If you’ve ever wondered how Robinhood really makes money then look no further! The race towards no fees is on, and the Robinhood App is leading the charge.
Robinhood labels itself as the “pioneer of commission-free investing”. They give retail investors the ability to “make unlimited commission-free trades in stocks, funds, and options”.
Why is this important
Brokers historically charged their clients absorbent fees for getting in to, and out of positions. Simply put, anytime you bought or sold a stock, fund or options contract, discount brokers charged an additional commission to the client for facilitating that transaction.
For example, if you bought a stock for $100 and made a 10% gain in the market, your position sits at $110. If your broker charged you the average commission of $10 per trade, then you stand to lose $10 for that trade even though the stock gained 10%.
If that math doesn’t make sense to you then you’re not alone. Discouraged investors opted out of investing because these fees were doing more damage to their portfolios than the actual market.
How Traditional Brokers Make Money
Commissions
Just for reference, I won’t be getting into much detail about full-service brokers, but focusing specifically on discount brokers. Traditionally discount brokers would charge a set fee or commission for buying or selling a stock, fund or option. On average these commissions ranged anywhere from $5 to upwards of $30 per transaction. This means that even though the broker provided no human interaction or customer service, they still charged you a fee to complete your transaction.
% of Assets Under Management Fees
The next most common type of fee charged by brokers was a set percentage fee based on the number of assets under management. This was a recurring fee that was charged every year, sometimes done quarterly. This fee was charged regardless of market conditions, so if your portfolio was up or down you would still be charged this fee. The combination of a commission and % of AUM fee could over time decimate a portfolio, leaving the investor penny-less even if modest gains were realized every year.
Account Maintenance & Inactivity Fees
The last two types of fees charged by discount brokers were account maintenance and inactivity fees. Brokers used account maintenance fees to offset their overhead and put the burden on the consumer. These account management fees had no impact on the performance of the underlying portfolio. Brokers also charged account inactivity fees to make sure revenue stayed consistent even if the consumer took no action to generate commission revenue.
In Comes Robinhood
How do you get people to do something that they don’t want to do? You make it free. Robinhood came onto the scene in 2014 with a solution to the commission problem by offering free trades for stocks, funds, and options contracts. Something previously unheard of in the finance community.
Interest on Uninvested Funds
The first method Robinhood uses to make money is by collecting interest on uninvested money in client accounts. This method is legal and utilized by banks every day. Instead of letting your extra money just sit there and do nothing, they invest it in treasuries or savings accounts and keep the additional interest gained on this money. When banks do this, they share a portion of that revenue with their customers in the form of interest. This could be interest paid on a savings or checking account, but they only share an extremely small portion back to their consumers.
While this method of making money is the easiest, this may be going away in the future since Robinhood has recently announced Robinhood Cash Management. This will allow clients to keep the bulk of that interest earned from uninvested funds.
Interest on Margin Accounts
Robinhood lends money to investors looking to buy or sell securities, and in exchange, charge interest on a certain portion of the borrowed amount. This is common practice for all margin lenders and does not affect the vast majority of the Robinhood client base.
Monthly Fees for Robinhood Gold
Robinhood is a great platform for beginner investors because the app prides itself on being simple and intuitive. This means that Robinhood allows you to buy and sell stocks for free but does not provide research or additional market insights to its customers. To gain this in-depth market analysis and additional margin, customers can opt into Robinhood Gold. This monthly subscription service provides access to professional research reports, margin trading, and larger instant deposits. Robinhood charges its customers around $5 per month for “Gold” features, but again this does not affect the vast majority of clients.
Payments for Order Flow & Rebates
Last but not least, Robinhood’s most important source of income comes in the form of payments for directing its order flow to certain parties and rebates from market makers. Bloomberg reported that Robinhood makes the majority of its revenue from “selling its customers’ orders to high-frequency trading firms, or market makers, like Citadel Securities and Two Sigma Securities“.
Payment for order flow essentially means, “Instead of orders being processed on a public exchange, companies like Robinhood can make money off of processing (or directing) trades through behind-the-scenes parties that provide the other end to the trade.” The market makers pay to facilitate the orders of Robinhood clients, and in exchange pays Robinhood a hefty fee. This trading method is controversial because these “Market Makers” can charge more when for securities when you are buying, or pay out less when you are selling.
Other Cost-Saving Opportunities
Robinhood’s customer service is all over email and they don’t have a substantial human presence at the moment. They try to direct everything to email, and as a user of the platform, I can attest that their customer service is terrible. This is one of the areas where they have decided to save a lot of money and not offer traditional call center services. They also keep all of their documents and reports online or in-app. This allows them to save money on paper and postage fees associated with monthly statements and tax documents. Lastly, the biggest cost saver for Robinhood is the fact that they have no physical presence, anywhere. No branches to upkeep, no offices to maintain and most importantly no brokers to pay.
How Long Can Robinhood Keep Trades Free
Venture Capital
According to Crunchbase, Robinhood has raised approximately $912 million in money from the private markets. Robinhood uses this funding to finance their commission-free trades, develop their app and website, and market their services to the masses. Although private market funding is great for startups, investors eventually want to see some type of return on their investment. For investors to see tangible returns, Robinhood needs to either monetize their services enough to pay back investors, look for additional funds in the public capital markets, or get acquired by another company.
Robinhood Going Public
The most logical route for Robinhood to sustain its current operations and expand its services is to go public. This will allow early investors to cash out in the secondary market, and bring in new funds from an IPO. Going public requires Robinhood to open up their books. Since we have already established how Robinhood makes money, these financial disclosures will help us determine if these methods are profitable, and more importantly, if they are sustainable.
Getting Acquired
Although going public seems like the most logical next step for Robinhood, acquisition is not out of the question either. Acquiring a company like Robinhood would give its new parent company access to millions of retail investors and tons of behavioral data, which could prove to be even more lucrative than their portfolios. Knowing where, when, why and how an average joe invests their money could give Robinhood more insights on how to properly monetize their platform in the future.
I think this would be a great fit for a company like Goldman Sachs, who traditionally has been known for its ultra-high net worth and institutional client base. Goldman is starting to dip its toe in the retail pool by starting Marcus, a savings and retail consumer bank, and a company like Robinhood would round out that suite of offerings perfectly.
Summary
Free trades became the norm, and it’s forced brokers to take a second look at retail investor needs. By making money through indirect methods like interest, directing order flow, and rebates, Robinhood has established itself as a financial services industry disputer. Hopefully, Robinhood will be able to continue offering free trades to its consumers, but with the consolidation in the discount broker market, this task gets harder and harder each day.
I love the Robinhood app, and I’ve recently started a portfolio with them, leveraging their commission-free platform to build my million-dollar stock portfolio.
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