Robinhood Business Model: The Secret of Payment for Order Flow

Robinhood Business Model

Robinhood Business Model: Dissecting the secret of payment for order flow

Robinhood, with a mission to democratize finance for all is less than 10 years old (founded in 2013), but it is already so popular in America with over 22 million customers as at 2021. In fact, in 2016, Robinhood became the fastest brokerage in history to hit $2 billion in transactions. They achieved that feat just within 3 years of formal launch.

But what really is Robinhood? How does it operate? What is the business model that has helped Robinhood grow so fast and so big? And how exactly does Robinhood make money from this business model? These are other related questions are going to be duly addressed in this post – Robinhood Business Model. Don’t go anywhere.

What is Robinhood?

Robinhood Markets Inc (popularly known and addressed as just ‘Robinhood’) is a fintech company that operates an online discount brokerage with commission-free trading. It provides a web- and mobile-based financial services platform through which investors can buy and sell stocks, exchange-traded funds (ETFs), options, and American depositary receipts (ADRs). Interestingly, Robinhood users also can invest and tap into the power of cryptocurrency.

Robinhood Business Model – How it Works?

The Robinhood business model operates an online brokerage that offers commission-free trading by allowing users to buy and sell assets such as stocks, ETFs, options, American depositary receipts (ADRs), and even cryptocurrencies.

It provides a mobile phone application for transactions. But users can also check on their financial/investment performances through the company’s website or even a smartwatch apps.

While it is free and very easy for users to invest or trade through the Robinhood app, it does however have a way of making money. It makes money in an asymmetric way similar to the Google and Facebook models.  In fact, instead of charging commissions, what the company does is to make money on the transactions placed by its users, through what is known as payment for order flow (“PFOF”).

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Robinhood Business Model – The Value Proposition

I think the Robinhood business model carries an emotional value preposition that makes it very easy to attract users. And that emotional value proposition was not made up. They were built on sincere discovery.

First, they stumbled on the mantra that the stock market is one of the greatest wealth creators of the last century. Secondly, they discovered systemic barriers that have kept millions of Americans from investing.

Barriers like:

  • Expensive commissions – between $5 to $10 per trade
  • Minimum balance requirements – usually $500
  • And complicated, jargon-filled paperwork.

With this, the stock market became an opportunity for few – mostly the rich, which kept getting richer.

So what did Robinhood do?

They decided to appeal to every other person but those who are already investing in stock.

They said:

  • With us you don’t need to pay any commission at all
  • We are not setting any account minimums
  • With us you don’t need to pay heavily to have a stock broker
  • We present all information in easy to understand languages and not technical terms known to just a few
  • And most importantly, you do everything with your mobile phone; no paperwork

These formed the value proposition for Robinhood. And to show how well it resonates with the masses,nearly one million people signed up within the first year, processing over $1 billion in transactions.

Robinhood Business Model – How They Make Money

Who could have believed that a brokerage firm that does commission-less service can make as much as $565 million in just a quarter? But that is the exact story of Robinhood and the Robinhood business model.

Robinhood made $565 million in Q2 of 2021 alone. And that should get you asking, “how did that happen?” Well, Robinhood’ business model allows it to make money in a number of ways. The most notable one of them been the popular payment for order flow. That is, Robinhood routes its users’ orders through a market maker who actually makes the trades and compensates Robinhood for the business. The compensation is usually at a rate of a fraction of a cent per share. But it easily and quickly accumulates based on the volume of shares traded.

And that is how you get to see those millions Robinhood makes from this business model. Payment for order flow remains Robinhood main revenue source. For example, the company made $1.81 billion in total revenues in 2021. And guess what? $1.4 billion (77% ) comes from transaction-based revenues (payment for order flow).t

But that is not the only way Robinhood makes money. So let’s take a look at the other ways.

1. Rebates from Market Makers and Trading Venues

The first way Robinhood business model brings money to the company is through the rebates it receives from market makers.

Each time investors place trades for stocks, ETFs, and options, Robinhood uses market makers to execute them. In order to compete with the major stock exchanges, market makers offer rebates to Robinhood (being the brokerage). They also ensure that investors get better deals.

Under proper exchange fee schedules, the fintech pays the exchange when it takes liquidity, and gets paid when provides liquidity.

The same occurs to Robinhood Crypto, which receives volume rebates from trading venues, that provide competitive prices.

