How Robinhood Makes Money?
Robinhood, the American financial services company based in Menlo Park, California, has risen to fame in recent weeks for the GameStop case and the cunning ploy carried out by Reddit users. This risky bet was successful thanks to Robinhood's peculiar business model, which is characterised by offering commission-free operations on stocks and exchange-traded funds through an app for smartphones. But how does Robinhood make money?
Robinhood has made investments accessible even to inexperienced investors and clients without financial knowledge. Through a gamified and no-fee approach, it has attracted more than 13 million users. But this system also has its risks.
Since its launch in 2013, Robinhood has risen to one of the most popular and influential fintech apps in the world. Valued at more than $11B, this company focuses its profits on greatly reduced margins on large volumes of individual operations, a lucrative but precarious strategy.
Robinhood's innovative business model
Robinhood's approach is based on earning income from very small amounts of money in large-scale individual operations. To do that, it attracts many users through benefits and incentives, such as free shares and $0 commission operations. The commercial activity results in very low margins through a process called payment for order flow (PFOF).
It attracts many users through benefits and incentives, such as free shares and $0 commission operations.
This innovative system breaks down traditional barriers to entry into the investment world, since any user can start investing in record time and easily through a smartphone. Also, it allows trade fractional shares. This means that users can buy a part of a share instead of a whole sale. With this method it is easier to invest in high-performance stocks, such as Google, Amazon or Apple.
This innovative way of investing reaches beyond typical older, wealthier investors and aims to the younger and inexperienced ones. In fact, the average Robinhood client is 31 years old, compared to the average investor of 50 years.
When Robinhood was launched in 2013, no other major investment company offered zero-commission trading. The situation remained that way for six years, until in 2019 Charles Schwab, TD Ameritrade and E-Trade announced they would no longer apply commissions on ETFs, stock trading and options. Trading without commissions is now considered the norm after Robinhood's market breakthrough.
How does this trading model work?
Each Robinhood user has to apply for an account. All brokerages operating in the United States have to collect and verify the personal data of the clients trading on their platforms, according to the requirements of the Securities and Exchange Commission (SEC). This process can take up to a week.
Once the users have access to their accounts, they must link it with a bank account. And this is where the two key elements that differentiate Robinhood from its competitors come into play. On the one hand, it provides clients with only the most relevant information to reduce the complexity of investments. On the other hand, it takes advantage of gamification, rewarded actions and behavioural triggers to encourage frequent use of the app.
On the one hand, it provides clients with only the most relevant information to reduce the complexity of investments. On the other hand, it takes advantage of gamification, rewarded actions and behavioural triggers to encourage frequent use of the app.
To simplify the information, the positions of the users are summarised in red (negative) and green (positive). Thus, at a glance they can get an overview of their portfolio. Additionally, stocks can be bought and sold with two simple taps on a stock's ticker page. All this is presented on the interface in a similar way to online banking services apps.
Robinhood's gamification system
Robinhood uses behavioural triggers and rewards to keep holders interested. The first incentive is the granting of a random free share of a company. Although it is true that users may receive a stake in a company like Tesla, Alibaba or Apple, it is unlikely. The most common is that new clients get a share valued between $2.50 and $10, but who knows.
The first incentive is the granting of a random free share of a company.
In other words, Robinhood's UX is based on short-term rewards, positive reinforcement and success messages. All this is complemented by push notifications that the app automatically sends when there are new movements in the portfolios, inviting them to access again and, perhaps, acquire more shares.
What is the problem?
This gamified perspective is not without its critics, because under this appearance of successes and prizes are hidden the risks of operating in the stock market with mechanisms designed to be addictive. These patterns of behaviour are known as "dark patterns."
This, together with the COVID-19 pandemic, are surely the main responsible for the more than three million new users that Robinhood registered in the first four months of 2020. As a consequence, these so-called “pandemic day traders” traded many more shares than in other similar platforms during the same period. In fact, they traded 88 times more risky options contracts as Charles Schwab clients.
But criticism of Robinhood's business model for targeting inexperienced investors was redoubled in June 2020, when a University of Nebraska student committed suicide after seeing a seemingly negative balance indicator of $730K in the app. However, a recent research published by the National Bureau of Economic Research (NBER) suggests that the risky movements do not fully reflect user activity, and that Robinhood investors “principally held stocks with large persistent past share-volumes and dollar-volumes, making them invest overwhelmingly in large rather than in obscure stocks."
The diversification of Robinhood
In order to attract other sectors of investors, Robinhood has diversified its services. Everything seems to indicate that their intention is to pursue a greater market share in the fintech space.
Robinhood's initial registration offering was based on $0 commission stock brokerage, inviting investors to "stop paying $10 for every trade." This proposal got a million subscribers even before its launch. This product could be offered thanks to their service of payment for order flow (PFOF), a controversial practice in which brokerages use third parties called “market makers” to execute trades on their behalf. This process prevents Robinhood from having to manage the difficulties of executing trades itself.
Robinhood's initial registration offering was based on $0 commission stock brokerage, inviting investors to "stop paying $10 for every trade."
Another revenue-generating service is Robinhood Gold, a subscription service that offers additional features in relation to the "freemium" users of the app, such as instant deposits, professional research reports of the market by Morningstar and margin loans. This service has a cost of $5 per month, added to 5% interest depending on the amount loaned to users. Additionally, other Robinhood services are the tertiary fintech products.
The future of Robinhood
Right now, Robinhood operates in a grey area on the edge of regulatory legality. Wider regulation of the financial sector and fintech products could seriously affect its risky business model.
Some of the challenges it will face in the near future will be difficulties in getting new users, increasing the value of its accounts to justify its recent valuation and increasing the value of its average user rather than sheer volume alone. After all, its competitors are hot on their heels. Maybe they have fewer clients, but they manage more assets.