How Does Robinhood Make Money? Business Model Of Robinhood


How Does Robinhood Make Money

If you’re a motivated first-time investor, then you may have heard of an app called Robinhood. The name certainly sounds familiar, right, but what exactly do they do? The business model of Robinhood will be discussed in full detail below.

Robinhood makes money by receiving payments for order flow, Robinhood Gold subscription fees, interest on stock loans, interest on uninvested cash, and interchange fees from debit card service.

As of 2021, the average account in Robinhood totalled $3,500. This is significantly lower than most other investing platforms. Users can buy and sell stocks and much more with the touch of a button.

Robinhood participates in some practices that some financial experts consider risky. This includes methods such as generating revenue through a payment-for-order flow (abbreviated PFOF). If you’re confused, then don’t worry, as this topic will be explored below.

Business Model Of Robinhood

Robinhood is an online and mobile-based financial company that provides a platform where users can buy and trade stocks, EFTs, options, and American depositary receipts (ADRs).

Robinhood is a web-based and mobile app-based trading platform that operates on a commission-free online brokerage business model.

In some geographic locations, users can also invest in certain cryptocurrencies.

The History of Robinhood

Robinhood Markets is the handiwork of two roommates from Stanford University. Their mission is to provide entry into the stock market for everyone, not just the rich. Hence, the company name.

The company was formally founded in April 2013:

  • By December 2014, Robinhood was first published on AppStore.
  • In 2018, a waitlist for commission-free crypto trading was announced. There were more than 1,250,000 names on the list by the end of the day.
  • Trading on the platform has increased heavily during the pandemic.
  • As of July 2021, the company is now public on the NASDAQ.

Even if you haven’t been on the app, you’ve probably heard the name Robinhood all over the news the last few years. Below, you’ll learn more about why this is the case and how good of a job the company is doing at carrying out its original mission.

 

Commission-Free Online Services

Trading is commission-free on the Robinhood platform. This is huge because many brokers and advisors charge a brokerage fee every time an investor buys and sells stocks. Typically a fee falls within the range of 1-2% of a client’s managed assets.

 

Plan for Profit

Robinhood generated $682 million in payment-for-order revenue in 2020. There are several ways that Robinhood used to generate this revenue:

  • Payment-for-Order flow: Although Robinhood allows trades to occur free of commission, the company does make money by earning revenue from market-makers (don’t worry, this will all be discussed in further detail below)
  • Premium features: Robinhood does offer a premium subscription service, which comes with benefits like larger allowable deposits and enhanced research data.
  • Interest on uninvested cash
  • Interchange fees from debit card service

In the section below, you’ll learn much more about what each of these means and why Robinhood has unique (and in some cases controversial) sources of revenue.

 

How Does Robinhood Make Money?

Robinhood earns most of its revenue through a process called payment-for-order-flow.

You may recall from earlier in this article that investors are attracted to the platform for its lack of commission rates. Although, Robinhood doesn’t have commission rates, there is a catch (sort of).

 

Payment-For-Order Flow

The payment-for-order flow (PFOF) is the method that Robinhood uses to generate income, even though the company doesn’t charge any commission fees. This means that Robinhood communicates with third-party vendors called “market makers.”

Here’s how it works:

  • Robinhood makes money by directing investors to the market maker.
  • Market makers are defined as “third-party institutions that typically act as liquidity providers and execute the orders”.
  • Payments from market makers typically only come in the form of fractions per penny for each.
  • However, when this occurs as frequently as it does on Robinhood, the company can generate revenue.

Robinhood defends the practice of order-routing as the best way to provide its services at a low cost.

 

Net Interest Revenues

Robinhood also earns a small portion of its revenue from net interest on marginal loans to users.

You may have heard of the term “buying on the margin”. This means that users are taking out loans with Robinhood to buy stocks, options, or other securities.

