#1235 2013 · Robinhood · Financial technology
Robinhood made stock trades free and billed market makers for customer orders instead
the problem
Brokerages charged $8-10 per trade, pricing small investors out since commissions ate their returns on modest positions
background
Every major U.S. brokerage in the early 2010s charged a per-trade commission, a legacy of a business built around human stockbrokers even after execution had become almost entirely automated. That fee structure made frequent or small-dollar trading uneconomical for retail investors, since a $10 commission on a $200 trade was a 5% tax before the position even moved.
Cutting the commission to zero outright looked like giving up the brokerage's core revenue line for nothing in return, since matching and executing trades still cost money to run. Robinhood needed a way to keep executing trades for free to the customer while getting paid by someone else for the exact same order flow.
what everyone would do
Cut commissions partway to attract price-sensitive customers while still charging enough to cover execution costs — the standard competitive response, which every incumbent brokerage had already tried without eliminating the fee that kept small investors out.
what they saw
A customer's order was valuable to someone besides the customer: market makers would pay for the right to execute it. The commission was just the price Robinhood asked of the wrong party.
the move
Robinhood routed customer orders to market makers like Citadel Securities and Virtu, who paid Robinhood a fee for the right to execute those trades — a practice called payment for order flow. Customers paid no commission at all; the market makers funded the brokerage instead, profiting from the small price differences on the trades they executed.
why it works
The mechanism works because market makers profit from executing high volumes of retail orders at the bid-ask spread, so their willingness to pay for order flow scales with volume rather than depending on any individual trader's fee tolerance. Removing the commission increased trading volume, which increased the very order flow Robinhood was selling — the free price for customers and the paid price for market makers reinforced rather than competed with each other.
the payoff
Commission-free trading forced Schwab, Fidelity, and TD Ameritrade to drop fees too; order flow became Robinhood's top revenue line.
where it breaks
It requires an order or transaction with genuine value to a third party independent of the customer, which works for liquid securities market makers want to trade against but doesn't exist for illiquid or unusual assets no one wants that flow for. It also creates a structural incentive to route orders toward whichever market maker pays most rather than whoever offers the customer the best execution price, which regulators have penalized when the gap grew large enough to harm customers.
what came after
Zero-commission trading is now the retail brokerage default industry-wide, funded by market maker payments rather than customer fees, reshaping how the entire online trading industry makes money.
references
- [1]Here's how Robinhood is raking in record cash on customer trades — despite making it freeCNBC, 2020cnbc.com
- [2]Robinhood Markets, Inc. - Form S-1U.S. Securities and Exchange Commission, 2021sec.gov