Robinhood: The Free Lunch That Isn’t

What do unicorns and free lunches have in common?

That’s right, neither of them exist, (though if I could choose one or the other, I would take a free lunch in a heartbeat). While the phrase, “there’s no such thing as a free lunch” is well-enough known, it’s also one of the most easily forgotten wisdoms in today’s America. We are all so willing to believe that free is good, we scarcely stop to question the price of that free stuff.

And believe me, there is always a price.

 The price of a free piece of fudge outside a candy store may just be stopping and awkwardly eating the fudge without taking the time to enter the store and walk around inside of it, but there’s a reason those candy stores still have free samples.

They want to draw you in.

A piece of fudge is a small cost to potentially selling a whole bar.

Costco’s sampling techniques were tremendously successful pre-coronavirus. Some people went to Costco on Saturdays just to take advantage of the free samples and did quite a bit of shopping in the process. After all, we all need something, right?

One of the most popular free lunches in recent memory is the advent of the free trading app, the most popular and well known of which is Robinhood, whose very name was purposefully chosen to invoke the user with a sense of empowerment.

The very act of being invested in the markets is an act of defiance against the corporate overlords of America who have long made billions from assets while the rest of us have withered away from the effects of taxation and inflation. Taxation and inflation hit the poor much harder than the rich.

One of the reasons for that, is because, during periods of inflation, markets also go up in value, and so, at the very least, you’re not losing as much money as everyone else.

After the 2008 financial crisis, the gap between the rich and the poor in America grew, in part because the Federal Reserve’s easy monetary policies allowed borrowing at such low rates that large companies could still grow, companies that the rich were still invested in.

Poor and middle-class Americans, on the other hand, had to sell what assets they had to stay alive. Hence, people fell away from the markets and the wealthy were able to ride the waves back to the top.

Staying invested makes a difference.

Even if you had purchased your assets at the highest point before the crash, you’d still be making money now if you stayed invested. Stocks rebound. They go up. But taxation and inflation just eat at your money a little bit at a time.

That’s why Robinhood is so appealing. It promises the chance to capture some of that wealth by growth, which, for most Americans is a good thing. We at Emergent try to encourage as many people as we can to become invested and let their money work for them. We do not, however, encourage people to join Robinhood, for a number of very good reasons. Once you know the reasons, however, the choice becomes yours if you still want to remain invested with them.

Here is our first big one:

A free trade is as much of a trap as it is a blessing. Sure a $5 trade is a lot less of a percentage for one million than it is one thousand and hence trade commissions weigh heavier on small traders than large ones, but if Robinhood isn’t making money selling commissions, then, how, exactly, are they making money?

One of the ways is “Payment for Order Flow.”

Payment for order flow is when Company X pays Broker Y a commission. In exchange for this fee, Broker Y routes beneficial orders to Company X so that, with market orders, Company X is receiving the best possible price.

Meaning, when you’re on Robinhood, you’re not going to get the best price possible on every order you make. At least, not if a hedge fund like Citadel is involved. Now, the CEOs of Citadel and Robinhood both claim that payment for order flow is necessary to democratize markets because these payments are the only way to maintain no-cost commissions for Robinhood.

This is true in the sense that Robinhood is a company and not a charity. Access to exchanges is expensive in addition to paying for all their costs and salaries. Someone needs to foot the bill, so why not the hedge funds and big players like Citadel?

At the same time, this is just one of the ways that free trading apps hide how much you are sacrificing on a trade.

Let’s say, for instance, you are buying 1,000 shares of stock A and you put in your market order, hoping to get shares at $10.01. A major hedge fun who’s paid for order flow, however, also wants shares in stock A and they put in an order near the same time. What happens is they’ll grab the shares at $10.01.  

If the $10.01 shares are all filled and the only market orders remaining are for $10.02, your order is filled at $10.02.

You might reply: “that’s just one cent, it’s not $5!”

Well, hypothetical noob-trader, it’s actually much more.

1,000 x $0.01 is $10.

You effectively just paid ten dollars extra that you would not have had to pay if your order had come in before hedge fund’s. It’s possible this can happen on every trade you do or on none of them. There’s really no way for you to know, and hence the true costs of trading free may be hidden from you.

At Emergent Financial Services, we don’t use brokers who follow the practice of “payment of order flow.” Instead, we use brokers who focus on best execution, so orders are filled as they are placed, instead of flowing beneficial orders to large institutions who pay the most money.

This is just one of the ways we protect our clients from predatory services that mask the ways they make money.

There’s more to uncover on the subject of free trading apps. After all, there’s lots of ways they make money that you may not be aware of, but you’ll have to come by next week to check out the other ways that your free trading app lunch is not quite so free.

Until then,

Nickolas Urpí
Investment Strategist