Robinhood's Fork(s) in the Road

It has had a meteoric rise, but why exactly? And, what is next?

Full disclosure, English is not my first language, you will likely experience my thick Brazilian accent and fair share of grammar errors below. I hope that it does not discourage you from exploring the main idea of this post.

This week’s post is based on a conversation I had recently with a friend about Robinhood, the Millennials’ commission-free trading platform of choice. We were talking about how Robinhood has had a tremendous run so far, but we wondered what is next for Robinhood?

I thought it would be fun to do a macro analysis, so here it is.

BTW, I am not Robinhood customer/investor. I do have concerns about uneducated investors trading stocks/options but this post is not to rant about it

🚀 Meteoric rise

Robinhood started the development of a commission-free trading app in 2013, launched it in early 2014, hit 1 million users by 2016, 2 million by 2017, and 10 million by Dec of 2019. Between Jan/Apr 2020 it amassed another 3 million users. The circumstances created by COVID-19 continue to be a major tailwind, and there is a good chance that in the last 4 months (May/Ago) it may have added another 3 to 5 million new active accounts. Since 2013, the company has raised around $1.5 billion, and its latest funding round (a two-part Series F) valued the private company at $8.6 billion. Not shabby at all! But what is next?

👏👏👏 Great timing, great team, great focus and great execution

To understand what is next, it is worth understanding what came before. Robinhood’s meteoric rise is no accident but rather a fortunate sum of great parts. The co-founders were in the right place, at the right time, with the right skills. Robinhood’s rise also shows that new ideas are almost never new and that understanding inflections points and its consequences is key to build new businesses.

Robinhood was NOT the first broker to offer commission-free trading. There is a chance you haven’t heard about Zecco (short for Zero Commission), a discount brokerage firm that started offering commission-free trading in 2006.

Zecco was well-capitalized, in 2006 it raised $4 million for its seed funding round (compared to Robinhood’s $3 million in 2013). It also had a good technical and product team. But… Zecco is no longer! It tried a few different business models based on zero commissions, but it did not work and it was ultimately acquired by TradeKing in 2012, a broker that charged low commission fees (TradeKing/Zecco was then acquired by Ally Financial in 2016, also at the time a low commission broker. Ally Financial now offers no-commission trading). The bottom line, Zecco failed at the zero commission attempt.

That does not mean that zero commission is or was not possible, it just means that Zecco did not find a way for it to work. A few people I spoke to suggested that Zecco was trying to lure customers with commission-free trading just to be able to charge them commission fees after a certain number of trades. If that is the case, commission-free was not the end goal but a mere marketing gimmick. That is not a sound strategy. The model did not work, there were many frictions left untouched in Zecco’s offer (from a suboptimal user interface to the small number of free trades offered, to minimum account balances, etc).

It is important to observe Zecco’s timing. It launched in 2006, a time when almost nothing was developed to be mobile-first, a time when PCs (Personal Computers) still ruled. The smartphone industry was still more promise than reality. The first iPhone was released commercially in June of 2007, the Apple App store took another year to be launched.

Zecco started as a desktop trading platform and only years later tried to adjust to an increasingly mobile world. In 2011, in one of its last attempts to make it work, it launched a trading app. Unfortunately for them, it was not an app in the Apple/Google stores, but a Facebook app. It was technically very well executed but definitely not the right app, not at the right place, Zecco was still not fully thinking mobile.

💨 Tail winds matter…

Robinhood started with major tailwinds: in 2013 there was a very vibrant and growing smartphone/mobile scene. Apps were the best thing since sliced bread, free stuff became the norm (e.g., free games, free social networks, free media), network effects and gamification principles were well-understood elements of a strategy to influence customers’ behaviors and drive engagement.

In 2013 it was also cheaper to start a business. Infrastructure as a Service (IaaS) like AWS (Amazon Web Services launched in 2006) were a no-brainer choice in helping to keep basic infrastructure investments at a minimum while allowing businesses to scale quickly as needed. In 2016, when it reached 1 million active accounts, Robinhood still only had 2 DevOps engineers.

