SEC charges Robinhood $65M for misleading customers about revenue sources

Here's an analogy I once heard from Matt Andresen (founder of Island, one of the major early electronic exchanges). Equity markets are like a high-end clubs in Miami. A club that doesn't make any effort at "face control" at the door will find that it's ratio of guys-to-girls will continuously skew higher. And both groups will eventually stop going to any venue where the guy-to-girl ratio is persistently too high. However guys generally are willing to pay more than girls for entry, so it's a balancing act between maximizing short-term revenue and long-term brand value.

Similarly in any given market there's the ratio of informed trading to uninformed trading. Generally the former are large institutions, and the latter are small retail daytraders like the Robinhood customers. Since active management is a zero sum game, a venue with all informed traders is not a place you want to trade at.

By law the public exchanges are not allowed to segment order flow. Imagine a club that's legally prohibited from discriminating based on gender at the door. As you can imagine, the ratio at these venue is extremely biased towards informed traders.

Dark pools and internalizers are not bound by that restriction. However they're legally obligated to meet or beat the best price in the public market. (More on that in a second.) Retail brokers like Robinhood are essentially like club promoters, whose job is to get paid for bringing as many pretty girls to these venues as possible. And on the other side the informed traders at these venues (usually just the internal prop desk) pay big money for the privilege of trading somewhere with such a good ratio.

Is this a bad deal for the girls being herded by club promoters? To a first order approximation: no. At the very least they're getting free entry and drinks, instead of paying listed fees at the public venues. Sometimes they even get other perks like free meals or zero-commissions from the promoter. Still it feels exploitive because the promoter is making far more money off the girls than any fringe benefits they're getting.

As a second-order effect, the segmentation may degrade the overall ecosystem. Eventually all the girls wind up at the private clubs, and the public ones become ~100% dudes. Analogously the public lit exchanges have become highly toxic. Which is bad because market makers set prices based on the quality of the flow they interact with.

Remember that price protection on dark pools is based on the best price available at the lit exchanges. This creates a negative feedback loop. Dark venues can improve on prices at lit exchanges by segmenting order flow. Which forces lit market makers to worsen their prices. Which gives the dark venues even more of an advantage, allowing them to price out even more desirable order flow. Which then makes the lit order flow even more toxic, and the public quotes worsen. Which then drives even more flow to dark pools and internalizers...

Also, just adding onto my own post, I worked on a trading desk for a large bank. Shortly before I arrived there was an issue with order marking (the details of which aren't as significant and were caused by a genuine mistake). The SEC made us go through every trade the desk had ever handled and identify which orders were marked incorrectly. It was so tedious and painful that the bank wanted to settle and pay a bigger fine if it meant not having to deal with all that nonsense. The SEC were unyielding. The moral of the story is that there is no negotiating with the SEC once they decide they've had enough of you. I'm not sure to what extent RH have institutional customers but institutions have a fiduciary duty to seek best execution. RH are on a real legal ledge here. I wouldn't be surprised if this is just the start of a very challenging era for Robinhood.

That's just a cost of doing business.

Want to fix this as the problem:

* bar every officer and every director from serving as an officer or a director

* make the fines 30% of revenue

The ol' break the rules and expect the fines approach

Sorry, and the relevance at hand is?