The rise in popularity of zero-commission investing platform Robinhood Markets (NASDAQ:HOOD) has been the most important event in the financial markets in the past decade. That’s right, I said it. Furthermore, the HOOD stock debut was the most impactful initial public offering so far in 2021.
Actually, I’m probably not saying anything controversial here. Many commentators have declared, more or less, that the advent of commission-free trading marked a sea change in personal finance. And now, in a weird twist, the retail crowd can trade HOOD stock, which represents the platform that opened up trading to much of that same retail crowd.
Wouldn’t it be a shock, though, if the government put the kibosh on Robinhood’s business model? Shocking though it might be, don’t dismiss the possibility. Keep your eye on the Securities and Exchange Commission’s (SEC) next moves, which could be make-or-break for Robinhood.
A Closer Look at HOOD Stock
Robinhood’s IPO was one of the year’s most highly anticipated. On July 29, HOOD stock went public at $38 a share. While that was at the low end of the anticipated range, shares still fell more than 8% on their first day of trading. I suppose we could call it an instance of “buy the rumor, sell the news.”
Now, I can’t actually prove that the Reddit short squeeze mob was responsible for the share-price rally that came next. Yet, it’s certainly a possibility. I’ll let you decide for yourself what precipitated the moon shot in HOOD stock on Aug. 4.
On that day, a Reuters headline announced, “Robinhood surges 65% on Reddit buzz.” The share price topped out at exactly $85, before closing up just over 50%. As is often the case, though, price chasers were punished. HOOD stock has seen its value cut by more than half, with shares currently trading around $41 and change.
That’s a pretty ugly technical picture, and the fundamental picture isn’t exactly ideal, either. Robinhood’s trailing 12-month earnings per share is -$8.50.
How Robinhood Makes Money
OK, I’ll admit it. I got caught up in the hype, too. While HOOD stock was flying high in August, I predicted it would reach $100.
And it still could. Anything is possible, after all. Yet, now there’s a threat to the payment-for-order-flow practice, one of Robinhood’s largest revenue sources, that cannot be ignored. I’ll try to explain what this means as concisely as possible for the uninitiated.
Commission-free brokers like Robinhood make money, in part, by routing customers’ buy and sell orders to market makers. The market maker’s role (among other things) is to “inventory” or store shares of stocks and other assets, and to play matchmaker between the buyers and sellers so the trades can take place. The market maker pockets the difference between a stock’s bid price and ask price, which can add up to millions or billions of dollars. Therefore, the market makers are often more than happy to pay Robinhood to send them order flow.
This payment-for-order-flow business arrangement has been quite lucrative for Robinhood. In the first quarter alone, Robinhood received a whopping $331 million in order-flow payments. That represents a roughly 264% increase over the $91 million from the first quarter of 2020.
Here’s the rub, though: The government might step in a put an end to this practice.
A Bombshell From the SEC
In December, the SEC effectively charged Robinhood with poor trade execution. Those paid market makers were allegedly executing trades at inferior prices in exchange for high order-flow payments.
In June, SEC Chair Gary Gensler said that certain types of payment for order flow “raise questions about whether investors are getting best execution.” Moreover, Gensler said in a recent Barron’s interview that the practice of payment for order flow involves an “inherent conflict of interest.” In fact, he went so far as to say that an outright ban of payment for order flow is “on the table.”
This week, Robinhood’s Chief Legal Officer Dan Gallagher defended the payment-for-order-flow practice, arguing it benefits retail investors. Gallagher said he believes the SEC is “going to arrive at the conclusion that payment for order flow is undoubtedly an amazingly good thing for retail investors and they’re not going to ban it.”
“The notion that our customers are stupid, that they need protection, that they need the government and the nanny state to come out and save them for making bad decisions, I think they’re insulted,” Gallagher continued.
The Bottom Line on HOOD Stock
You might agree with Gallagher that banning payment for order flow is government overreach. And perhaps Gensler is all bark and no bite. But, as an investor, I’m simply not interested in trying to play a game of chicken with the SEC.
If payment for order flow is banned, Robinhood will lose one of its primary revenue sources. Therefore, the best strategy for investors is simply to let the dust settle and see where Robinhood stands, legally and financially, before taking a position in HOOD stock.
On the date of publication, David Moadel did not have (either directly or indirectly) any positions in the securities mentioned in this article. The opinions expressed in this article are those of the writer, subject to the InvestorPlace.com Publishing Guidelines.
David Moadel has provided compelling content – and crossed the occasional line – on behalf of Crush the Street, Market Realist, TalkMarkets, Finom Group, Benzinga, and (of course) InvestorPlace.com. He also serves as the chief analyst and market researcher for Portfolio Wealth Global and hosts the popular financial YouTube channel Looking at the Markets.