How Does Robinhood Make Money?

Robinhood has been the go-to online brokerage for millennial investors because of its commission-free model, and Robinhood says its mission is “to democratize finance for all.” That sounds great and all, but there’s got to be a catch, right?

Robinhood’s business model and revenue recently came under question in January of 2021 after the brokerage raised margin requirements and froze trading on certain stocks, including GameStop, AMC, and Blackberry.

There have been controversies regarding how Robinhood makes money going back several years, including investigations by the Securities and Exchange Commission (SEC), Financial Industry Regulatory Authority (FINRA) fines, and class action lawsuits.

So How Does Robinhood Make Money With No Fees? And Is It Legit?

What is Robinhood?

Let’s start with a little background on Robinhood. It was founded in 2013 by Vladimir Tenev and Baiju Bhatt, who met as classmates at Stanford back in 2005. The Robinhood app has a user-friendly interface, and it has made a name for itself as the first commission-free brokerage app.

Robinhood quickly grew to over 20 million users in 2020, seeing over $150 billion in transactions. Its low-cost business model attracted many millennial users, and it sparked other brokerages, like Charles Schwab and TD Ameritrade, to adopt its same commission-free model.

Commission-free trades make investing more affordable to new users, but there’s a reason Robinhood can offer those free trades.

Payment for order flow (or PFOF), which I’ll explain more about in just a second, is one reason Robinhood can offer such an affordable alternative to traditional investing. PFOF accounts for almost half of its revenue, and it was why Robinhood got in trouble with the SEC for not fully disclosing its payment for order flow practice until 2018.

Related: Micro-Investing 101: Best Apps for Beginners

How Robinhood Makes Money

To offer commission-free trades and a range of affordable financial products and services, Robinhood has several streams of income:

Payment for order flow

According to the SEC, “Payment for order flow is a method of transferring some of the trading profits from market making to the brokers that route customer orders to specialists for execution.”

What that means in simple terms is that when you buy a stock or other kind of security, your trade is first routed through a high-frequency trading firm (often known as “market makers”). The market maker pays the brokerage a small fee to execute clients’ orders. The market makers are also compensated for the trade based on the spread between the bid and asking price.

The spread is the difference between the bid (highest price a buyer is willing to purchase a stock) and the asking price (lowest price someone is willing to sell a share.

It’s beneficial to smaller brokerages to use PFOF because they can’t easily handle thousands of orders. They send orders off and are paid compensation for the practice to keep customer costs low, but the problem is that there’s a gray area when it comes to whose best interest the market makers are looking out for because they can play multiple sides of the trade – and it’s beneficial for them to do so.

Interesting side note: payment for order flow was pioneered by Bernie Madoff. Yes, that Bernie Madoff.

This may sound nefarious, but it’s actually a practice used by many discount or retail brokerages – Schwab, E*Trade, Robinhood, and TD Ameritrade all do this. These brokerages outsource your trades to firms like Citadel, Two Sigma, and Wolverine Securities, who pay for the right to handle your trades.

The amount brokerages are paid is a tiny amount per share. According to SEC filings, Robinhood makes around $0.20 per equity trade, and closer to $0.60 per option trade. Those are small amounts of money, but they add up quickly. Robinhood made over $600 million from payment for order flow in 2020.

Because payment for order flow can create a gray area, brokerages are required by the SEC to disclose their financial agreements with the market makers.

However, Robinhood hasn’t always done a great job at disclosures, and in December of 2020, the SEC charged Robinhood with a failure to disclose this information between 2015 and 2018. Robinhood agreed to pay $65 million to settle the charge.

Robinhood Gold

Robinhood Gold is Robinhood’s premium account option and costs users $5 per month. It’s not as exciting to talk about as payment for order flow, but it does come with extra features like:

• Access to professional research and NASDAQ Level II market data
• Instant transfers up to your Portfolio Value starting at $5,000, compared to $1,000 with a standard account
• Your account is approved for margin trading (this is another Robinhood revenue stream in itself, and I’ll explain it next)

Robinhood Gold is free for the first 30 days. Clients can give it a try, and if they like it, Robinhood will bill them $5 every 30 days for the service.

Margin lending

This is the practice of borrowing money from a brokerage to purchase an investment. The securities in your account are the collateral, and margin refers to the difference between the total value of securities held in an investor’s account and the loan amount.

You’re basically borrowing money to buy investments, and with any kind of loan, you have to pay back the loan with interest. It’s also worth noting that the money Robinhood is lending for trading on margin is uninvested cash that clients keep in Robinhood accounts. This is how banks lend money.

You have to be a Robinhood Gold subscriber with at least $2,000 in your account to trade on margin. Robinhood gives you up to $1,000 in margin, but you pay 2.5% yearly interest if you borrow more.

Margin lending can be used to trade securities or meet short-term financial needs. But as far as margin trading, it’s not recommended for stock market beginners.

