On Capitol Hill today, lawmakers spent hours digging into the stock market frenzy over GameStop.

This hearing is entitled Game Stocked with Winners and Losers with Shorts.

A group of the key players, including the CEO of Robin Hood, the stock trading app, faced questions about winners and losers and who has access to the markets. Lawmakers took aim at an issue that goes to the core of Robin Hood's free trading business model.

Let's talk about the attention that this pay for order flow has received. You explain the payment for order flow.

It's the source of revenue propping up Robin Hood's commission free trades.

And today it's coming under scrutiny in Congress because payment for order flow has a toxic reputation.

Welcome to the journal, our show about money, business and power. I'm Kate Limor. It's Thursday, February 18th. Coming up on the show, how payment for order flow makes trading free and why Congress is asking big questions about it. This episode of the Journal is brought to you by the new Love Your Car Guarantee from CarMax, featuring 24 hour test drives and a 30 day money back guarantee up to 1500 miles. Learn more at CarMax Dotcom. Tons of people trade on Robin Hood every day, and I asked our colleague Alex Assa Pavic, who covers the stock market and trading, to walk us through how a trade on the app actually works on the back end.

So let's say you want to sell a stock that you own from your Robinhood account. You enter a sell order, Robinhood. So at the current market price, Robin Hood takes your order and within a few hundredths of a second will routed over to one of several big high frequency trading firms, the biggest in the space, or Citadel Securities and Virtu Financial. One of these firms will buy the shares that you're selling and money will be credited to your Robinhood account.

So when you sell a stock on Robinhood, you're actually selling it to a middleman. One of these high frequency traders, high frequency trading firms are very technologically sophisticated, computerized trading firms that basically write programs to trade stocks and they tend to do so on very short time frames. They need to execute trades very quickly and they do many, many trades a day, often millions of shares traded per day.

These high speed traders want to buy your stock because they can make money on it.

They turn around and then sell that stock, making money on what's called the spread, the tiny difference in price between what a buyer is offering and what a seller is asking for. Often the spread is really small, like a couple of cents or even a fraction of a penny.

As long as you buy for a little bit less than you sell, do it over and over and over again. You can make good money that way.

But to make good money, a high frequency trader like Citadel needs tons of orders flowing its way.

They need to keep trading all day to stay in business. The worst thing for high frequency trading firms is when volumes drop down and there's just not much business going. So they're willing to pay for that. And that's where payment order flow comes from.

The high frequency trader pays Robinhood a tiny amount for each trade that Robin Hood sends its way. The payment for order flow system has been around for a while and has been, in fact, around for decades.

Interestingly, one of the early pioneers of this back in the 80s 90s was Bernie Madoff.

Bernie Madoff, the guy who's serving 150 years in prison for orchestrating one of the largest Ponzi schemes in history.

He ran a market making firm, Bernard Madoff Securities, that traded a lot of Nasdaq stocks. And he paid brokers for this type of order. And if you look up interviews with them in the 90s and early 2000s, he goes and talks about the same thing we're talking about right now. That was, of course, before he was exposed as masterminding a giant Ponzi scheme.

The Madoff connection might taint payment for order flow in some way, but it's perfectly legal and has been in practice for years. But Robinhood had the key insight. You could use this, scale it up and make trading free.

Robin Hood figured out that as long as you ran a lean operation and made money from the payment for to flow, you could offer your customers zero commissions. And the bet was that customers would flock to this model and do so much trading that they'd be able to make money and get by on the payment order flow.

And the idea has worked. These payments are really lucrative part of Robinhood business. Last year, the company made nearly 700 million dollars this way.

Has Robin Hood said anything about why it uses the system? They say that we do this because, well, for one thing, we have to make money, but also it's a good experience for the customers. Customers orders get routed to these high frequency trading firms. The orders get filled. It's often at a price that's slightly better than you would get publicly on an exchange. And everybody wins and wants.

Robin Hood did it. Other companies followed Schwab, TD Ameritrade, E-Trade, Weeble, any number of other brokers that you would have heard of are probably collecting payment for. There are a few exceptions, but generally they collect payment for to flow for both stock trades and options trades.

So it's like a pretty common practice nowadays because customers like things to be free.

Yes, there is a perception that when you don't pay a commission for trade, it is free.

And would you say that that is not true? So there is kind of a hidden cost. Robin Hood says it uses high speed trading firms instead of public stock exchanges because it can get better prices for its customers. And that's kind of a benefit that the high frequency trading firms provide. So if you're buying the stock, you'll buy for slightly less. And if you're selling the stock, you'll sell for slightly more.

They call it price improvement, but that price improvement doesn't necessarily trickle down to you, in part because high speed traders have to pay Robinhood for the order flow. So some of the money you may have gotten from there, better prices instead goes to Robinhood. In other words, you're more likely to kind of just get the plain vanilla price of a stock and not a slightly improved price.