At the center of the mobile revolution was an entire generation: Millennials, a group of ~70 million people in the U.S. born between 1981 and 1996. The youngest Millennials in 2013 were 17 years old and the oldest ones were only 32 years old. Most had never traded stocks before, but almost all of them had a smartphone. It is no secret that the average age of Robinhood’s customers is 30 years, and that half of them are first time traders.

But the tailwinds didn’t stop there: the financial markets were having a great Bull market. Trading volumes had dried considerably post the dot-com boom and bust cycle in the early 2000s, and then again during the 2008/2009 house market crash. By 2013 the bull market was going strong and trading volumes were recovering from previous lows.

There could not have been a better time for a mobile first trading app designed with gamification principles and targeted for Millennials

As favorable as the environment was, it still required a great team with the ability to deliver on the promises of those great conditions. A great team is way more than engineering skills. Technical skills do count, but equally important you need a team that understands how to navigate the regulatory environment, how to market for a particular audience, how to keep operational costs extremely low, and how to develop alternate sources of revenue.

Vlad Tenev and Baiju Bhatt, the two co-founders proved to have all those skills. The math Wizards met at Stanford before joining forces in 2009 to open two financial businesses: an algorithmic trading firm and high-frequency trading software for hedge funds. The experience of running those two businesses exposed Tenev and Bhatt not only to the technical aspects of a trading platform but equally importantly it allowed them to learn how to navigate the treacherous finance regulatory space.

Lastly, to be successful Robinhood also needed the right level of capitalization. More than money and access to money, right capitalization means having access to influential equity investors that can open doors when needed (and it is always needed).

GV (previously known as Google Ventures) was the first venture firm to bet on the two co-founders in an early seed round in 2013. At the time, Robinhood did not offer a trading app but a crowdsourced stock advice app, a mix of a fantasy game and a social network that allowed users to track stock recommendations from other users. They removed that app from the app store and went back to the drawing table to design the trading app (along with working with FINRA to obtain the proper broker-dealer license).

By the end of that year, there was an additional $3 million seed round connecting the startup with another set of influential investors (funding round led by Index Ventures and joined by A16Z plus many individual renowned investors).

It also helps that a few celebrities/influencers (Jared Leto, Snoop Dogg, and Nas) got involved early on as well, as they proved to be a great asset during the 2013/2014 launch campaign, which was superbly well executed. It is said that it created a waiting list of 1 million potential users.

🔮 Looking ahead: the many forks in the road!

Will it be acquired by a competitor? Should it acquire another Fintech? What are the best growth strategy options for Robinhood? Could it become more than a broker?

Before we try to answer these questions, I suggest we take a quick look at the last 45 years of the brokerage industry as it will help us to better frame Robinhood’s fork(s) in the road, the many options it has to continue to grow and also the many risks it is facing.

🐣 1975: an industry is born

For almost 2 centuries until May 1st of 1975, stock brokerage firms were only allowed to charge fixed commissions. Discounts were a big no-no and any firm caught offering discounted fees risked losing its brokerage license. On that May 1st, however, the Securities and Exchange Commission (SEC) passed a new rule allowing brokers to charge varying commission fees and with that, a new industry was born: the discount brokerage firms.

The new rule was controversial at the time, the older and well-established brokerage firms considered it to be a disaster-in-the-making as it definitely made it much harder to keep the status quo. A few small new firms, however, quickly realized that this was a major regulatory inflection point for the brokerage industry, it was about to be reshaped.

On that same May 1st, a then young broker firm was the first to offer discounted brokerage services. You might recognize the firm’s name: Charles Schwab & Co.

A few firms aggressively experimented with discounts and quickly observed a substantial increase in the number of new accounts and higher trading volumes, helping to offset the lower commission fees. A new business model was being figured out, and efficiency was at the heart of the new business model’s flywheel.

While the new regulation was a boost to a new industry, those were the early days of computing and application software. The industry as a whole lacked automation and continued to be a high-touch, human intense business. Overall operational efficiency was capped, keeping operational costs from falling fast and substantially, and along the way holding back how fast and how low discounts could go before hurting the bottom line.

