3 Red Flags in Robinhood’s Revenues
Two years ago, Robinhood was quietly becoming one of the most popular stock, options, and cryptocurrency trading apps amongst millennials, with its no-commission, mobile-first platform.
Our mission to democratize finance for all drives our revenue model.
- Robinhood as per its Prospectus
A year ago, Robinhood was at the epicentre of the meme stock trading bonanza, months before going public in one of the most controversy-riddled IPOs in recent memory. Today, Robinhood’s stock is in turmoil, trading at less than half the price at which it was taken public.
For a company that completely captured the zeitgeist of the retail trading revolution over the course of the last few years, Robinhood’s inability to translate its popularity into share price strength is a product of four major factors:
- Unhealthy Revenue Mix;
- Cyclicality Not Offset by Net Interest Margins;
- Existential Indecision Leading to Stalling Product Innovation.
Unhealthy Revenue Mix
Contrary to the popular misconception masked behind the “commission-free trades”, there’s no such thing as a “free lunch”.
Like most investment dealers, Robinhood makes money from brokering transactions and from the interest it generates from margin trades. It also makes money from its $5/month subscription service for Robinhood Gold, which offers customers access to better data, analyst reports, and margin trading.
If you dive into Robinhood’s SEC filings, you’ll notice the company’s revenues are split into these three generic categories:
- transaction-based revenues;
- net interest revenues; and,
- “other revenues”, which primarily consists of fees generated from Robinhood Gold.
Before we dive into the numbers and discuss why it could be a dangerous mix for Robinhood in the short-to-intermediate term, let’s look more closely at transaction-based revenues.
Transaction-Based Revenues = Payments from Market-Makers for Commission-Free Trading
When Robinhood advertises “ commission-free trades”, it would be naive to think that these trades are free — someone, somewhere is paying for the margin lost to those “commission-less” trades.
The payment comes in what is called “payment for order flow” (PFOF), whereby wholesale buyers and sellers of securities (like large hedge funds, institutional money managers, and hedge funds) pay brokers like Robinhood for routing their client’s orders through to these wholesalers. The wholesalers, in turn, make a profit on the spread between, on the one hand, the price that buyers are willing to pay and, on the other hand, the price that sellers are willing to sell (which is referred to in the industry as the “bid-ask spread”). A portion of the bid-ask spread realized by the wholesaler is paid back to the broker, which can in turn be passed on to the end-client.
Arguments for and Against PFOF
Robinhood argues PFOF benefits its customers. Eliminating commissions from the investment calculus for retail investors lowers the costs of entry into the stock market for retail investors — so the argument goes. Critics of PFOF, however, submit that the arrangement actually produces the opposite result: it raises prices for retail traders by encouraging market makers to make up the money they lose paying for order flow through higher bid-ask spreads. These critics also argue PFOF creates an untenable conflict of interest by indirectly incentivizing brokers to route client orders to the highest bidder rather than to the market maker that offers to best price and fastest execution. There are not any peer-reviewed empirical studies to prove retail clients of commission-charging brokers get better price and trade execution, on average, than customers of commission-less brokers.
There are also somewhat convincing arguments to suggest that charging commissions would create a psychological barrier to force retail investors to do more due diligence when entering or exiting their positions (as opposed to YOLOing in and out of stocks and crypto). On this point, we’re not convinced. If the stock market crashes of the last half-century have given us any insights into stock market psychology, the link between paying commissions to place trades and prudent investing seems tenuous at best. And, certainly, if you were to look at the author’s trading history — with commissions or without commissions — you’d see a very negligible difference in performance!
Why This Revenue Mix is Dangerous
The old adage “never put all your eggs in one basket” couldn’t be more true in business. When it comes to sales, you want to ensure that you have multiple customers and, ideally, multiple products. In Robinhood’s case, having multiple customers isn’t an issue. Its issue lies in the staggeringly high proportion of revenues dedicated to transaction-based revenues.
PFOF has become an even greater proportion of Robinhood’s revenues over time. This increases the risk that Robinhood’s top-line could be significantly reduced or even eliminated entirely if PFOF is more tightly regulated or outright banned in the United States as it is in other countries. SEC chair, Gary Gensler, has publicly expressed his interest in critically evaluating PFOF and is believed to be against the practice, citing conflict of interest argument. While the SEC and other financial regulators have taken a hands-off approach to this subject, Robinhood is not out of the woods yet and has faced increased scrutiny ever since the meme-stock mania of early 2021.
Another alarming trend in Robinhood’s revenue mix can be found when drilling deeper into each of its reported sub-segments. Here, you’ll notice that Robinhood’s most impressive revenue print (June 2021) was in a quarter where it witnessed lots of crypto-related activity.
At the peak of the meme stock mania in the first quarter of 2021, Robinhood reported that trading in dogecoin accounted for more slightly more than a third of all its crypto transaction-based revenues. In the quarter ending June 30, 2021, Robinhood reported that over 60% of its funded accounts traded crypto. Crypto accounted for more than half of its transaction-based revenues for that quarter alone…let that sink in for a second. One of the most controversial (and prone to future regulation) asset classes makes up more than half of Robinhood’s PFOF (itself prone to future regulation). And following its best quarterly print, the revenues fell back down to earth in September, even with volatility in both the stock and crypto (and, consequently, options) markets rising throughout this same period.
If the revenue mix isn’t a red flag, we don’t know what is!
Cyclicality Not Offset by Net Interest Revenues
Lending is the lifeblood of the commercial and retail banking industry. In good times and in bad, banks and brokers rely on lending revenues as a source of funds. The industry term for the spread between the interest that financial institutions pay depositors and the interest they earn from borrowers is called net interest margin.
