Robinhood: no such thing as a free lunch

If you hadn’t heard of Robinhood (the company, not the fairy tale character) prior to this week, you probably have now. If this is the first time you’ve heard of it even after the events of the last week— you are living under a rock.

This week, it became the most-downloaded free app in Apple’s App Store, according to Apptopia. As one of the largest online brokerages, Robinhood struggled with an extremely high volume of trading this week as many individual retail investors bought into stocks like GameStop. I won’t rehash the saga too much as it’s been really well covered by many news outlets and I know readers of this blog are pretty switched on. I’ve broken down the main components of the story below.

What is GameStop?

GameStop is an American high street shop that sells games, consoles and other electronics (this is the kind of store you would find in a shopping mall). It’s really not an exciting company (edit: Emem asked me to stress here that the company is essentially obsolete, and the fact they’re even still listed or trading is miraculous)— to add to this, things weren’t looking too good for the company due to the pandemic.

Okay got it, so why did so many people choose to invest this week?

Enter r/wallstreetbets (Reddit forum with more than 4 million people, discussing the market and where they’re going to invest money). People in this forum cottoned onto the fact that GameStop was one of the companies that lots of hedge funds had bet on to lose a lot of value and as a result, they bought the stock. This demand raised GameStop’s share price massively, and everyone who had banked on it dropping in value had to buy their shares back.

The result? Retail investors ‘won’ and hedge funds (theoretically) ‘lost’.

I still don’t get it, what was the point?

Good question! For many, the aim was to make stockbrokers and hedge funds lose money. Popular threads on Reddit include people describing it as payback — taking revenge against the big financial institutions that were seen to have caused the financial crash in 2008. Also, I think for many people, it was actually just really fun — the meme content this week has been phenomenal.

So why do people hate Robinhood now?

On Thursday, Robinhood was forced to stop customers from buying a number of stocks, like GameStop, that were heavily traded this week. At the time people viewed the trade limitations as a kind of conspiracy (many still do) and against the philosophy of the company. In reality, Robinhood was facing what seems like a liquidity crunch as the volume of trading exceeded levels they were prepared for.

Company Overview

Founded in 2013, Robinhood disrupted the retail trading industry by eliminating trading fees. Prior to the app and many like it, you would have paid brokers a ~$10 fee per trade. Traditional players like Charles Schwab and TD Ameritrade have since followed suit and ended commissions on stock trading. No fee trading has now become the new normal but despite this, Robinhood’s mobile-first offering leads the pack.

The company, which is based in Silicon Valley, has empowered individual retail investors, and adoption of the app soared in the pandemic as the stock market surged and people wanted to get involved in the action. The company has drawn in millions of young investors who had never traded before through an app that critics have said makes buying stocks feel like an online game.

A few quick facts

• 13 million users as of May 2020. Given this week’s events, it will be interesting to see what this number looks like now or will look like in a few weeks
• Q2 2020 revenue of $180 million, annualising that gets us to $720 million estimated annual revenue
• $150 billion total transactions 2019
• Valuation of ~$12 billion with investors such as Sequoia, DST Capital, New Enterprise Associates, Index Ventures and Andreessen Horowitz. It’s also rumoured that Robinhood sought an IPO this year (oops)

Revenue Drivers

Trading fees were just one way out of many for online brokerages to make money. Robinhood makes money via:

1. Rebates from market makers and trading venues (aka ‘Payment for Order Flow’)
2. Robinhood Gold
3. Stock loans
4. Income generated from cash
5. Cash Management

1. Payment for order flow

This is where the majority of Robinhood’s revenue comes from. Bare with me on the explanation of this one — it takes some concentration

Essentially, market makers such as Citadel (other hedge funds are available) pay online brokers like Robinhood for the right to execute customer trades. This means that Robinhood sells your data (anonymised details on what kind of trades you make) to these high-frequency trading companies.

For example, say you are an investor looking to purchase shares of Company X. You would submit an order through Robinhood and during the processing, companies like Citadel (with the help of some super fast computers) buy the shares before you do at a cheaper price and then sell them back to you. When this process is repeated again and again, these high-frequency trading companies (HFTs) make millions from it. Since this was possible via Robinhood — they are paid for the service (rebates).

In 2018, Robinhood’s CEO issued a statement stating that Robinhood earns $0.00026 in rebates per dollar traded. So if you buy a stock for $100, Robinhood earns $0.026. Simple!

