Robinhood Business Model Analyzed And Explained

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Every seasoned stock trader or crypto lover must have heard of Robinhood, registered under Robinhood Markets, Inc. This is an American Financial Services company founded in April 2013 by Baiju Bhatt and Vladimir Tenev, with headquarters in Menlo Park, California. It is known for providing commission-free trade of different commodities such as stocks, cryptocurrency, and exchange-traded funds through its mobile application introduced less than a decade ago.

The first time Robinhood came into the limelight was in March 2015 when it officially launched its application, a few months after showcasing it on LA Hacks. The founders, who graduated from Stanford, started the company to take advantage of the increasing familiarity of smartphones but the ensuing lack of access to investment options by convincing two major players to invest roughly $3 million in seed funding.

With the right steering, the entity recorded over a billion dollars in transactions and over a million users within the first year of operation. Three years later, it was recognized as the fastest brokerage in the world to clock $2 billion in transactions, which is no mean feat. It is one of the fewest companies to witness something positive during the Covid-19 pandemic since it gained an additional 3 million users.

Now that you know what this company is all about, let’s take a more detailed look at its business model to understand how it makes money and a little extra information about it. Let’s get right into it.

Robinhood Business Model: How Does It Make Money?

Robinhood has diverse revenue streams, which explains why it has been successful. Let’s delve deeper into them to help you understand their profitability.

1. Order Flow

Robinhood makes lots of money from order flows, which can be considered its main revenue generation stream. How does this happen? Let’s go back to how this platform works. Anytime a user trades any option, stock, or exchange-traded fund on the platform, Robinhood forwards it to several market makers, trading platforms, or venues to bring them to fruition, who in return pay brokerages through rebates. This is because retail brokers can’t execute customer orders and must pass the trades to wholesalers at a fee.

The phenomenon explained above gives rise to what is known as payment for order flow, regularly shortened as PFOF, which can be defined as the payment of brokerages by trading platforms and market markers via rebates in exchange for buy/sell orders offered by Robinhood.

What’s more interesting is that Robinhood ensures that it gets the best price in the market before selling any order through a critical algorithm, often referred to as a smart order router. It is a highly practical algorithm that can also send a given percentage of the orders to exchanges, which offer liquidity in exchange for payment.

If you have been wondering why this company can easily offer commission-free trading to all its users, then you have the right answer, i.e., over 70% of its revenue is obtained through this arrangement.

Let’s clearly explain how this phenomenon works. Once the customer instructs Robinhood to execute a stock trade, it will send the trade to a wholesaler at a fee. Finding the best execution that guarantees the lowest price and fastest trade is placed upon the wholesaler, who then remits all the proceeds to Robinhood, who must then credit the customer. We hope that the explanation was clear enough.

2. Gold Subscription Free

Anybody who uses this platform knows about the gold subscription fees paid by those with a premium account. This premium membership is known as Robinhood Gold and normally costs $5 monthly, which many people can afford.

A gold membership account comes with many offerings that several users prefer, including access to different investment tools and benefits and discounted rates on margin investing. The latter means customers only have to pay a 2.5% yearly interest on settled margin accounts over $1,000 if they use $1,000+ for margin investment. Quick research also shows additional benefits, such as Morningstar research reports and greater instant deposits.

Even though this stream only accounts for 10% of the platform’s annual revenue, it is still important.

3. Interchange Fees

This business has a spending account program known as the Robinhood Spending Account Program that gives users debit cards. However, these are not normal debit cards since whenever a cardholder makes a transaction, they are charged a small amount as interchange fees.

The interchange fee is, therefore, the transaction processing fee that this business charges cardholders. This income stream is also usually referred to as cash management. The card is issued by Sutton Bank and licensed by Mastercard.

4. Interest from Loans

This fintech company’s success over the years can also be attributed to the interest it earns from both margin and security loans. Margin loans refer to the funds this platform gives its investors, allowing them to acquire more securities. The fund, therefore, acts as an incentive to invest more. To make money, Robinhood charges a 5% interest for any amount above $1,000.

On the other hand, secured loans are awarded to counterparties, who have to pay a given amount of money in the form of interest to Robinhood. This revenue stream accounts for almost 20% of Robinhood’s total income, which makes it an important stream.

