Robinhood: good samaritan or evil menace?
Assessment of this disruptive and controversial trading app
Robinhood is a disruptive (and controversial) trading app and the 4th most downloaded financial services app in 2020.
It was launched in 2013 when founders Baiju Bhatt and Vladimir Tenev saw an opportunity to disrupt the investment broker market....which they did!
Today, Robinhood has more that 18 million customers who are predominently young men, with average to poor credit ratings and who have never invested in the markets before.
And the pandemic has been an accelerant for Robinhood.
The markets have boomed at the same as people have shifted to working from home, giving them more free time, whilst increasing their disposal income with less opportunities to go out and spend it.
Exploiting Silicon Valley's best techniques for engagement and technology addicition, Robinhood have ridden the perfect storm.
The two big growth areas for Robinhood are options trading and the buying and selling cryptocurrency. Both are highly risky and both carry the very real possibility of the trader losing all of their money on a trade (something that is not so likely 99 times out of a 100 in a conventional trade to buy stocks).
Named after the fictional character who robbed the rich to feed the poor, Robinhood's founders say they created the platform to "democratize America's financial system".
Their mission was to make it cheaper and easier for a new generation of investors to begin building their wealth in the stock market.
However, as we will see, far from being the people's hero redistributing wealth from the haves to the have nots, Robinhood are using technology and techniques to trade on a "get rich quick" promise.
Robinhood disrupt the market
Before Robinhood came to market, there had always been a cost to the buying and selling of shares. Online brokers were usually charging somewhere between $5 and $10 for every single trade.
Then along came Robinhood with free trades.
Now, free trades are the industry standard directly as a result of Robinhood's success. This has spurred established industry brokers like Charles Schwab, E*Trade and TD Ameritrade to eliminate their charges too.
But, like everything in the tech economy that is "free", e.g., Facebook, Google, Twitter... you and I are the product.
And like the social media platforms, it is the data on its users that Robinhood sells to make money to pay for the "free" trades. This is called Payment For Order Flow and I'll explain it shortly.
But it's not just the free trades that has made Robinhood so appealing to a demographic that is predominately made up of young men, with average to poor credit ratings and little to no experience in trading.
Gamification of high risk trading
The user experience on the app is intuitive and very easy to use. A new user can sign up with just an email address and a few questions. Anyone can do it as long as they have a mobile phone. No experience necessary!
Within 10-15 minutes, new users are up and running and placing their first bet.
The Robinhood app has different levels to unlock as users start trading. Level one is usually just buying and selling stocks. As the user progresses, they move to level two which gives them access to options trading. Level three opens up access to more sophisticated (higher risk) investment options.
It is this kind of a video game aspect that had not been seen before in a brokerage account.
And it is this recipe of an easy to use, sticky experience and free trades that has helped Robinhood achieve engagement levels of a top-tier social network.
This is measured by the ratio of daily active users to monthly. (Robinhood has 18 million customer accounts, of which around 98% of them, approximately 17.7 million, are active every month.) Of these 17.7 million monthly active users, almost half (47%) of them are active on the app every day.
Over-simplifying the complicated
Robinhood places a large emphasis on options trading.
Options trading is an exotic and high risk investment that is different to (just) buying a stock in a listed company. That's because when you (simply) buy a stock for the long term, you are buying an asset that will give you a regular return (through a dividend) and betting that the price of the stock will go up over time.
But with options trading, you're making a short term bet on which way the stock price will move. When you get it right, the returns are magnified and big money in a short time period can be made.
However, the issue with options trading is that you are also magnifying the downside. In the same way that options can lead to huge gains, they can also lead to a catastrophic and total loss.
But for Robinhood, this emphasis on making options trading seem like a game is working. Robinhood traders trade 88x the number of options than on any other platform.
And although options trading accounts for (only) around 15% of trading volume, it is roughly 50% of transaction revenues. Why, because it is roughly 7x profitable!
Gambling or Investing?
Around half of Robinhood's customers report that this is their first trading account. With little or no experience or knowledge of trading, they turn to social media to learn about trading. And to find out what are the hot meme-stocks to make their bets on.
One of the problems with gamification is that it can lead to addiction (23% of men who gamble get addicted).
Or worse.
In June 2020, a first time Robinhood day trader called Alex Kearns committed suicide. Kearns was 20 years old and he took his own life after the Robinhood app mistakenly reported that he was down $730k on his account. However, the balance did not accuraetly reflect the portfolio's value. Before his death, Kearns emailed Robinhood asking for help.
In his suicide note, that his family shared on social media, Kearns said that he didnt know what he was doing and he never intended to take such a high risk.
Robinhood responded by adding more education and support onto their platform, But critics say Robinhood still makes it too easy for inexperienced individuals to trade. And they have a point becuase Robinhood still has fewer hurdles for options trading than other brokers.
Payment For Order Flow - How Robinhood makes money
If the trades are free but Robinhood’s revenue is expected to be around $2 billion this year, where does it come from?
Around 80% of Robinhood's income comes from a mechanism known as Payment For Order Flow. This is a controversial practice that is banned in the UK and Canada, but is permitted in the USA.
In simple terms.
When you or I want to buy a stock, it needs to be matched to someone who is selling a stock. This matching of buyers and sellers is performed by high speed trading firms known as market makers.
Here's how it works.
Robinhood, as the broker, take the order from you or me. They then pass the order to a market maker and in return, the market maker gives Robinhood a commission. The market makers make money from the difference in the seling price from the buying price.
The issue for Robinhood's traders is that these high speed traders don't all see on exactly the same prices. The Robinhood trader may have a "commission-free trade", but if they don't get the very best price when the trade is made, then the deal has actually cost them money.