Uninvested cash

It’s not uncommon to have uninvested cash in your brokerage account. You might be deliberating on how to invest the money, holding it for future investing, or it could be income earned from dividends.

Robinhood generates income from that uninvested cash in a couple of different ways. I’ve already mentioned the first: margin lending. Robinhood may use uninvested cash to fulfill margin trade for Gold inventors.

Robinhood earnings also come from taking uninvested cash and depositing it into interest-bearing accounts. This is called “sweeping” and cash often goes into a money market account.

Many brokerages offer you the option of sweeping your uninvested cash into an account that earns you interest. Betterment has a feature called the Two-Way Sweep that uses an algorithm to analyze your checking account to find your spending sweet spot and then moves uninvested cash into low-risk ETFs in your savings account. But it works the other way too if cash in your checking account gets too low.

Cash management

In 2019, Robinhood launched a Cash Management feature that lets users save uninvested cash in a brokerage account so it can earn interest. This is the alternative to letting Robinhood earn interest on your invested cash.

This is an FDIC-insured account without account minimums, transfer fees, or foreign transaction fees. Robinhood still makes money on this account through interchange fees (fees the merchant’s bank account must pay whenever a customer uses a credit/debit card to make a purchase from their store). They also make money on fees received from program banks for sweeping funds to them.

Miscellaneous Robinhood fees

Does Robinhood have fees? Yes, even commission-free trading brokerages have fees that investors may have to pay. Here are the miscellaneous fees Robinhood investors may encounter:

• Regulatory trading fees: $22.10 per $1,000,000 of principals (sells only)
• TAF (Trading Activity Fee): $0.000119 per share on equity sells and $0.002 per contract on option sells, no greater than $5.95
• American Depository Receipts: These are a form of equity security created to simplify foreign investing for American investors, and some have custody fees
• ACATS (Automated Customer Account Transfers) or outgoing transfers: $75

Robinhood also charges for paper statements and confirms, overnight mail fees, and overnight check delivery.

Criticism About How Robinhood Makes Money

The Robinhood business model is stated on its “how Robinhood makes money page.” Yes, they have one and you can go check it out after reading this article. The criticism is about what Robinhood doesn’t make clear to their clients.

Payment for order flow is a major concern. There was the SEC investigation about how Robinhood didn’t disclose that they received payments from market makers until 2018, and Robinhood settled this civil fraud investigation with a $65 million fine in 2020. And back in 2019, FINRA fined Robinhood $1.25 million with best execution violations between 2016 and 2017.

Best execution refers to the legal mandate brokerages have to put their clients’ interest first. That includes a better price, speed, and likelihood of trade execution. The brokerage is supposed to overlook what a market maker might pay them for a trade and go with what’s best for their client.

The SEC alleged that, “‘Commission-free’ trading at Robinhood came with a catch: Robinhood’s customers received inferior execution prices compared to what they would have received from Robinhood’s competitors.” Adding, “These inferior prices were caused in large part by the unusually high amounts Robinhood charged the principal trading firms for the opportunity to obtain Robinhood’s customer order flow.”

To put it simply, the SEC claims that Robinhood put their best interest over their clients’.

Another issue is that Robinhood’s business model encourages risky trading for inexperienced investors, like margin lending and options trades, which are really complicated practices for newbies. Massachusetts securities regulators filed a complaint against Robinhood citing these concerns in December of 2020.

The Massachusetts complaint also addresses outages on the platform when clients weren’t able to access their cash or securities. Other clients have filed class-action lawsuits because of these outages.

There’s also a 20-year-old client who died by suicide in June of 2020 after not understanding how a “bull put spread” (a kind of complicated options trade not meant for new investors) made his Robinhood account temporarily show a negative balance of $730,165. Bull put spread is an options strategy that an investor may use when they expect a moderate rise in the increase of an underlying asset.

And of course, there’s the whole GameStop issue in January of 2021 when investors in the subreddit r/WallStreetBets and others coordinated a number of major short squeezes. There wasn’t just the issue of Robinhood halting trades – there’s a major conflict of interest here.

See, Robinhood routes more than half of its customer’s trades (this is PFOF) through Citadel Securities, founded by Ken Griffith. Griffith also owns Citadel LLC, a hedge fund that helped bail out Melvin Capital, another fund that sank because of the short squeezes. The concern is that Ken Griffith may have pressured Robinhood to limit trades.

We can expect to hear more about Robinhood and Citadel as they, and others, are set to testify before a House committee on February 18, 2021.

The Final Word on How Robinhood Makes Money

While Robinhood may have practices that some people call questionable, the reality is that many brokerages and banks make money in really similar ways.

Payment for order flow is something many discount brokerages do. If it’s a deal-breaker for you, Fidelity, Betterment, Interactive Brokers, among others, don’t sell order flow.

The best thing you can do for yourself is to keep educating yourself and do your due diligence. Research brokerages before you start investing and remember that free isn’t always free.