2. Subscriber Fees from Robinhood Gold

Robinhood also offers premium services, one of which is called Robinhood Gold. Robinhood Gold is a suite of investment tools that provides research reports, market data, larger instant deposits, and margin trading to subscribers. The monthly subscription fee for this service is $5.

With this subscription, a user gains access to:

  • Morningstar research reports
  • NASDAQ Level II Market Data
  • Bigger instant deposits
  • Margin investing.

3. Stock Loan: Income from Margin Trading

Another way the Robinhood business model allows it to make money is from stock loan.

When a subscriber uses margin for trading, they are practically borrowing from Robinhood Securities. Robinhood calls this service “Stock Loan.” While basic margin trading comes with the Robinhood Gold service and doesn’t attract any interest. But once a subscriber decides to beyond $1,000 for margin trading they will be required to pay a 2.5% interest rate. That is another revenue source for Robinhood.

4. Cash Management Fees

Robinhood offers a debit card in connection with a brokerage account. This is provided through Robinhood Financial LLC, a member of SIPC and FINRA. The card is issued by Sutton Bank, pursuant to a license by Mastercard. And the bank receives an interchange fee that is passed to Robinhood. The fees just like most other financial institutions covers things like transaction, processing and fraud loss.

Robinhood also receives fees on cash rom program banks for sweeping funds to them.

5. Income from Univested Cash

Robinhood business model also allows it to earn income form uninvested cash of customers. What happens is that if a customer have some univested cash that isn’t swept into the cash management network of program banks, Robinhood will move to deposit the cash in an interest-bearing bank accounts. From there Robinhood Securities may earn income too.

6. Fees on Transfers and Other Services

If users want to transfer their money out of Robinhood and to another broker, they’ll pay a $75 transfer fee. This is statutory and investors are made to know this at the point of subscribing to Robinhood. But that is not all. There are some other miscellaneous fees that bring revenue to Robinhood coffers. For example, it charges $20 for overnight check deliveries, $5 for paper statements, and also $5 for paper confirms.

Robinhood Business Model – The Business Segments

Robinhood currently operates five products on its platform and they are:

  1. Stocks
  2. Options
  3. Robinhood Gold
  4. Cash Management
  5. And Crypto.

We have explained virtually all of these earlier.

But when it comes to financial results, Robinhood operates and reports ithem as one business segment. However, it does provide a breakdown of its revenue into the following categories:

  • Transaction-based revenues
  • Net interest revenues
  • And other revenues.

Robinhood Business Model – What Makes it Unique

Three major things set Robinhood apart and made them so unique and popular when they started:

  1. Their products and services were made available through a web- and mobile-based platform.
  2. It was a commission-free trading model
  3. There were no minimum amount for investors

But just like most innovations, it is just a matter of time before others get to copy it. So, though Robinhood pioneered this, but other players (including the big players) in the discount brokerage industry didn’t have an option than to adapt and follow a similar model.

And that actually brought stiff competition to Robinhood.

Robinhood Business Model – The Competitors

Robinhoodis now a victim of the system it pioneered. Running a commission-free discount brokerage is no new thing again. But it was not so, when Robinhood started.

The company therefore faces significant competition from other discount brokerages today. Both new and established fintech companies, banks, cryptocurrency exchanges, asset management firms, and technology platforms are coming with similar models as Robinhood.

And here are the top 10 competitors are:

  1. Fidelity Investments
  2. Cash App
  3. TD Ameritrade
  4. Charles Schwab
  5. Morgan Stanley’s
  6. E-Trade Financial Holdings
  7. Coinbase Global
  8. Square Inc.
  9. River Financial Corp.
  10. WeBull

However, the first mover advantage that Robinhood enjoys still counts. And it still enjoys the lion share of the market.

Robinhood Business Model_Market Share
Robinhood Business Model_Market Share

Is Robinhood Making Profit?

Though Robinhood gross revenue has continue to increase, but the net income fluctuates.

For example, in 2019, the company made a loss of about $107 million. But managed to make a profit of $7 million in 2020. But by 2021, the loss increased to about $3.4 billion, its largest recorded annual loss so far.

Robinhood’s success and ability to increase revenues and operate profitably will depend to a large extent on customers continuing to utilize its platform, even as global social and economic conditions shift.

Robinhood business model and the secret of the payment for order flow.

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