Robinhood: Ushering in a New Age of Trading?
Jake Sullivan, Dartmouth Business Journal
Robin Hood, the titular character of the classic folk tale, is known for his egalitarian cause: ‘taking from the rich and giving to the poor.’ This maxim sounds as if it has no place in any profit-seeking business. Although they do not actually take from the rich and give to the poor, Baiju Bhatt and Vlad Teneu, creators of the increasingly popular app Robinhood, are trying to give less wealthy investors more of an opportunity. A zero commission stock service app, Robinhood has darted its way onto the iPhones—and soon, the Android devices—of day traders everywhere.
With zero commission and $16 million in total funding, the facts behind Robinhood’s success just don’t seem to add up. How exactly does the app work? Where can revenue come from? Will it last?
In July 2013, Forbes discussed a few tips for what makes a successful app. The first is that it must be a great product. The app must be both well designed and user-friendly and is either an original idea or one that builds on an old idea. Although not spearheading the zero commission trading business, Robinhood repurposes the concept for the mobile era. It was born and developed to run on mobile platforms, making it unique from its predecessors. Because it is based on high mobile functionality and easy accessibility, Robinhood acts like the first of its kind. The second tip well understood by Robinhood’s creators is to have a small market in mind. They know that the young, highly mobile trader has neither the resources to afford high trading fees nor the disposable income to meet minimum account balances that many financial services companies require for their customers (see chart 1). So far, their assumption has been correct with around 80 percent of their customers ranging from ages 18 to 29. Furthermore, 25 percent of their clients are first timers, and the average user age is only 26 years young. Robinhood offers a service that will command a loyal customer base that will age and remain loyal as the company continues to scale upwards. The final, most important tip Forbes offered is to track all app related data – and Robinhood has been doing just that. Keeping a close eye on app-related metrics, Robinhood has disclosed that even the smallest in-app portfolios checked the app around 20 times per week, and it has discovered that current users have a high propensity (90 percent likelihood) to recommend the app to a friend. By ensuring consistent usage and constant user expansion, Robinhood is the definition of a viral app with a lot of potential for expansion.
On three accounts, Robinhood is primed for success. But how will it be achieved?
Robinhood prides itself on a lean business model. From the minimized trade costs and a small number of employees, Bhatt and Tenev are ensuring that their overhead costs remain as low as possible. Characteristically, low expenses have allowed them to focus more on brand exposure as opposed to short-term profitability. Unlike most electronic intermediaries like Uber and eBay that charge sellers a small fee for connecting them to buyers, Robinhood does not seek commission. While this cuts out the most obvious and possibly largest source of revenue, Robinhood does offer some features that can generate revenue.
Robinhood currently has two small revenue streams. The first is offering a margin buying service from which it collects a certain percentage of interest on trades. Most of Robinhood’s unseasoned users do not employ this method given their general unwillingness to face the risks of buying on margin. Coupled with a lack of assets to leverage in the process, the young investor will generally stay away from this. The second current revenue stream is gaining interest on customers’ uninvested cash balances. Just as a bank account accrues interest over time, a brokerage firm performs a similar transaction on unused cash balances in their accounts and internalizes the interest. Even for the largest brokerage firms, these balances only yield margins of around 1.5 percent. This source of revenue, however, can only grow, especially as the app’s popularity increases. The future for the company is still bright.
One future revenue stream that Robinhood has been considering as its customer base continues to grow in size is generating revenue on order flows, or compensation received by brokers for turning trades over to different parties to execute. Typically, order flows generate only a few cents per redirected order, but when thousands of trades are turned over, the pennies begin to add up. Another choice in the long run is to offer premium analyst advice, guidance and investment education to some customers at a price, which has been a growing source of revenue for large brokerage firms. The final, and most drastic, long-term revenue opportunity would be for Robinhood to go back on its most fundamental value and start charging a commission. Such a move could condemn Robinhood to the same fate of Zecco, a similar company that launched in 2006 and faced the grim fate of obscurity. Bhatt and Tenev still have a lot of time and funding to figure out ways to avoid charging commission, but with significant streams of future revenue still largely uncertain, this core aspect can still be up in the air.
There are some beneficial long-term benefits Robinhood offers to the financial services industry if it can survive the long run. Forbes notes in October 2014 that Robinhood could create substantial pricing pressure for large financial services companies like E*Trade and Charles Schwab. By setting a zero commission pseudo-standard, Robinhood would be forcing these larger companies to reduce commission price tags in order to retain large portions of their customers. Additionally, through the most efficient current mobile platform, Robinhood is showing that the trading world does not need to have limited access, which can prove beneficial to overall markets. An Organization for Economic Co-Operation and Development study from July 2013 notes that when the incentives to participate in a market diminish for any party – issuers, investment banks, legislators, regulators, stock exchanges, and investors – then the market is not operating at its full potential. Robinhood is diminishing the barrier for investors to participate in public markets. It is exposing more people to the world of trading, which can help the market access its full economic potential.
Despite these benefits, there are reasons to be wary about the fundamentals of Robinhood’s concept. Victor Reklaitis from Marketwatch wrote that the app’s convenience and low barriers to high frequency trading could produce harmful results. He cites Brad Barber and Terrance Odean’s paper in the Journal of Finance of April 2000, which shows that households that used discount brokers had significantly less gains than the market’s gains on year-to-year comparisons (around a 6 percent difference in favor of the market). By increasing the exposure of a pseudo-discount brokerage especially over time, Robinhood’s ‘comfortable trading’ model for stocks, which currently seem to be arcane to an inexperienced investor, will lead to higher buying and selling frequencies that have, in the past, led to diminished returns for the investor. Robinhood’s accessibility may end up hurting the very people that the app that set out to give a chance.
With the goal of revolutionizing stock trading, Robinhood has provided a solid foundation to make stock markets more conducive to young, small-time investors. While the app has been completely hammered out, Bhatt and Tenev still need to figure out if the rest of their business model is soluble. With many of the most forward-thinking and largest venture firms already investing, Robinhood must be doing something right. Only time will tell.