What is Margin?
In Robinhood’s case, net interest revenues are the revenues that Robinhood generates from lending securities, the interest earned on margin lending and cash deposits, less the costs of borrowing related to Robinhood’s revolving lines of credit. For the most part, net interest revenues are derived from the sales a broker generates from offering its customers the ability to buy and sell securities using margin.
Margin trading is a risky endeavor. The more margin customers use, the greater the interest charged against their accounts. If the equity value of a customer’s account begins to erode in relation to the amount borrowed, it can result in margin calls. Most broker-dealers have sophisticated credit check policies to determine whether or not a customer is eligible for margin trading so as to prevent the likelihood of credit losses due to delinquent accounts.
When a customer’s account falls into margin call territory, they’re given a warning and asked to fund their account by a certain deadline. If margin calls aren’t met, the broker has a contractual right to liquidate a customer’s account, often at a loss to both parties, which leads to credit losses. Margin-related revenues are, therefore, inherently tied to counterparty credit risk.
Robinhood’s Margin Business is On Shaky Footing
Robinhood has had a notoriously difficult time with its margin trading business.
In 2019, the WallStreetBets subreddit community uncovered a flaw in Robinhood’s lending system that allowed customers to borrow outsized margin limits with very small deposits. Although the bug became public early in 2019, Robinhood did not take action until November 2019, losing millions in the process.
More recently, Robinhood settled a fine with FINRA to the tune of $70 million — the largest penalty ever levied by FINRA. FINRA alleged that Robinhood gave customers false or misleading information regarding (amongst other issues) the amount of money customers had in their accounts and their ability to trade on margin. FINRA cites the tragic incident of a young customer who committed suicide in June 2020 after incurring hundreds of thousands of dollars of margin debt, after erroneously interpreting the negative cash balance on his account.
Debacles like these are damaging Robinhood’s reputation as a broker-dealer and will significantly impact its ability not only to retain customers but also to keep out of the crosshairs of regulators.
Margin Alone Will Not Support the Cyclicality in Revenues
While net interest revenues is a significant revenue source for Robinhood, margin alone will not be enough to keep the top-line growing if and when regulators clamp down on PFOF or if Robinhood starts to lose market share in the crypto trading space as other entrants (with more stable business models) like Coinbase start to attract more retail investors.
Moreover, any significant downturn in sectors where its customer base is heavily invested will lead to credit losses and provisions, the magnitude of which could lead to ripple effects across other areas of Robinhood’s business. With rising interest rates, inflationary pressures, stalled plans for fiscal stimulus in the United States, and recurring lockdown scares worldwide, the stock market has been on edge for the last few months of 2021. January portends more volatility on the way. If the NASDAQ-heavy portfolios of Robinhood account holders start to nosedive and margin calls start to escalate, it could spell serious trouble for Robinhood.
Margin is, therefore, yet another red flag in Robinhood’s business model.
Existential Indecision Leading to Stalling Product Innovation
Robinhood’s UX is predicated on making the trading experience as frictionless as possible. It takes less than 5 minutes to download the app, set up a profile, enter your financial information, link your bank account, apply for margin, get approved for said margin, and start trading on everything from ETFs to meme stocks to options to crypto. While revolutionary for their time, the competition has caught up and now Robinhood is faced with a series of existential forks in the road with where to take its platform next.
Tax-Sheltered Accounts like 401(k)s or IRAs?
Unlike its peers, Robinhood does not offer tax-sheltered accounts like IRAs or 401(k)s.
Adding these features could help attract a more mature customer base with higher account balances. At the same time, however, these sorts of accounts require a more advanced tech stack to handle tax reporting and other compliance matters. This means more staff and higher SG&A expenses — things investors don’t like to see without an RoI plan.
Can Robinhood Attract Institutional Traders to its Platform?
Among the professional trading community, Robinhood has long been ridiculed as a gimmick, more akin to a gambling platform than an investing tool. Guy Adami, an outspoken commentator on CNBC’s Fast Money, often chides Robinhood as being a business model in peril. “The only revolutionary thing about Robinhood”, Adami quips, “is the name and the hair”, alluding to the long, wavvy hairstyles of founders Vlad Tenev and Baiju Bhatt.
For the old guard of Wall Street, Robinhood has too many red flags to justify taking a chance with its platform. Robinhood’s reputational risks and close-knit relationship with certain market makers gives institutional traders reasons for pause.
Institutional clients are also uncomfortable with having their high-volume, high-value trades televised to other market-makers. They are more than happy to pay commissions, provided they do in fact get best price and order execution.
Traders at major firms are demanding clients and will expect tailored service offerings, which may be beyond the reach of the current UX provided by Robinhood. They are also much more likely to use computer-driven algorithmic trading and/or margin-based strategies along with FX hedges, derivatives, and the like (all of which are not currently offered on Robinhood’s platform).
Could They Start Charging Commissions?
What would happen to Robinhood’s business model if it were to start charging commissions? Could they survive the churn? Would they have a way of off-setting the churn by allowing some sort of bifurcated offering: one where clients pay no commissions but are subject to PFOF and another where a flat commission is paid and price execution is prioritized? These are major existential questions that would completely change Robinhood’s current strategy and its UX.
Revenue mix woes, low concentration of net interest margin revenues, and UX limitations are just some of the red flags we’ve spotted while looking at Robinhood’s SEC filings.
We’d love to hear your thoughts about it! Let us know in the comment section!