1975 / 1994 - The 1st Wave

Discount brokerage firms understood that investing in operational efficiencies (e.g., automated back-office operations, improved sales process) was the only way to lower its operational costs and allow greater discounts to be passed on to customers, attracting more customers, increasing trading volumes and cash managed (deposits and margins). Economies of scale + synergies mattered, opening the gates for a consolidation wave. Growth meant merging and acquiring, gaining volumes, and lowering operational costs.

1995 / 2008 - The 2nd Wave

It was not until the mid to the late 90’s that the industry experienced another major inflection point: the Internet. Discount brokerage firms were quick to implement self-service trading platforms, helping to drive transactions costs down by an order of magnitude and allowing commissions to continue to fall even more sharply. Commission fees went from over $100 to under $40 per trade. High-speed internet connections attracted more first-time users and retail self-trading started to become mainstream. The flywheel continued spinning…

As game-changing as this second wave was, it is important to notice that it was predicated on the PC (personal computer) world. All online trading platforms were designed for desktop use, requiring the user to be seated in front of a computer screen to be able to trade. The lack of mobility limited trading activities and volumes.

2008 / 2020 - The 3rd Wave, the end of an era

From its early days in 1975 until today, the discount brokerage industry followed one single direction: falling commissions. When Robinhood started in 2013, the discount brokerage firms charged between $7 and $10 per trade.

So, how low could it go? Is zero commission viable? Is it even possible that brokerage firms will pay for users to trade in the future? It all depends on the combination of two variables:

• a broker’s ability to bring operational costs down (with no impact to quality)

• a broker’s ability to replace the revenue generated by commission fees

As observed during the first wave, a sure way to bring operational costs down is by increasing trading volumes, the number of active accounts, etc. That is why there have been many mergers and acquisitions over the last 10 years. The industry is consolidating as a way to lower operational costs while at the same time improving a firm’s ability to generate alternate revenue through cash management activities:

• Users’ deposits (idle money on trading accounts) receives zero or ridiculously low-interest payments. That money is channeled to lending activities by banks associated (or owned) by the brokerage firms, earning the firms considerable revenue

• Users trading on margin accounts and paying interest to the brokerage firms

The last two mega consolidation moves are very telling: Morgan Stanley is acquiring E*Trade and Charles Schwab is acquiring TD Ameritrade.

The 3rd wave marked the end of an era: commission-free trading is mainstream, mega consolidations are taking place. The industry will have to find a new frontier, the industry will have to develop a new flywheel.

💸 What does the recent industry consolidation wave tell about Robinhood’s latest valuation?

Morgan Stanley will be adding 5.2 million active accounts by acquiring E*Trade, and at $13 billion for the deal, each account is valued at ~$2,500. Charles Schwab will be adding 12 million active accounts by acquiring TD Ameritrade and at $26 billion for the deal, each account is valued at ~$2,165. More than the number of accounts, each deal is aiming for massive deposits, a major source of revenue as I explained above.

Robinhood’s latest valuation at $8.6 billion and 13 million accounts, values each account at $660 (when the series F closed, Robinhood likely had over 15 million accounts, which would bring the value per account even lower).

At a valuation of $660 per active account, Robinhood seems like a bargain when compared to E*Trade’s and TD Ameritrade’s recent valuations, but is it? Could it be acquired by another major player?

One, its current valuation does not price it as a bargain, and two, it is unlikely it is a target to be acquired. Robinhood’s lower valuation is explained by its users’ demographics: predominantly cash-strapped younger users, users who are not at a point in their lives that they generate substantial income excess for investing or generate sizable deposits. As a result, Robinhood’s overall deposits are likely to be much lower than its competitors on a per-account basis, which limits its ability to generate revenue through cash management (cash sweeps/lending activities). The bigger players would be more interested to acquire Robinhood if it had huge deposits.

As a private company that is not required to share its operational results, there is not much information about its revenue streams, how diversified they are, how they are evolving, etc.