And here's the rub. The real customer is the market maker, not the user who has opened and account and deposited their hard earned cash. (Remember, when the product is free....you are the product!).
Far from taking from the rich and giving to the poor, Robinhood is moving money the other way!
This practice is not transparent to Robinhood's users, who, by all accounts, seem to be ambivalent to them. In a recent consumer survey from Cornerstone Advisors, nearly nine in 10 users said Robinhood made it easier for them to buy and sell stocks.
But Robinhood's business model has not escaped the scrutiny of the regulator.
Note: Here's an excellent explainer of Payment For Order Flow by A16Z.
In the regulator's crosshairs
Robinhood's latest bust up with the regulators, this time it was the Financial Industry Regulatory Authority (FINRA), resulted in a $70 million fine. This was the largest fine ever dished out by FINRA and included $13million in restitution payments to users.
FINRA says Robinhood has caused “significant harm” to its customers, including the enabling of risky trading (via options) and misleading info around other trading tools (margin lending).
This followed a $60 million fine in December to the SEC for failing to properly disclose its order-flow revenue and prior fines of $27m and $35m fines with FINRA.
Robinhood have also disclosed they anticipate paying another $15 million in fines to New York’s trading regulatorand that they are currently under multiple separate investigations by federal agencies and authorities in California, New York, and Massachusetts.
In reporting the latest fine, FINRA accuse Robinhood of “systemic supervisory failures and significant harm suffered by millions of customers." The brokerage is alleged to have:
Displayed “significantly” inaccurate cash balances. For example, Robinhood displayed negative cash balances that were twice as large as they actually were.
Provided false information to customers about the risks associated with options trading. Robinhood told customers they would “never lose more than the premium paid to enter a debit spread” when in reality many customers did lose much more than that.
Issued erroneous margin calls and warnings. Robinhood told customers they were in danger of a margin call when in reality they weren’t.
The regulator fines aren't Robinhood’s only legal trouble. Since the GameStop debacle earlier this year, nearly 90 lawsuits have been filed against the brokerage. Class-action lawsuits related to actions the startup took to restrict trading during the GameStop episode. It has also bee confirmed that the Feds seized Robinhood CEO Vlad Tenev’s cell phone during a related investigation.
But, these fines are simply slaps on the wrist and they are not going to slow Robinhood down given the amount of money that has been pumped into the trading platform.
Since 2013, Robinhood has raised a total of $5.6 billion in venture capital. With this war chest, these fines are little more than rounding errors that many commentators see as an endorsement of Robinhood's business practices.
It's like leaving your car parked illegally on the street if the parking ticket is only a fraction of the cost of the car park. The fine is hardly a discouragement to your behaviour.
Robinhood and Crypto
Robinhood is also making a big move in the cryptotrading market.
In Q1 of this year, 17% of the company’s total revenue came from fees on crypto trades, and 34% of that revenue came specifically from Dogecoin (remember Dogecoin is the joke crypto that has no utility but has since evolved into the sixth-most valuable cryptocurrency, with a market capitalization of nearly $33 billion).
Around 9.5 million Robinhood customers traded crypto in Q1 and in the coming year, Robinhood plans to let customers move crypto off and on its platform and have a full blown crypto wallet as a gateway into the world of DeFi (a subject for a future WiserIn5!).
This will put Robinhood into direct head to head competition with Coinbase.
Robinhood is now almost doing as much trading volume in crypto as Coinbase, but making a lot less on it. This is because of Coinbase’s high fees, which will almost certainly come down as the market matures and competition from the likes of Robinhood takes effect.
Robinhood’s current take rate on crypto is less than a tenth of Coinbase’s!
Now, it is no coincidence that Robinhood are making money from trading options and from trading crypto. Because the demographic for its users is the same. And the narrative is appealing to a "beat the establishment at their own game" tagline that has seen distressed stocks like Gamestop, AMC, Blackberry and Hertz, alongside useless cryptocoins like doge, all perform in ways that don't match any fundamentals.
IMHO, this isn’t going to end well, but for now, we're still in a "roaring 20s" post pandemic bull market.
Robinhood’s going public
Last week, just as FINRA were handing down the $70 million fine, Robinhood officially filed its S-1 paper for an IPO. When Robinhood goes public they will trade under the ticker $HOOD (which is kinda fitting as it sounds more gangster than good samaritan!).
The headline numbers from the filing were;
The number of accounts grew 151% over the past year, up from 7.2 million in March 2020 to 18 million now
Assets under custody have increased by 417% year on year
Q1 Revenue was $522m, up 309% from Q1 2020
Robinhood has gross margins of around 85-90%
Robinhood’s profitability improved by over 40 percentage points during the pandemic
Marketing was the biggest cost (c45%) but now represents under 20% of revenue
Robinhood is on track to double revenue to $2 billion for 2021
Robinhood's valuation is forecast to be around $40B+ at listing
They made a loss of $1.4 billion in the first quarter of 2021, largely due to a $1.5 billion fair-value adjustment to convertible notes and warrants that were used to raise emergency funding during the GameStop saga.
Sources and articles of interest:
S-1 teardown, Tanay´s Newsletter
Robinhood: $30billion cockroach of Fintech, Forbes
No Mercy/No Malice, Prof G
Robinhood ordered to pay $70m fine, ZDnet
Robinhood to Pay $70m to settle FINRA probe, CFO
Robinhood made $30m in Q1 from Dogecoin, Business Insider
The Good, the Bad and the Ugly of Payment For Order Flow, BestEx Research