Robinhood’s Business Model and Practices Make It a High-Risk Bet

Robinhood (NASDAQ: HOOD), the zero-commission investment app that has upended the brokerage industry, has filed to go public. The company indicated that it wants to raise $100 million from the IPO. This is usually a placeholder value, so we can expect changes to these terms as the company makes amendments to its investment prospectus. In this article, we will discuss some of the key findings from the prospectus to determine if the company is a good investment prospect.

Robinhood is Gamifying Investing

Robinhood follows in the tradition of many IPOs in having sensational revenue growth. Revenues grew from $278 million to $959 million in 2020, a rise of 254%. That kind of sensational growth has continued into 2021. Revenue was $522 million for the first quarter of the year, up 309% from the same period last year.

The cause of the company’s quite exceptional growth is the company’s success in bringing in retail investors en masse. At the beginning of the year, the company had 31 million registered users, double what it had in 2020. The company was able to grow the number of funded accounts by 151%, between the end of 2020 and the end of the first quarter, reaching 18 million funded accounts, compared to 7.2 million funded accounts in the same period last year. The number of funded accounts in 2019 was 5.1 million.

The financial establishment is necessarily conservative: when investors take on too much risk, that makes markets unstable and presents the possibility of widespread investor losses. Critics of Robinhood have accused the company of gamifying investing through its combination of rewards, bonuses, and push notifications and other prompts. These tools are designed to get users to trade more frequently. Systemically, this makes markets more volatile, in terms of Robinhood’s own customers, it may lead to negative returns over time, despite the success they have had with meme stocks. The critics are right that Robinhood’s app is designed to encourage high frequency trading.

As we will discuss below, the company’s revenue is largely derived from exploiting the spread between the bid and ask prices of stocks. The wider the spread, the more money Robinhood makes, and wide spreads mean stocks such as Herz, GameStop, and sneaker store shares, examples of meme stocks. So not only does the company encourage high frequency trading, it benefits enormously when its users invest in specific kinds of stocks. Amorally, Robinhood is within its rights to have such a business model. The trouble is, that business model is inherently risky.

The company has been supremely successful in bringing in new users and these users are committing more and more capital to Robinhood. Average revenue per customer for the first quarter was $137, 65% more than for the same period in 2020, when the average revenue per customer was $83. The cohort of investors who signed up last year committed 45% of their funds to Robinhood, making them the most lucrative cohort in the company’s history.

Payment for Order Flow

We have alluded to how Robinhood makes its money. More technically, Robinhood’s revenues are largely derived from what’s known as “payment for order flow” (PFOF). This controversial practice is banned in Canada and the United Kingdom and importantly for investors, is under review by the U.S. Securities and Exchange Commission (SEC). PFOF has been referred to as a kickback. Essnetially, the practice is one in which a broker such as Robinhood, sells customer trades to a market maker (Robinhood likes Citadel Securities, for example), in return which that market maker pays compensation, in the case of Robinhood, equal or greater than the market price. PFOF in 2020 generated 75% of Robinhood’s revenue, a figure that rose to 81% in the first quarter of 2021.

The trouble for Robinhood is that PFOF is, as we said, under review. Gary Gensler, the SEC chair, believes that PFOF does a disservice to retail investors. Admittedly, it’s a disservice they do not see, a hidden cost, unseen opportunity costs. The SEC’s attitude toward PFOF will effectively determine the viability of Robinhood’s business model. You might think that this would hurt its rivals too, given that TD Ameritrade and Charles Schwab have also embraced zero-commission trading. Yet, PFOF makes up only 10% of the revenues of both TD Ameritrade and Charles Schwab. The SEC will not then be constrained by fear of market-wide disruption. This lopsided risk makes the company highly unattractive.

Regulatory investigations 

The other day as I was thinking about how often people get tripped up when it comes to spousal support/alimony, it struck me that the scale of the regulatory challenges Robinhood faces are potentially existential. Don’t ask me how I made the link. The company’s prospectus was issued just a day after the Financial Industry Regulatory Authority (FINRA) fined the company a record $70 million for causing “widespread and significant harm” to its customers. FINRA found the company to suffer from a number of failings, including technical problems during periods of high volatility.  The company was found to have several failings, including technical problems during high volatility periods.

The prospectus shows that the company is being investigated by seven federal and state regulators and is the subject of 50 class-action lawsuits and three individual customer actions. The legal troubles are related to the company’s January decision to impose restrictions on investors at the height of the GameStop and general meme stock frenzy.

With a business model that is under such immense regulatory pressure, the company appears to me to be too risky at present.