The only piece of information available about Robinhood’s revenue is related to one particular revenue stream: payments for order flow (PFOF) - here is a good article that explains what PFOF is. This information comes from quarterly reports Robinhood is required to file (see Regulation National Market System, approved by SEC in 2005). You can find these quarterly reports under Robinhood’s website page Disclosure Library.

What we learned from these (imperfect) quarterly reports is that Robinhood is generating a lot more revenue through payment for order flows than its competitors (Charles Schwab, TD Ameritrade, Fidelity, etc). Additionally, it tells that every quarter Robinhood is increasing this particular revenue stream incredibly.

Take 1Q 2020 for example, Robinhood generated around $90 million, and in 2Q 2020 it generated around $180 million, ~100% increase quarter-over-quarter. From a quick look at these reports, I noticed that in Jun/2020 Robinhood’s PFOP revenue was almost equal to the whole 1Q.

Most importantly, these reports also tell around 75% of the PFOF money is coming from options trading. Options trading generates almost three times more revenue (for the same trading volume) than stock trading. Order flows of options trading are more valuable than order flows of stock trading in part because they offer a bigger spread for the market-makers buying them.

Robinhood’s 2020 PFOF revenues are really strong! Is it sustainable?

🏋🏼‍♂️ When strengh turns into weakness

These reports show that Robinhood’s current revenue model is heavily dependent on two things:

1. Big trading volumes

2. Options trading

PFOF is not the only source of revenue Robinhood has, we have no visibility into the other ones but chances are that PFOF is the company’s cash-cow at the moment.

What are the risks of relying on payment for order flows? The sad truth is that tailwinds lose strength over time, it is just a matter of when. That will potentially limit Robinhood’s growth and viability if it does not develop alternate strong revenue streams in due time.

First, let’s talk about trading volumes: they are cyclical and behave according to market conditions. When volumes are high, they are high for all players, and when volumes are low... they impact players that have a higher reliance on high trading volumes to generate revenue (like Robinhood).

As expected, Bull markets (and bubbles) experience much higher trading volumes than Bear markets. It took from 2000 to 2007 (a Bear market) for trading volumes to get back somewhere near to 1999 trading volumes level (the previous Bull market). During the great depression of 2008/2009, volumes dried up again. We are, arguably, on the last legs of one of the greatest Bull markets ever, one that Robinhood rode from the very beginning, its timing was perfect.

It is not a safe bet, or good strategy, to count on the current levels of trading volumes as a continuum. It has been historically high but it will go lower. What is the plan for when it goes down?

Now, on to options trading. While Robinhood is doing a great job in attracting and serving many new-to-trading users (partially fulfilling its goal to democratize finance for all), it needs to do a much better job when it comes to educating users before they trade, especially when they trade options.

I will argue that a great number of Robinhood’s users have no idea what they are doing when it comes to investing, and particularly trading options. Educated investors (not including distressed markets investors) don’t buy stocks of bankrupt companies. Many, many Robinhood users bought Hertz after its bankruptcy… Many Robinhood users bought COKE (the stock ticker for a Coca-Cola distributor) thinking they were trading KO (the stock ticker for the Coca-Cola Company). Many Robinhood users traded… I could go on… Those mistakes were made trading stocks, a much simpler trading transaction than options.

Many users think that trading options is even more fun and exciting than trading stocks. Real and fake bragging stories of users making thousands in hours go viral on social media, creating a huge FOMO (fear of missing out) across Robinhoood’s users. That only leads to more uneducated users jumping into the options trading wagon.

The media has finally given some well-deserved attention to the side effects of uneducated trading after the tragic suicide of Alex Kearns last June.

There is no real democratization of finance for all unless there is substantial finance education. Only qualified, well-educated users should have access to advanced trading, like options trading

Robinhood deserves tremendous credit for making it easy to trade (including options trading), but it deserves equal criticism for not having established an effective gate to allow only qualified users to trade options.

That would be easy to do, but the challenge of establishing a gate is that it would likely bring options trading volumes down considerably, directly impacting Robinhood’s main source of revenue, a clear conflict of interest at play.

