Robinhood Heads for IPO With a Tarnished Reputation

Robinhood Markets Inc., whose popular trading app has either disrupted and transformed the discount brokerage business or turned investing into a video game, depending on your viewpoint, has filed confidentially for an initial public offering of its stock. The question now is whether Robinhood can make the business case to compel users of Robinhood the app to click on Robinhood the publicly traded company. 

Robinhood’s success will depend on which narrative comes to define the company. It sometimes takes a while for the equity markets to discover the truth about a business and for share prices to reflect it. One thing that’s certain, though, is that the day of reckoning always arrives at some point. 

The positive narrative is that Robinhood has a snazzy platform that appeals to investors. Its user interface face is slick, friendly and uncluttered. Robinhood is said to provide the lowest “barrier to entry” for uninformed investors who want to try their hand at the stock market, and it has millions of users. It has been called the “most intuitive app” ever. Robinhood has been credited with motivating the Schwab acquisition of Ameritrade and causing other big broker-dealers to offer commission-free trading platforms.

The alternative narrative perhaps carries more weight, and its centerpiece is Robinhood’s tarnished reputation. In late January, Robinhood dominated the headlines, and not in a good way, by blocking its customers from trading in some of the so-called meme stocks hyped on platforms like Reddit, including GameStop Corp. (GME) and AMC Entertainment Inc. (AMC). Commentators postulated that the company had suffered a reputational catastrophe, “lost the trust of traders” and developed a “big user trust problem” and maybe even a “political problem.”

Robinhood’s botched messaging — Chief Executive Officer Vlad Tenev said on CNBC that the decision was “not based on a liquidity issue” —  and its lack of transparency — there was never much disclosure about the capital call it supposedly received — sent a strong signal that Robinhood was more loyal to the hedge funds and the market makers who pay Robinhood for order flow than to the regular users of its trading platform. “In light of current market volatility, we are restricting transactions for certain securities to position closing only, including $AMC and $GME,” Robinhood tweeted. In other words, it allowed customers to sell their stock but not to buy any more. Thousands of frustrated Robinhood customers surmised that it was more than a coincidence that the downward pressure on stock prices caused by Robinhood’s favoring sell orders over buy orders provided a much-needed lifeline to the powerful hedge funds that had shorted these stocks.

Still more ominous reputational news about Robinhood relates to $65 million in fines the company paid to the Securities and Exchange Commission for misleading customers who lost $34 million on inferior trade prices. In December 2020, the SEC announced that Robinhood neglected to tell customers for four years (2015-2018) that its largest revenue source was derived from the trading firms to which it routed customer orders, a practice that ultimately resulted in trades that generated less money for customers than they would have received at other brokers. As the SEC observed, Robinhood “failed to disclose the firm’s receipt of payments from trading firms for routing customer orders to them, and with failing to satisfy its duty to seek the best reasonably available terms to execute customer orders.”

While Robinhood’s disclosures have improved, its business model still relies crucially on payment for order flow, a practice that has called into question its ability to satisfy its duty as a broker-dealer to provide the best execution of customers’ trades, even when the companies pay for Robinhood’s order flow. (Robinhood says it routes orders to market makers that are likely to provide the best execution based on historical performance.) Payment for order flow has already been banned in Canada and the UK. In other words, Robinhood’s reputational risk is compounded by regulatory risk. 

Many of Robinhood’s shortcomings are hidden from unsophisticated investors. Smart investors with limited capital are better off investing in the low-cost index funds offered by many big mutual fund companies such as Fidelity and Vanguard. Trying to pick stocks, day trade and outperform the market is a tough game that only professional investors should play. Oddly, mutual fund investments are not available on the Robinhood platform. In addition, spreads for cryptocurrency trading are larger on Robinhood than they are on other platforms.

Most important, though, retail investors are going to realize at some point that Wall Street firms are paying for order flow for a reason: Robinhood users are bringing valuable information to the market. At some point they will also realize that it sets up an inherent conflict of interest. 

That’s a reputational issue that’s probably not going away.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Jonathan Macey is the Sam Harris Professor of Corporate Law, Corporate Finance and Securities Law at Yale Law School and a professor in the Yale School of Management.

©2021 Bloomberg L.P.

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