With the launch of Superhero, the cheapest online broker offering $5 trades, many have been talking about Robinhood coming to Australia. And many have discussed the impact that stuck-at-home amateur stock pickers could be having on the market as cheap brokerage houses like Superhero woo them in.

But is Superhero the new Robinhood? Is there anything to worry about? And how do discount brokers work, anyway? Below we explain.

  1. How US discount brokers like Robinhood work

Robinhood introduced Americans to free trading and in so doing triggered a tsunami of first-time amateur stock pickers buying shares, ETFs and options.

How does Robinhood provide free trading? Partly by selling people’s trades on to specialist traders called “internalisers” for fractions of pennies. Citadel Securities, twin company of the hedge fund run by billionaire Ken Griffin, is one of the bigger internalisers.

This practice is called “payment for order flow” (PFOF) and means that Robinhood users – often unbeknownst to them – are not actually trading on exchange. PFOF is competitive and done by all of Robinhood’s competitors such as Charles Schwab, TD Ameritrade and E*Trade. By some estimates, over 75% of all retail order flow in the US goes through these internalisers before going onto an exchange.

Now, you may have read in the business media that investors can get screwed this. After all, PFOF creates pretty obvious conflicts of interest: it encourages your broker to send your trades to whoever pays them the most. And if you get a worse price for the shares you are trying to buy, it is not your broker’s problem.

What stops this in the US is regulations, which require the Citadels of the world to give investors the best possible price in order to receive their orders. So PFOF and investors getting fair prices can live together.

In the US, this system works well and investors on Robinhood, Schwab, etc. often get slightly better prices than what they could on exchange. However PFOF remains controversial and it is unclear to what extent - if at all - the superior prices available on Robinhood owe to PFOF rather than other variables. (For example, retail investors use market orders and trade smaller volumes, meaning making a market for them is cheaper and less risky).

How does Robinhood make money if trading is free? Partly due to scale: the fractions of pennies can add up. But also by giving traders a low interest rate on the idle cash in their accounts. Much like a bank, discount brokers make money on net interest, meaning they like it when interest rates rise.

  1. Robinhood’s business model is illegal in Australia

Now, is what Robinhood does legal in Australia? No, not at all. ASIC, the finance regulator, bans PFOF, believing it creates conflicts of interest. (And in the UK it certainly has created conflicts of interest.)

ASIC also requires off-market trades to provide “meaningful” price improvement. This usually means at least 1 cent per share better than what's available on exchange. In the US, by contrast, the price improvement provided by Citadel et al. is typically a fraction of 1 cent.

  1. How Superhero works – nothing like Robinhood

The way Superhero works is very different to its American peers. They’re not selling order flow – for one. And for two, their users are actually trading on exchange.

So how does Superhero provide cheap trading? In a very clever way: by partly replacing the ASX’s ledger – known as CHESS – with its own cheaper subledger.

When investors buy shares with CommSec, NABtrade, etc, they each pay the ASX for moving the shares around and transferring legal ownership to their names (under their Holder Identification Number, or HIN).

This means, that if 10 people all buy the same ETF on a given day with their CommSec accounts, they each pay a settlement fee for each trade that hits their individual HIN.

Image: John Winters, CEO of Superhero

The way Superhero works, however, is that everyone is under the one HIN: Superhero’s. And within that HIN, Superhero runs a subledger that determines which of its users’ own what. (In legalese, Superhero uses a bare trust where investors are beneficiaries.)

This means that if you have 10 Superhero users buy the same ETF one day, the costs to settle all of those trades are only charged once as there is only one HIN. This then lowers costs for everyone. It also means that Superhero users do not have their own HIN. 

There’s been some discussion online about whether the absence of a HIN matters. (SelfWealth and Superhero have argued about it on Reddit). Plenty of other brokers do not provide individual HINs – such as Interactive Brokers, which is used by most rich and sophisticated day traders. These brokers have opted to be the custodian instead.

The people I’ve spoken to say that the lack of HINs on Superhero is mostly a problem for big shareholders that want iron-clad control of voting rights. For everyone else it’s not necessarily a big deal.

Superhero also makes money by providing other features, such as tax reports and live data for $9 a month.