I think it is a matter of time for Robinhood users currently trading options to realize that commission-free is not worth it when you don’t know what you are doing. When that happens the mania will fade and Robinhood’s options trading volumes (on a per-user basis) will decline substantially.

Robinhood needs alternate revenue streams for when that happens. The time to develop new revenue streams is now before a revenue crisis takes place.

🙈🙉🙊 Classic ways a business can grow revenue: sell, sell, sell

There are three classic ways to increase revenue in any business:

• Sell to more users

• Sell more products/services to the same users

• Sell more frequently to the same users

Although all three being classic ways to increase revenue, each will lead to a different journey. Let’s look at how each could play for Robinhood.

• More users

Organic Growth w/ Millennials: one way to offset for lower revenues once trading volumes go down (specifically lower per-user options trading volumes), is to continue to add new users: for one there is still plenty of Millennials out there, and let’s not forget that Gen Z is just coming around the corner, the oldest Gen Zs are already 23 years old today (anyone born after 1997). It will be, however, likely more expensive to acquire customers that it has been (= higher CAC - Customer Acquisition Cost).

Robinhood should leverage its brand elasticity to incorporate new products/services as a way to attract more Millennials and Gen Zs. Financial needs go well beyond trading and Robinhood is an extremely well-positioned brand within these generational groups. Take advantage of it!

Organic Growth w/ older customers: of course Robinhood is not limited to growing its user base of Millennials and Gen Zs. It could also try to attract older and wealthier users currently served by the incumbents. That, however, would be a mistake for a couple of different reasons:

• Risk of losing focus - there is a ton of opportunities to be explored while better serving Millennials and Gen Zs

• Risk of weakening its brand - Robinhood is heavily identified as the broker for younger users, to attract older and more affluent customers it would have to change its products/services mix and re-work its brand’s appeal, risking becoming a neither/nor brand (losing being attractive to the younger crowd and not being attractive enough to older customers)

Older and wealthier customers have a completely different profile. They trade less often, meaning lower trading volumes, resulting in lower PFOF revenue per user. The flip side is that they do have bigger accounts, meaning more deposits, resulting in potential revenue from cash management activities. But cash management is becoming a race to the bottom, it is becoming less profitable by the day, size matters a lot to dilute operational costs.

Trying to attract those users is very expensive. Most discount brokerage firms are already offering commission-free trading. What would Robinhood’s value proposition be to attract Charles Schwab users, for example? What is it that those users will get from Robinhood that they are not getting from their current brokers?

Growth by attracting customers from incumbents is a bad idea. Robinhood is unlikely to become a true disruptor of the discount brokerage industry, and that is absolutely fine!

Growth through International Expansion: another strategy to grow its user base is to grow internationally, either through acquisitions, partnerships, or organically.

While possible, international growth is a completely different ball game. For one, all the tailwinds that Robinhood had starting in 2013, as I explained above, are much weaker now. Secondly, different markets mean understanding local industry practices and regulations. If Robinhood decides to explore the international expansion route, it might be better served through local partnerships, as it has already established in China (with Baidu), and keep a close eye on operational costs.

Out of these three “more users growth” strategy options, I would say the better one is still to grow the user base by continuing to attract Millennials and Gen Zs in the U.S.

• More products/services

Given Robinhood’s brand’s strong gravitational pull, it would not be hard to expand its products/services and become the go-to financial services brand for young adults. Robinhood is uniquely placed to try it. The trick part is defining which new products/services verticals it should add and in what sequence.

The company has been smart by picking some very low hanging fruits. It made basic progress by expanding its products/services into crypto, fractional shares, as well as by offering a premium monthly subscription service (called Gold, which includes a bit of research, lower cost for trading on margins, etc). It has also launched a debit card, an important convenience for its customers.

Robinhood should look into products/services with great synergies across all aspects of the current business, like user acquisition, marketing, compliance/regulatory, operations, etc. The more synergies the greater the chances it will be able to keep its operational costs relatively low.

Once those products/services that present great synergies have been identified, Robinhood should prioritize those with better operational margins, the ones less commoditized. Avoid competing in crowded spaces. Robinhood grew on a void, grew by serving the underserved, there is no reason to change it.

