How did Robinhood, a zero commission broker become the second largest fintech company in America?

Apart from the blistering growth, what surprised me the most was the $5.6 billion valuation. How does a company that prides itself on a zero commission end up raking up such a high valuation? How does it even make money?

Robinhood — a new age brokerage firm recently passed Etrade, a giant in the brokerage industry in 3 years. The firm, now valued at $5.6 Billion is transforming itself into a financial services powerhouse, offering access to cryptocurrency, and has other products in the pipeline.

The mobile app only platform that got millennials excited about the possibility of zero commission trading and the ultra-simple user interface has grown to over 4 million users today. The app has also created social value in making it easier for first-time investors to start saving within minutes.

Robinhood: The mobile app has received multiple design awards

Apart from the blistering growth, what surprised me the most was the $5.6 Billion valuation. How does a company that prides itself on a zero commission end up raking up such a high valuation? How does it make money?

Source: Robinhood Website

The above picture is taken from the website. For all customers that do not opt for Robinhood Gold — the platform is completely free (well..almost)

Let’s talk about Robinhood Gold.

Robinhood Gold is offers leverage so that investors can double their capital invested for a fee. This upfront interest cost (6%) is disguised as a fee payable monthly. By converting the interest fee into a subscription fee three things happen :

  1. Customers see it as unavoidable. Let’s face it — nobody likes pausing subscriptions.
  2. It shows that customers prefer being charged upfront fees (as opposed to seeing interest charges on their stock statement). Just to clarify — the 6% fee is charged irrespective if the customer uses the leverage or not (free money)
  3. Robinhood provides other features — such as aftermarket hours trading and instant balance access after a stock sale (usually it takes 2 days for stock settlements). These added features make customers less susceptible to pause subscriptions (even though they are not using the 2x leverage).

I think Robinhood Gold is the most disruptive pricing strategy in the brokerage space. By converting the one-off commission/interest income to a dependable monthly subscription model — the company has changed the way the industry operates.

Suggestion — I would like customers of Robinhood to think harder before signing up for Robinhood Gold — leverage magnifies gains and losses and in most cases destroys more capital than it creates over the long-run. And if one’s not using leverage — does he/she really need to upgrade to Gold? I don’t think so.

What about the second source — “interest on cash and securities.”?

There is always a cost associated with capital. When Robinhood gives 2X leverage at 6% (discussed above) — it’s borrowing it as a lower rate from banks and other institutions.

However — my guess is that Robinhood just uses the cash sitting idle in its customer accounts (at 0% cost) and lends it at 6%. I believe this is consistent with industry standards.

Other sources of revenue — Oh yes!

There’s a popular saying — ‘If you’re not paying, you’re the product.’ That’s how business models around Google and Facebook are built.

What about a large number of customers who are using Robinhood free of cost? What about the ones that have not subscribed to Gold.

Turns, out Robinhood, is able to monetize on all their customers’ orders (I only wished they disclosed this!).

Robinhood sells the order flow (stock buy/sell data) to high-frequency traders who help execute these orders coming from clients. The high-frequency firms usually buy stocks at slightly lower prices due to their use of complex algorithms.

It’s important to understand that by the time the light from your computer screen displaying stock price data reaches your eyes, hundreds and thousands of stocks have changed hands at different prices.

Computers and complex algorithms are able to make millions of decisions on which stocks to buy or sell in milliseconds and therefore high-frequency trading shops are able to monetize this order flow data to their advantage.

I’m confident that in exchange for zero commission — customers of Robinhood’s platform are slightly overpaying for the stocks and options they buy.

There is also a huge debate whether high-frequency trading firms commit front-running (description). For an in-depth coverage of these firms, check out Flash Boys, written by Michael Lewis.

Robinhood, as a result, gets paid by selling ‘dumb’ order flow to high-frequency firms (see SEC. disclosure below for more how much Robinhood earns on them).

SEC disclosure:

Using simple math — Execution of $1 million dollar worth of stock relates to a revenue of $260 for Robinhood. I assume it trades billions of dollars worth of stock every day.

Other sources of income I’m not sure.

Conclusion

Robinhood’s slick user-interface and intelligent pricing model has led to huge success.

It is currently the second largest valued fintech startup in America (after Stripe) and deserves this fully. For first time/novice investors — I would love for them to disclose and educate customers on the pricing of their products and services.

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Pratik Oswal

Pratik Oswal

#Fintech strategist @Strati_fi, helping to create the future of financial services. Big believer in the power of compounding + the #India growth story. MBA @LBS