Zero Commissions. Great Business.
Robinhood’s “cash management” pre-launch last week got me curious, as I’ve been many times in the past, about Robinhood’s business model. If you’re the only brokerage not charging commissions on trades, what’s your play?
Searching around, I found this article claiming that Robinhood was being paid a lot in exchange for its “order flow”. What the hell is order flow? Apparently, instead of routing client orders directly to the exchange, you instead send it to the one of the big high-frequency trading firms and these firms will pay you for that. And apparently, every online brokerage out there was doing it. Time to do some digging.
Robinhood’s biggest competitors are all public corporations: TD Ameritrade, ETRADE, Charles Schwab, InteractiveBrokers, etc.
TD Ameritrade
Looking through TD Ameritrade’s 2017 annual report, I was surprised to learn that Ameritrade’s commissions and transaction fees are only about 38% of the revenue. But this also includes order routing revenue. Breaking that further down, 9% of overall revenue is order routing, and 29% is commissions.
The next biggest component of revenue at 30% is “bank deposit account fees”, which is mostly money made from investing excess idle funds in people’s brokerage accounts. Since you can’t do anything too risky or long-term with this cash, the average yield here is very low: 1.16% in 2017. But the total average client balance of $93 billion makes up for that low yield.
Net interest revenue, which includes revenues from margin loans i.e. short-term loans given to customers to buy stocks, is next up at 19%. The yield here is comparatively great (3.79%).
Investment product fees are the last big piece at 12%, which are fees earned on money management advice and mutual funds, etc.
You can already see the skeleton of Robinhood’s business model: no commissions, yes but a wide variety of income sources are possible. And the much lower customer acquisition cost with the virality of having no commissions, and perhaps, increased trading volume means you can actually compete on revenues with the incumbents much earlier than most people expect.
In any case, commissions across the industry are heading down in lockstep. In 2017, Ameritrade reduced commissions by 30%, moving from $9.99 per trade to $6.95 per trade. Not to be outdone, ETRADE made the same reduction from $9.99 to $6.97 in the same month, March of 2017. Charles Schwab, and Fidelity went even lower in 2017 to $4.95 per trade.
ETRADE
Moving on, here’s the overall breakdown for ETRADE:
- Net interest income: 63%
- Commissions: 19%
- Fees and service charges: 16%
Net interest income, in ETRADE’s classification, includes revenue from investing idle cash and margin loans. Commissions include only commissions, and order flow revenue is classified under “fees and service charges” (coming in at about 5% of overall).
But the accounting here is a little trickier for two reasons. First, ETRADE used to sell mortgages prior to the 2008 financial crisis, and they still have some of these on their balance sheet and included within the “Net interest income” category. Secondly, while interest generated on idle cash balances is mostly included under “Net interest income”, about 10% of their idle cash balances are held by third parties, and the revenue generated from these third parties falls under “Fees and service charges” instead.
But roughly, we can make some comparisons with Ameritrade. The revenue related to investing idle cash and margin trading adds up to about 50% for Ameritrade. But for ETRADE, it is about 63% (because we are including its legacy mortgage portfolio, and not including cash held by third parties). This drives the commission proportion down as well (19% for ETRADE vs. 29% for Ameritrade).
Charles Schwab
The financials of Charles Schwab convey a similar story too. However, because Charles Schwab provides a wider range of financial services, commissions are a much smaller percentage of overall revenue. In 2017, 50% of revenue was net interest revenue (includes margin loan profits, and idle cash interest). Commissions, on the other hand, as percentage of total revenue went down from 13% in 2015 to 7% in 2017.
The Model
Since commissions only range from 10% to 30% of revenue for most of these big players, Robinhood can still make a ton of money through primarily three different revenue streams:
- Investing idle cash (interest income)
- Loans for margin trading (the Robinhood Gold product)
- Selling their order flow to HFTs
It’s interesting to note that for a while, Robinhood did not acknowledge the third source of revenue and there was a lot of controversy about this. But much of that hysteria is unwarranted, to be honest. I mean, everyone — TD Ameritrade, Charles Schwab, ETRADE — (except for InteractiveBrokers) is doing it. And it’s also dubious, as this article claims, that “Robinhood makes the majority of their revenue by routing orders through Apex Clearing, Citadel, KCG, and Two Sigma”. As we’ve seen from the public filings above, TD Ameritrade makes 9% of its income from order flow while ETRADE makes about 5%. Nice chunk of change, but not substantial. I have a hard time understanding why HFTs would pay Robinhood substantially more. Pretty unlikely.
The brilliant realization of Robinhood is that you can run a great business — roughly 70% of the revenue of a stable public company — charging no commissions for trades. “Zero commissions” blows people away: I remember the hype from five years ago when Robinhood launched their waiting list for the app.
If these large public companies were smart, they would start offering commission-free trades immediately, and improve their mobile offerings but that seems unlikely. This is the classic Silicon Valley disrupter story: the incumbents make gradual changes, by cutting commission prices, but by the time they hit $0, it’ll be too late and the newcomer will have dethroned them.
