robinhood hoodwinked the public

How Robinhood Hoodwinked the Public into Billions

Robinhood rose to fame in 2014 when they launched on Apple’s App Store in 2014, with a waitlist of 1 million users without spending almost anything on marketing.

Vladimir Tenev and Baiju Bhatt, Robinhood’s founders who had met studying at Stanford in 2005, built their trading platform around no commissions and no minimum balances, at a time when even low-cost rivals like E-Trade and TD Ameritrade made billions on such fees.

Bhatt focused maniacally on app design, trying to make Robinhood “dead simple” to use. iPhones flashed with animations and vibrated when users bought stocks. The app went on to win an Apple Design award in 2015, a prize given to just 12 apps that year.

The apps simplicity is only half of the equation for its success.. The other half is Robinhood’s use of behavioral triggers and rewards.

Much of Robinhood’s user experience is rooted in positive reinforcement and short-term reward structures. When account holders make their first deposit, they receive a congratulatory message saying that funds have been made available immediately so they can start trading.

By the fall of 2019, Robinhood had raised nearly $1 billion in funding and swelled to a $7.6 billion valuation, with 500 employees and 6 million users. Tenev and Bhatt, both minority owners of Robinhood with estimated 10%-plus stakes, were rich.

The app allows users to invest in and trade stocks, exchange-traded funds (ETFs), options, and American depositary receipts (ADRs). It also allows users to invest in several cryptocurrencies.

The company makes money through payment for order flow, premium membership fees, stock loans, interest on uninvested cash, interchange fees related to its debit card, and other smaller revenue streams.

Chart: Matthew Johnston Source: SEC Form S-1 for Robinhood Markets Inc.

Robinhood’s Business Segments

In 2021, Robinhood revealed on average the are able to earn $137 a year per user which is a significant jump from the $83 in average revenue per user Robinhood was earning in March 2020.

Robinhood operates and reports its financial results as one business segment. However, it does provide a breakdown of revenue into the following categories:

Transaction-based revenues:

Robinhood makes most of it’s money from selling your data. In fact, the entire online brokerage industry relies on what’s known as payment for order flow as their profit engine. The pioneer of “free trading,” Robinhood’s business model hinges on the back end payments, which thanks to a recent change in SEC rules, these brokers are now required to give more disclosures on how trades are executed, and how much money they bring in for firms.

Market makers, such as Citadel Securities or Virtu, pay e-brokers like Robinhood for the right to execute customer trades. The broker is then paid a small fee for the shares that are routed, which can add up to millions when customers trade actively.

“All market makers we have relationships with pay us at the same rate. We have relationships with a number of market makers in an effort to optimize speed and execution quality,” a Robinhood spokesperson stated.

Robinhood attracts the highest rate for equity trades at 17 cents per hundred shares. Charles Schwab, by comparison, makes 11 cents per hundred shares. For options trading, the disparity is even bigger.

TD Ameritrade and Robinhood make by far the most off of options at 58 cents. Schwab and E-Trade make 37 cents and 46 cents, respectively. According to disclosures, Robinhood saw the biggest increase quarter over quarter of any brokerage firm, with order flow nearly doubling in the past year.

Payment for order flow is typically paid on a per share basis. Robinhood, however, receives a fixed rate per spread which is higher than the average rate the other major brokers receive.

Citadel Securities pays for this order flow and makes money by automatically taking the other side of the order, then returning to the market to flip the trade. It pockets the difference between the price to buy and sell, known as the spread.

It is in the best interest of market makers like Citadel to trade against noise, uninformed, and liquidity traders because they are less sophisticated in pricing products. This naturally includes most of the retail traders aka Robinhood’s target consumer.

Another reason as to why Robinhood is payed a up to 48% premium on its order flow is the fact that most order coming from the platform are extremely small. The lower the number of shares in an order the less risk there is for market makers to lose money on that order.

Critics of Citadel also argue that market makers can, in theory, “front run” orders by, for example, jumping ahead of a customer’s stock purchase to buy it themselves, making a small gain if the share price increases. There is no proof that Citadel Securities engages in front running, which is prohibited by SEC and requires market makers to immediately execute retail orders.

Net interest revenues

Robinhood generates net interest revenue on securities lending transactions. Interest is also earned on margin loans to users, and interest expenses are incurred in connection to the company’s revolving credit facilities. Net interest comprises approximately 12% of Robinhood’s total revenue.

Other revenues

Robinhood’s other sources of revenue primarily consist of memberships fees for Robinhood Gold. Robinhood Gold is a paid subscription service that offers users premium features, including enhanced instant access to deposits, professional research, Nasdaq Level II market data, and access to margin investing for approved users. This accounted for nearly 8% of companywide revenue

‘Conflict of interest’

Trading options is far more lucrative for Robinhood than a simple equity trade.

Because options are traded less frequently, there’s a larger spread between the bid, or the price buyers are willing to pay, and the ask, or the price sellers want. Retail brokers “without a doubt” steer customers to options trades since those provide the bigger payday.

“It’s a huge conflict of interest for these free trading platforms. The Citadels, the active traders of the world, know that Robinhood has much more unsophisticated traders, so they can make money on them.” –Tim Welsh, founder and CEO of wealth management consulting firm Nexus Strategy

These complicated trades give clients the option to buy or sell securities at predetermined prices. The process is typically used by professional traders, such as hedge funds. The technique tends to be more speculative — it gives clients more ability to use leverage, and therefore more upside. But it can also provide more downside losses.

Robinhood screenshots were posted to a Reddit community on investing.

Robinhood made more than $111 million, of its $180 million total, from options trades in the second quarter but recently made it more difficult for customers to access its options offering, in the wake of a customer’s death this summer. Alex Kearns, a 20-year-old Robinhood customer, died by suicide and in a note to his family cited what he incorrectly thought were $730,000 losses from trading options on the trading platform.

“I think they should put a cigarette warning label on Robinhood, because it could be hazardous to your financial health the more you trade. Every study on planet Earth has shown day traders that are not sophisticated do not make money. They game-ify it, they throw confetti after each trade, the make it ‘free’ but ultimately it’s a losers game,” Welsh said.

Robinhood said the majority of its customers are not “day traders.”

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