5. Interest from Cash

Robinhood is a financial company, and therefore, one of its revenue generation avenues is interest earned from uninvested brokerage cash. Such cash is always deposited into bank accounts that offer interest on deposits. However, given the tiny nature of this revenue stream, it is often classified under ‘other revenue,’ similar to the gold subscription fees we have discussed.

These 5 avenues account for how Robinhood makes its money. It’s important to note that they differ in magnitude, which we have highlighted in our discussion.

Robinhood Competitors

Robinhood faces fierce competition from several entities offering the same services. Here is a list of the major ones:

1. Webull

Webull was founded in 2017 and hasn’t been in business for long. However, it has managed to give Robinhood, which is relatively older, a run for its money owing to its features and the value propositions it offers investors. It is one of the best platforms for intermediate-level investors interested in the stock market and options trading. It offers 5 investment options, i.e., ADRs, market stocks, options, ETFs, and select cryptocurrencies, and charges no annual or inactivity fees.

Some of the advantages users enjoy with Webull include several analysis tools, commission-free trading, no minimum balance requirement, and access to stocks listed on major ETFs, exchanges, and options. The only downside is that the platform does not have managed investment options and doesn’t support direct bond purchases.

2. Public

The public is also relatively new, given that it was founded in 2017. It has contracted Apex Clearing, an able third party, to ensure the effective running of user accounts. Like Robinhood, users get the option to follow specific companies. As the name suggests, they can make their portfolio public and view other people’s portfolios. It is mostly recommended for those interested in social trading.

Some features and pros investors get include free investments, zero trading fees or commissions, lots of social trading features, and the ability to keep track of other users, including their investment strategies. However, the Public may not be the right option for advanced traders due to certain limitations. It also lacks a wide range of asset types, which may give Robinhood the edge.

3. M1 Finance

M1 Finance is one of the strongest Robinhood competitors, given its features and offerings. Users enjoy professional investment guidance on top of traditional investment services, making it quite unique. Money can also be accessed and easily transferred between investments. It works best for those who don’t want to manage their portfolio actively.

Some features and advantages M1 Finance users enjoy include 2% loans through its signature service, M1 Borrow, the ability to send physical checks at the touch of a button, the ability to earn back from spending, and a fractional stock shares purchase option. This platform also allows users to automate their investments. However, it charges monthly fees and requires a slightly higher minimum balance. It doesn’t also cater to day traders.

4. Coinbase

Coinbase is one of the most popular crypto trading and exchange platforms. It is highly lauded because it allows account holders to monitor their assets’ real-time value and prices through its powerful dashboard. They can also sign up for a Coinbase VISA debit card, allowing them to use their assets to make purchases.

Some of the features and pros users get are the ability to own and manage multiple assets, access to 100+ cryptocurrencies, the ability to generate spending summaries and transaction receipts, insurance on assets, and high-end protection. However, this platform charges higher fees than most of its counterparts and may not be the best when it comes to supporting.

5. TD Ameritrade

This is one of the easiest-to-navigate platforms on our list, thanks to its excellent user interface. Users enjoy extensive stock research and several investment opportunities. It has several tools that new and intermediate investors can use to be good at what they do. It also permits the creation of multiple watchlists and setting custom alerts, which helps stay updated with different trends.

Some of the pros and features users enjoy include multiple trading options, zero commissions, interactive courses, detailed research reports, options and futures trading, and tax-loss harvesting for minimizing portfolio losses. Despite all these excellent features and pros, users have reported experiencing problems with the application, which they say freezes occasionally.

Robinhood Strengths

Here are some of the reasons Robinhood still exists despite the stiff competition it faces from the companies listed above:

1. It Enjoys a Strong Brand

Nobody can rid Robinhood of its brand. It remains the first company to offer commission-free trading; a privilege other businesses do not enjoy. It, therefore, had time to inspire customer loyalty, which may not be the same for other businesses.

2. It Has Diverse Offerings

Robinhood has a diverse portfolio for its users. They can invest in stocks, options, cryptocurrency, or ETFs. It also supports the purchase of fractional shares and American Depository Receipts for 250+ companies.

3. Target Audience

Robinhood targets millennials, a customer base easily interested in long-term investing. Therefore, the company’s target audience assures it of a great future and can help it better personalize its services.

