.
“As there's more light shined on this dark corner of the online investing world, how much are investors going to want to give their trades and give their time and equity and trust to a firm that's effectively selling off information... to Wall Street insiders?” he said. “That kind of goes against the whole Robinhood ethos, right? So I just don't know how long that trick works.”
Grace is an assistant editor for Yahoo Finance and a UX writer for Yahoo products.