It would not make much sense to…

I think it would make no sense for Robinhood to become or acquire a neo-bank. The neo-bank market is already very crowded (it will go through consolidation in the next few years, for sure) and it is ultimately too much of a commodity. Robinhood could just hire a bank as a service (BaaS) partner to start offering banking services, as it has done with its debit card offer.

But it could make sense to…

There are many finance products with great synergy with Robinhood’s existing products/services. For example, it could add foreign exchange and international money transfers (competing directly with Transferwise), or it could venture into retail lending (as a banker), or move into the crowd-lending marketplace (as the marketplace broker).

While these are possible new services, maybe the most promising space is to offer end-to-end financial planning. Millennials (and the upcoming Gen Zs) are super underserved when it comes to financial planning, most have low financial literacy and that is hurting them a lot.

No single finance service company today can say it elevates its customers into being the smartest and more educated customers in the industry. Nobody even thinks in those terms yet. Robinhood could definitely expand into paid training/education, as well as start offering white-gloves advisory services (both not limited to investments/trading). It is not difficult to show that being financially educated pays off big time.

In March 2019 Robinhood acquired MarketSnacks, a digital media company that publishes an “educational” newsletter. It was a good move and served the purpose of checking the box of offering basic free investing education. I am sure it also served to attract new users. It seems the weekly newsletter now has more than 20 million subscribers… there are plenty of opportunities to expand in this space which would lead to revenue growth.

In parallel, Robinhood’s expansion of products/services could happen either organically or through mergers/acquisitions. A wealth management company like Betterment or an insurance broker like Lemonade, for example, could offer plenty of synergy with a lot of cross-selling potentials.

These are just a few of the more obvious options to be carefully analyzed. The point is, there are many products/services that Robinhood could add to become the go-to finance services brand for Millenials and Gen Zs.

And before I forget, Robinhood could also venture into sports/e-sports betting. Just kidding, that is the last thing it needs to be associated with (and I reckon it would also cannibalize trading volumes given many users are trading like they were in a casino)

Whatever products/services Robinhood decides to add to its line, execution needs to be flawless. It cannot become a distraction. Bad execution will also attract the attention of the regulators.

To date, the company has experienced only a few growing pains and hiccups. In Dec 2019 it paid FINRA a $1.25 million fine for best execution violation. It is under review by the SEC as well, and likely receive an additional $10 million fine. During last March’s market frenzy it had a few technical glitches (3 days). Users have been very forgiven for the most part, but these mistakes cannot continue to happen or the brand will suffer greatly.

• Increase sale frequency of products/services

This, for now, is the least important way for Robinhood to grow revenue. Robinhood has already proved to be very good at designing to maximize utilization and frequency. Its app was designed with gamification principles from the beginning, it delivered an easy-to-use mobile trading platform that is totally intuitive and engaging. Its users already trade more times proportionally than the users from the incumbent brokerages. It is no surprise that Robinhood was the first financial services app to win Apple’s App Design Award.

Robinhood understands its users, mobile, and gamification like few. It is fair to think that whatever products/services vertical it adds it will make sure to maximize sale frequency.

👊🏼 When you come to the fork(s) in the road…

As the legendary Yogi Berra once said, “when you come to the fork in the road, take it!”. People make fun of it, but the wisdom of this saying is clear: don’t stay stuck, move, try new things. This is a fitting end to this post.

The discount brokerage industry is at a crossroads after reaching a key milestone with commission-free trading becoming mainstream. What started in 1975 with a major regulatory inflection point came to an end in 2020. The next frontier for the players in the brokerage industry is well beyond trading and discounts.

Robinhood does not suffer from a lack of options to grow and evolve, on the contrary: it has too many options. A strategy is not only about what you do, but equally important what you choose not to do.

Choose wisely, continue to execute greatly, but take the fork(s) in the road.

And good luck!

---

So What? Do-Over! is a FREE publication dedicated to building a community of people interested in learning about technology, cultural changes, and how new and incumbent businesses are reshaping the world we live in (good and bad stuff).