Here’s the benefits of Robinhood earning through net interest:

  • This allows investors a chance to seize an opportunity without having to worry about withdrawing money from their savings.
  • Borrowers can benefit from an unrealized profit if the stock price increases.
  • Borrowers can also experience a loss if the price of the stock drops.
  • Those who want to leave the margin can do so by selling shares or depositing money.

In the first 6 months of 2020, the number of loans from Robinhood doubled. The company’s aggressive lending practices came under fire when it was revealed that unprepared borrowers could stand to lose significant amounts of money.

The response: On its website, Robinhood explicitly warns investors that the practice of buying on the margin is risky. Borrowing limits can also be set to limit the potential for inexperienced investors to bite more than they can chew, so to speak.

 

Cash Management

Robinhood Financial offers a Cash Management Account. It’s like a bank account, but not really. With this alternative to traditional banking, you can spend, save, invest and earn interest from a single account.

Here’s how Robinhood makes money off of this service:

  • No overdraft, transfer, maintenance, ATM fees, etc. are charged.
  • Customers are drawn to premium features with a $5 per month Robinhood Gold subscription.
  • Robinhood Gold benefits include bigger instant deposits, professional research, market data, and margin investing.

Robinhood can run this service with low fees because the company itself does not have to worry about FDIC insurance. Rather, Robinhood users are insured through a program in which deposits are swept to partner banks, which should be FDIC insured.

 

Robinhood Crypto

Robinhood also operates a commission-free cryptocurrency investing service. The barrier to entry is quite low because you can start with as little as $1.

Which cryptocurrencies are available on Robinhood?

  • Bitcoin
  • Bitcoin Cash
  • Bitcoin SV
  • Dogecoin
  • Ethereum
  • Ethereum Classic
  • Litecoin

Robinhood plans on adding even more cryptocurrencies to the mix. There have been rumors that the company could list Shiba Inu crypto in January 2022.

After Robinhood announced that it would be testing a crypto wallet, the number of users on the waitlist swelled to 1 million in October 2021. As is the case with other securities, Robinhood makes money off crypto by routing customers’ trade orders to market makers.

 

Robinhood Funding, Valuation & Revenue

This is a good time to discuss the company’s future. What is Robinhood worth? How much money did they make (or lose) in 2021? How many customers do they have?

All of these questions will be explored in full detail in the sections below.

Why Was Robinhood in the News Last Year?

Even if you didn’t know what Robinhood was at the time, you probably heard the name all over the news last year. So what exactly happened? Here’s the good, bad and ugly.

You may remember the social media-fueled frenzy of GameStop and AMC Entertainment share sales. A vast majority of the trading of these stocks occurred on the Robinhood platform. First-time investors flocked to Robinhood because of its ease of access.

Now for the ugly. Robinhood settled an SEC probe in December 2020 for $65 million. This was a result of charges stating that the company misled investors about how it makes money (the payment-for-order process mentioned earlier.)

There’s also the fact that Robinhood’s sudden and unexpected growth outpaced its ability to hedge against risks. In some cases, investors were even locked out of their accounts at pivotal moments.

Since then Robinhood has taken measures to prevent this from happening again in the future, while also marketing maximum accessibility for new investors.

 

Balance Sheet: Assets & Liabilities

Robinhood has seen its receivables from users nearly double over 9 months. This is why the company’s assets skyrocketed while liabilities went up slightly in the 9 months.

ParameterSeptember 30, 2021December 31, 2020
Total Assets$18,849,696$10,872,584
Total Liabilities$11, 932,786$8,864,057

Courtesy: Robinhood Quarterly Report

The leading liabilities for Robinhood include:

  • Payables to users: $6,811,169
  • Securities loaned: $3,129,650

 

Revenue

Why is the net loss so big? Just over $2 million of the net losses in 2021 can be attributed to “change in fair value of convertible notes and warrant liability.”

Don’t worry if you don’t know what this means, as the topic will be covered in full detail below.