4. It Revolutionized the Market

It is a well-known fact that Robinhood revolutionized the market with its commission-free trading idea and low-cost strategy, which new companies depend on to profit and stay in business. The company incorporated an innovative business model allowing those with no experience and little stock knowledge to invest freely.

Robinhood Challenges

Even though Robinhood has managed to fair well despite the stiff competition it experiences, it has faced and still faces several challenges. Let’s shed some light on these:

1. Plunging Stock

2022 has been an intensely difficult year for Robinhood. Despite going public in 2021, the company’s stock has consistently dropped, with the worst record being in November 2022 following the fall of FTX, which has more than a 7% stake in the company.

2. Decrease in the Number of Users

The number of active users has also dropped significantly. The platform had more than 22 million users in 2022, a figure that has reduced to less than 16 million, meaning that it has lost over 7 million users. A decrease in the number of users also means less revenue, given that the platform heavily depends on them to make profits.

3. Lack of Any Serious Competitive Advantage

Almost every Robinhood competitor uses its low costs strategy, i.e., no/minimal commissions and other charges, which was its biggest competitive advantage. This is a huge challenge, given that investors now have several options to turn to or try out whenever they feel Robinhood doesn’t work for them.

4. Limited Options

Even though Robinhood provides a considerable amount of assets to its users, its offerings at still limited compared to other platforms. For example, TD Ameritrade supports futures trading, which Robinhood doesn’t have. Limited options also mean that investors interested in advancing their trading skills may have to seek other options, which is definitely a huge disadvantage on Robinhood’s part.

5. Customer Experience Challenges

Even though Robinhood enjoys a relatively large market share, many of its customers have complained about their experience with the platform. Some common complaints that ought to be addressed include market surges, outages, and the occasional misleading information.

6. A not-so-perfect Brand Image

Despite its success, Robinhood has faced several fines and lawsuits, which harm its overall brand image. It has paid some of the heaviest fines to be handed out by regulatory bodies, which may have left a negative mark on its reputation. If it doesn’t learn from the past, we might just see such issues again.

Where Does Robinhood Stand Today?

Robinhood currently enjoys over 15.9 million active users today, which is commendable. The company has made remarkable achievements over the years, including a$3.4 billion increase to its balance sheet following the GameStop stock squeeze. At the beginning of 2022, Robinhood managed over $98 billion in assets, a $35 billion increase compared to the assets under management at the beginning of 2021.

Despite all these achievements, it’s worth noting that activity on Robinhood’s platform has decreased since 2021 when it had the highest number of users, i.e., 22.5 million. It also lags in the average account size compared to established brokerages such as Charles Swab. It seems that 2022 hasn’t been a great year for the platform since its valuation dropped from $20 billion (the platform’s valuation in 2021) to $7.7 billion.

In one year, Robinhood has witnessed a significant drop in its active users and had to lay off its staff twice, which is quite alarming.

What Does The Future Hold For Robinhood?

Robinhood’s stock has been tumbling for the better part of 2022, reaching an all-time low in November following the disaster with FTX.com, which owns over 56 million shares in Robinhood. Even before that, several publications were urging the platform to form an alliance with some of its biggest rivals to survive. In fact, in an August 14th, 2022 publication, CNN Business pointed out that Robinhood may have to join forces with a bigger wall street rival if it intends to stay afloat, which was quite the irony given that the platform was formed to rid some of its thriving rivals the power of the stock market.

The platform may have to heed the above calls and allow one of its well-established rivals to buy a considerable number of shares since its future is not bright. Alternatively, it can choose to expand its target market, which is majorly millennials at the moment. Other areas worth considering include mutual funds and retirement accounts which will appeal to the older generation.

Robinhood must also improve its customer support to enjoy a bright future. This may force it to offer additional training to its staff or acquire better talents. In conclusion, the company’s future is bleak as it stands.

Conclusion

Despite experiencing a flowery start and enjoying support from millions of investors, Robinhood’s story hasn’t been all rosy. 2022 has been a year of intense struggle occasioned by tumbling stock, layoffs, and high competition. Robinhood will need more than its strong brand and loyal customer base to survive in the coming years.