January 9, 2021 / Business

Robinhood Review: How Does Trading Platform Make Profit?

robinhood

Brokerage Robinhood is renowned for its zero fees and favorable rates. It is impossible to make a profit on shareware services, but the company managed to double its profit – from $ 90 million to $ 180 million by mid-2020. CB Insights analysts research what the brokerage service actually earns on the eve of Robinhood IPO.

Orders Flow Fee

Robinhood was one of the first companies to give clients the ability of zero-fee trading. The mechanism that allows this service to be offered has been around for a long time. It is called payment-for-order-flow (PFOF). The process is structured like this:

  • An investor submits an order to buy or sell a security to the broker.
  • Robinhood passes the order to the market maker, who will actually have to complete the deal. Market makers pay Robinhood a percentage of the deal for orders.
  • The order has been executed. The market maker made a profit on the deal by buying the securities just below the price at which they were sold to the investor. That is, he receives the difference in the form of a bid-ask spread.

PFOF is convenient in that Robinhood does not need to make deals on its own – the whole process falls on the market makers. US Securities and Exchange Commission defines market makers as those who have more information and capabilities than private investors and brokers – they should be ideal intermediaries for transactions in the stock market.

According to rules, market makers provide high-quality trade execution. If the transaction was completed at a price that is as close as possible to the market price, then it can be considered a quality executed.

It turns out that market makers should provide their clients with a market price, but not necessarily the best one. This leads to the fact that dishonest market participants choose those prices that are beneficial to them, and not to the investor. The more an investor pays, the more will go to market makers and Robinhood. This is the main problem of the payment-for-order-flow mechanism.

For example, brokers Charles Schwab and E-Trade also use the PFOF system: organizations receive 3% and 17% of annual revenue for a stream of applications, respectively. According to Forbes, PROF accounted for 70% of Robinhood’s revenue in Q1 2020. That is, the company manages to earn 10 times more money on the stream than other brokers. This is not due to large trading volumes, but due to the high percentage that Robinhood takes from market makers.

The abuse of PFOF has already led Robinhood to legal action. In December 2019, the American regulator FINRA sued the company for violations in the execution of transactions: Robinhood did not provide its clients with the best price conditions. Now the investment platform is still under the gun of the SEC, which accused the company of not disclosing the fact of cooperation with market makers. For this, the brokerage service was fined $ 65 million.

Premium Accounts And Margin Lending

Gold Membership is one of Robinhood’s most lucrative products – clients have access to margin trades, real-time quotes on the Nasdaq, and Morningstar analytics.

Margin transactions allow you to increase your potential profit and invest in those securities for which the investor does not have funds yet. The money is borrowed by the broker, that is, Robinhood.

Initially, the ability to borrow more funds depended on the level of the user. Now all operations on the “gold” tariff cost traders $ 5 per month, plus 2.5% per annum for using borrowed funds (according to CB Insights, the rate reaches 5%). The more customers use margin loans, the more Robinhood gets.

In January 2019, Reddit user discovered a vulnerability in the platform’s lending system. It was possible to borrow huge amounts with small collateral. So, someone managed to take $ 200 thousand with collateral of $ 5 thousand. For a long time, the company did nothing to eliminate the vulnerability – in November 2019, users were still using the bug.

Gold client revenues are more stable than PFOF, which largely depends on how regulators behave. Premium services are not affected by legal restrictions – the company has the right to set any prices and limits.

Expansion Of Services

Robinhood has never concealed its intention to expand its core business with value-added services. At the end of 2018, the company announced the launch of the Checking & Savings service. Its main advantage should have been relatively high deposit rates – 3%, instead of the market average of 0.1-0.21%.

However, the plans fell through. The safety of deposits in current and savings accounts in American banks is guaranteed by the Federal Deposit Insurance Corporation (FDIC). Robinhood claimed that all deposits of up to $ 250,000 in user accounts will be insured by the Securities Investor Protection Corporation (SIPC). However, the regulator denied this information.

Failure did not stop Robinhood. The company announced the launch of Cash Management debit cards in October 2019. As with Checking & Savings, account maintenance was completely free. The cards were launched in partnership with Mastercard, which gave their holders access to free cash withdrawals from 75,000 ATMs.

The safety of funds in Cash Management accounts this time was guaranteed by the FDIC. The annual percentage yield of such cards is 0.3%, which is also higher than the current average market rates. At the same time, the interest on deposits is paid not by Robinhood, but by its partner banks, to which it transfers funds from cardholders. These banks pay a commission for the funds transferred, in addition to this Robinhood receives a small percentage of the commissions from transactions that are made using Cash Management.

CAC vs LVT

Customer Acquisition Cost, CAC is critical to Robinhood’s high-volume, low-margin trading business model. The company is reluctant to share information about this indicator, but CB Insights believes that so far it has been able to keep it at a fairly low level.

Analysts estimate that Robinhood costs roughly $ 25 per new account. This low result can be achieved primarily due to a powerful referral program. For comparison: in 2018, E-Trade spent $ 170 million on the direct purchase of more than 1 million brokerage accounts from Capital One Financial, that is, the average CAC for the transaction was $ 170.

On the other hand, the potential value of Robinhood accounts may be lower than competitors: on average, users store from $ 1 to $ 5 thousand on them. This is much less than the same E-Trade, whose average brokerage account in 2020 was estimated at $ 69 thousand. Clients of Morgan Stanley, which acquired E-Trade, keep even more in their accounts – an average of $ 175,000.
But this situation also has its advantages. Targeting wealthier clients from traditional brokers allows Robinhood to actively attract all other users. As a result, it was the rapid growth in the number of new clients that allowed the company to conduct several successful rounds of attracting investments.

However, Robinhood’s high growth potential for its customer base does not mean that its accounts have a high Lifetime Value (LTV) – it turns out to be lower compared to that of its traditional competitors.

Problems With Law

Perhaps the biggest potential source of trouble for Robinhood is its vulnerability to the potential tightening of regulations across the fintech sector. This is unlikely to happen soon, but such a risk poses a great danger to a company that already has problems with the SEC – from the point of view of regulators, Robinhood operates in a gray zone.

Another important cost item for a company is litigation. This is not just about regulatory issues, as is the case with FINRA and the SEC. In March 2020, one of Robinhood’s clients filed a lawsuit against the company because its services were unavailable for two days, during which there was the largest daily rise in the Dow Jones index in history.

Although the legality of the plaintiff’s claims has not yet been determined, the court has merged his statement with similar complaints from 13 other Robinhood clients into one class-action lawsuit. The liability that the company may incur is unlikely to have a significant impact on its financial position, but the outcome of the hearing could have a big impact on the company’s reputation and its IPO intentions, which Robinhood has been talking about since 2018.

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