ParameterJanuary-September 2021January-September 2020
Revenue$1,452,430$641,291
Operating Expenses$2,673,000$646,667
Net Loss After Tax$3,263,165$5,579

Courtesy: Robinhood Quarterly Report

 

Here’s why Robinhood reported such big losses:

  • February 2021: Robinhood sold $3.5 billion in convertible notes
  • These notes can be converted into stock at a 30% discount in the initial public offering.
  • This means that Robinhood sold $5 billion worth of stock for $3.5 billion.
  • Robinhood needed the bailout from its investors after the GameStop and AMC frenzy.

 

When Will Robinhood Turn A Profit?

You might be wondering to yourself, is Robinhood a sinking ship? The answer to this question is that Robinhood is still very much in its infancy. The company did report a net income of $7.4 million in 2020.

Before last year’s GameStop ordeal, Robinhood was indeed on the pathway to profitability with operating expenses totaling $463.8 million for the first quarter, if you remove the “change in fair value…”

 

Valuation

Robinhood (HOOD) first went public on July 29, 2021. Since then, there has been a steady and consistent decline in the price per share. In July 2021 Robinhood had a market valuation of $35 billion.

In early December 2021, Robinhood had a market cap of $16.82 billion, making it the world’s 1084th most valuable company:

  • 8/4/2021 (price per share): $85
  • 10/1/2021 (price per share): $41
  • 12/1/2021 (price per share): $23

Investors are being told by online financial advisors to keep an eye on Robinhood, but not to buy any shares at the moment. Chief among concerns is the SEC’s review of payment-for-order-flow (PFOFs).

One reason for optimism would be the massive popularity of the Robinhood app among young investors. At the end of the first quarter of 2021, more than half of customers’ funding accounts were self-described first-time traders.

 

How Many Customers Does Robinhood Have?

In quarter 2 of 2021 (spring and early summer) Robinhood reported a customer base of 22.5 million users. This represents a significant jump from the end of 2021 when the app had a customer base of 12.5 users.

YearCustomers (in millions)
20186
201910
202012.5
2021 (Quarter 2)22.5

Courtesy: Statista

 

Who Are Robinhood’s Leading Competitors?

Financial services is a crowded field, to say the least. Robinhood faces stiff competition from similar discount brokerages, banks, cryptocurrency exchanges, and other asset management firms.

Some financial advisors warn inexperienced investors against using day trading platforms, like Robinhood. Instead, they might recommend apps where you can buy into mutual funds, such as Vanguard or Charles Schwab.

The average account for Robinhood is considerably smaller than what is seen with the leading competitors. The statistics in the table below are reflective of the company’s desire to provide the average American with an opportunity to invest:

CompanyAverage Account Size ($)
Robinhood$3,500
E-Trade$100,000
Charles Schwab$240,000

 

Is Robinhood Profitable?

Robinhood was profitable in 2020, to the tune of approximately $7.4 million. This was after a massive proliferation of new investors taking advantage of its commission-less stock exchange and margin lending program.

In 2021, the company reported significant net losses. This was a result of Robinhood needing a bailout from investors to fund the GameStop and AMC spending sprees. Since then the company has gone public and added itself to the crypto game. Losses in the third quarter of 2021 were much less significant than what was seen in the first quarter.

 

Conclusion: How Does Robinhood Make Money

Robinhood is one of the most exciting startups to have entered the fintech space in recent times. Unlike its major competitors (name any other financial service or stock brokerage firm, I dare you) it’s not just a broker, but rather an online brokerage that offers commission-free trades on stocks, crypto and ETFs.

The biggest difference between Robinhood and other brokerage firms is that they offer commission-free investing. If you’ve ever tried to buy stocks or ETFs through your discount broker, you know that trading costs can add up fast.

So there you have it, right from the horse’s mouth so to speak. That’s a wrap on how Robinhood makes money. I hope you enjoyed our journey through the Robinhood business model. If you have any questions or comments, feel free to send us an email.

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