There has been a lot of talk about whether hedge funds like Citadel front-run these trades (use inside information to profit). It’s important to note that this is very much illegal and there’s no real evidence to support the theory.

2. Robinhood Gold

This is your typical subscription product. Robinhood Gold allows users to make bigger instant deposits, access professional research reports and level 2 market data, and most importantly trade on margin (trading on borrowed money, very risky and usually a strategy implemented by experienced and professional investors)

Robinhood Gold starts at $5 per month and the first $1,000 of margin is included in this, users are charged 2.5% on margin above this. To see how the economics of margin trading work over $1,000, let’s look at the example below

User borrows $50,000 for a YOLO trade (again super risky, would not recommend)

• $50k - $1k = $49k on margin
• $49,000 x (2.5% /360) = $3.40 per day

3. Stock loans

Robinhood earns income from lending margin securities to counterparties.

4. Income generated from cash

Just like any financial institution, Robinhood makes a large portion of its money from interest made on lending out investor’s idle cash (uninvested funds in customer’s accounts).

5. Cash management

Interchange fees from the Robinhood debit card. Interchange fees are earned by most debit and credit card issuers and are meant to cover things like transaction processing and fraud loss.

Cost Drivers

Hardly an exhaustive list:

• Payroll: 1,821 employees with an average salary of $140k
• Server costs: approx $0.06 per user per month (remember they are reported to have 13m users. In March, the company had to raise more money after its app went down and left customers stranded with big losses, leading to a still-ongoing lawsuit.
• Sales and marketing: No exact figures here but as with any consumer-facing product/service, marketing can be expensive
• Regulation: This isn’t really a cost but broker-dealers must maintain net capital equal or greater to $250,000 or 2% of aggregate debt. In fact, in order to continue operating operations this week, the company had to draw upon a line of credit from six banks amounting to between $500 million and $600 million to meet higher margin requirements. It later raised $1 billion in cash from its existing investors.
• Legal: The company has faced many legal issues, including fines from regulators for misleading customers. The linked example totaled $65 million
• Customer support or rather, the lack of it: You can’t actually call Robinhood customer support or go into a branch. This saves the company a huge amount of money as everything is dealt with through email

Unique Business Strategy

This week’s article has been a bit longer than usual, so I’ll summarise quickly:

• 0% trading commissions: Made investing accessible to everyone and revolutionised the game
• Mobile-first: Robinhood is much more valuable than other players in the market as it is extremely popular with millennials and the most valuable demographic of all, Gen-Z’s. By making the service available through an app, Robinhood comes to its users in their comfort zone — the mobile phone
• User-friendly and addictive interface: Robinhood employs many of the same techniques used by platforms such as Facebook and Instagram. Using the platform actually prompts dopamine releases and it’s pretty scary — did anyone watch ‘The Social Dilemma’ on Netflix?

HTMM Opinion?

*Trigger warning — the section below mentions suicide*

The work I currently do makes me an insider, which means that I am limited to purchasing cryptocurrencies and broad-based ETFs (severe FOMO this week). Consequently, I don’t think I’ve ever really experienced the thrill of single stock investing but it’s evident that for those that are able to — Robinhood offer’s a genuinely enjoyable product/service (unless your trading is limited or the servers go down of course)

However, is any of this really responsible? Trading on margin, really guys? Last summer, news broke that a 20 y/o Robinhood user committed suicide after seeing a ~$730k negative balance on his account. Like so many others, the user had taken up stock investing during the pandemic and had begun experimenting with options. In his final note, the 20 y/o student said that he had “no clue” what he was doing. It turns out that whilst his account had a negative $730,165 cash balance displayed in red, it may not have represented uncollateralized indebtedness, but instead, his temporary balance until the stocks underlying his assigned options actually settled into his account (basically, things might not have been as bad as they seemed). As you’ve probably inferred from this week’s article, options and trading on margin are still available on Robinhood’s platform.

Robinhood seemed to recover from the tragic scandal but you can’t help but feel that this won’t be the only one. Additionally, given this week’s events — many users have lost trust in the platform and are switching over to others (Public is an alternative platform that doesn’t offer the ability to trade options or on margin)

The future seems uncertain for Robinhood and it will be interesting to see how this plays out

Special thanks to Emem and Evelyn Pall for their input on this week’s article.

— Kemi