75% of Robinhood’s 2020 Revenue is From ‘PFOF and Transaction Rebates’

In a recent S-1 filing with the SEC, Robinhood unveiled that 75% of its entire 2020 revenue was derived from ‘PFOF and transaction rebates’. In addition, PFOF and transaction rebates aggregated 81% of the company’s total revenue in Q1 2021. 

Clearly, Robinhood’s revenue is tremendously concentrated around market makers. Could this concentration impact the way Robinhood does business?

How Much Does Robinhood Make From Payment for Order Flow (PFOF)?

2020 was a prosperous year for the modernized stock trading app Robinhood. At a time when a substantial number of businesses faced enduring losses, Robinhood managed to generate a significant boost in revenue. Data reveals that Robinhood garnered a net profit of $7.45 million on net revenue of $959 million in 2020.

Moreover, Robinhood’s Q1 2021 revenue suggests that the fashionable stock trading app has resumed its surge. In comparison to Q1 2020, Robinhood’s revenue increased by a staggering 263%, totaling $331 million, according to an SEC earnings report.

Notably, the S-1 form reveals that 75% of Robinhood’s $959 million revenue in 2020 was derived from PFOF and transaction rebates. Following some calculations, we discover that Robinhood earned a whopping $719 million from PFOF and transaction rebates in 2020. 

In addition, the company has also revealed in the report that 59% of its total revenue in Q1 2021 came from four market makers, which accounts for $195 million. However, what is more surprising is that 43% of Robinhood’s Q1 2021 revenue came from Citadel Securities alone. Considering that Robinhood’s revenue is so fixated around market makers—or Citadel Securities, to be more specific, which has the same majority owner of Citadel LLC the hedge fund—the subject of “conflict of interest” is more applicable than ever. 

Payment for Order Flow (PFOF) is Distorted

Payment for order flow is the compensation a brokerage firm receives from a market maker in exchange for routing trades. Day by day, equity and options trading are becoming increasingly complex. Therefore, smaller brokers that don’t have the capacity to handle thousands of orders themselves, and instead leverage PFOF to both save costs and receive compensation.

However, a brokerage firm can use PFOF to route orders to market makers that not only disregard the best interest of investors but aim to exploit them. In other words, a broker might earn increased compensation for funneling trades to market makers that are not in the best interest of investors. This is where the subject of “conflict of interest” arises. 

In fact, the UK Financial Services Authority (FSA) banned PFOF arrangements back in 2012 because of the “conflict of interest” issue. Likewise, Canada has also banned PFOF for the same reason.

On the other hand, up until recently, the U.S. SEC was content with requiring brokerage firms to disclose their policies regarding PFOF. But with the GameStop saga exposing Wall Street giants’ transgressions, the United States House Committee on Financial Services has started to consider a ban on PFOF.

Can Decentralization Fix PFOF?

Zooming out, one can argue that centralization and the concentration of power almost always leads to discrimination. In the finance world, to overcome this obstacle, there could be a way out: Decentralized Finance (DeFi). Considering it has been around only since 2018, DeFi is still in an early stage of development with a user base estimated to expand over 2 million users.

DeFi aims to reshape the banking system for the entire world, offering an open, permissionless ecosystem where everyone can take part in the global economy. In addition, DeFi removes the need for intermediaries by introducing smart contracts that automatically execute orders. In turn, this will make everything more transparent and drastically reduce the opportunities for bad actors to exploit the system. 

To put this into perspective, think of a PFOF arrangement where brokers and market makers are algorithms that are designed to work automatically. In such a scenario, since human hands are not involved, all trades will be executed in the best possible order, depending on the rules—which are enforced by code—set forth.

Consequently, the major concern regarding PFOF as a “conflict of interest” could potentially be resolved. Whether or not this is actually the way forward, is anybody’s guess at this time. 

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Did you know that Citadel, which had a stake in Melvin Capital (a major GME short seller), has the same majority owner as Citadel Securities, which is Robinhood’s biggest customer? Bearing this in mind, do you think Citadel Securities can influence Robinhood’s decision-making? Let us know in the comments below.