But there's a bigger issue, the potential for a conflict of interest. So payment for your flow has a terrible reputation. It feels to a lot of people like kickbacks, basically. Wait, why is my broker taking a payment from some mysterious high frequency trading firm to execute my order? What's wrong with this? And there are legitimate questions about it. One of the biggest questions is so is my broker really looking out for me if they're getting paid for my order flow?

Are they giving me the best possible execution on my trades, which they're required to do under FCC rules? So that's one of the reasons that there has been a lot of skepticism over the years of payment for order flow, and it keeps coming under scrutiny.

And those problems might explain why. For years, Robin Hood didn't fully tell its users that it makes money from payments for order flow.

Robinhood historically was very shy about talking about payment for order flow. In fact, they got in trouble with the S.E.C. and had to pay a sixty five million dollar settlement in December because, among other things, they failed to tell their customers that they were taking payment for order flow on their website. As part of the agreement, Robin Hood didn't admit wrongdoing, but not long after settling with the SSI payment for order, Flow had Robin Hood back under the microscope, this time because of GameStop.

That's after the break. This episode of the Journal is brought to you by CarMax, finding the right car takes time. And with the new love your car guarantee from CarMax, you can take your time to make sure you found the perfect car for you, starting with a 24 hour test drive. Drive it to work school and the grocery store before you buy. And if it feels right, you've got a full month and 1500 miles to keep on driving with their new 30 day money back guarantee.

Learn more about the new love your car guarantee at CarMax Dotcom. Back in January, at the peak of the GameStop frenzy, some Wall Street watchers started growing concerned about payment for order flow. Those concerns centered on the relationship between Robinhood and one of the high frequency trading firms Robin Hood uses for its customers orders.

Citadel Securities is the number one destination for Robinhood customer orders. It is simply the biggest firm that does this retail trading business, and they do a lot of Robinhood flow. During the GameStop frenzy in late January, Citadel Securities was doing a very large portion of the trading volume in GameStop.

On January twenty eighth, Robinhood restricted trading in GameStop and essentially forced people to stop buying it. A lot of people were very upset by that.

And out of that moment, a conspiracy theory was born, a conspiracy theory that turned out not to be true, but that points to that bigger issue with payment for order flow, the potential for conflict of interest. Robin Hoods trading partner Citadel Securities is part of the same corporate group as Citadel, a giant hedge fund.

And in January, Citadel's hedge fund made a big investment in a group that had been betting that the price of GameStop would go down. But with so many people buying GameStop, a lot of them on Robin Hood, the price of the stock was going up.

And that could have meant that Citadel's recent investment was losing money. So when Robin Hood stopped allowing its customers to buy GameStop stock on its app, the conspiracy theory emerged that Robin Hood had been pressured to do that by Citadel.

In fact, Robin Hood stopped trading in GameStop for other reasons.

And if you want to know more about why they did that, check out our episode from earlier this month.

But the question is Robin Hood acting in the interest of me, the customer, or is acting in the interest of Citadel Securities?

It took on a life of its own. And that's why the CEOs of Robin Hood and Citadel faced members of Congress today in his opening statement, Citadel CEO Kenneth Griffin addressed the conspiracy theory head on.

I want to be perfectly clear. We had no role in Robin Hood's decision to limit trading in GameStop or any of the other meem stocks, in other moments from today's hearing, Congress members focused on payment for order flows, hidden cost to investors.

Democratic Representative Brad Sherman of California had a testy exchange about it with Citadel CEO who gets the better deal, the one that comes from a broker who is paying, being paid for order flow and one not so.

As I said earlier, the size of the order is only one factor. You are doing a great job of wasting my time.

Today's hearing was one of many that Congress is planning as lawmakers consider whether new regulation is needed.

How might the government regulate this system?

There are a few things that the government could do, potentially could just ban payment for order flow that's happened in other countries in Canada and the UK.

Historically, the FCC has considered prohibitions of payment for water flow, but they say that basically it would be sort of hard to ban because it would kind of creep back into the system and sort of a less transparent way. What the FCC is generally done in the past, several times it's reviewed payment for airflow is forced more disclosures upon the broker. So the brokers have to say where they're routing the trades, how much money they're getting and sort of material terms of those relationships potentially.

There's also this idea that's kicked around some times that maybe the benefits of payment for order flow should be passed on to you, the customer. What if you got that extra a couple of little fractions of a penny per trade? That would probably be a fair thing that would get rid of the whole conflict of interest problem. However, then probably zero emission trades would go away because the brokers wouldn't be able to keep that money because you always have to pay the piper.

Yeah, if payment for order flow were to get banned, it would transform retail investing once again.

If you got rid of it, it's very hard to understand how Robinhood could stay in business. Brokers need to make money.

Somehow they could collect commissions like in the old days, or they could make it off of payment for order flow. Like now, any way you slice and dice it, the brokers have to make money to stay in business. I think the important thing is that people and regulators need to be aware of all the practices need to be disclosed and customers need to be aware of this, too, to make sure they're not getting unduly harmed. That's all for today, Thursday, February 18th.

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