Is Robinhood (HOOD) an Emerging Trading Juggernaut?

“They have changed the investing world forever.”

At least that’s what Tom Sosnoff, Ceo of Tastytrade, believes about rival Robinhood (HOOD), which has disrupted the investing world with its free-mobile trading app aimed at democratizing Wall Street for retail investors.

The big question now is whether the firm, which staged a lukewarm IPO last month, will have lasting appeal or fade amid a likely decline in trading volumes when the pandemic grinds to a halt.

Currently, opinion is divided between those who envision the fintech company becoming an investing giant—prompting established players such a Fidelity and Charles Schwab to emulate its innovative streak and possibly mount a takeover of its business—and those who see it progressing as a niche player catering to gamers treating stocks like lottery tickets.

First, however, let’s look at some numbers. Worth roughly $42 billion, Robinhood’s revenues tripled to $522 million in the first quarter and are in line to more than double to $2.1 billion in 2021, according to Wolfe Research, which sees the top line surging 20% annually in five years.

Growth milestone

Last year marked a milestone for the company as homebound traders, flush with cash from stimulus checks, began speculating with cryptocurrency, equities and options, helping the firm turn its first $7 million net profit and acquire new customers, which have more than quadrupled to around 22 million since 2019. Robinhood's average customer is 31 years old and an avid trader of ‘meme’ or joke stocks pumped through social media sites such as Reddit, Wall Street Bets or TikTok. 

Robinhood’s marketing centers around ‘democratizing finance’ for individual investors but the Menlo Park, California-based firm actually generates 75% of its revenues from so-called payment-for-order flow. PFOF basically means Robinhood sells its massive volumes to high-frequency trading hedge funds such as Citadel and Virtu – the very type of institutional investors that day traders targeted when pumping Game Stop (GME) in January, bringing them heavy losses from a historic short squeeze.

During the meme stock frenzy, regulators forced Robinhood to halt trading amid concerns it lacked enough collateral to cushion losses if share prices fell, angering traders who lost money and quickly exited to a growing clutch of rivals.

Taste of its own medicine

Some analysts say angry Game Stop traders helped trigger an 8% drop on Robinhood’s shares after debuting at $38 on July 29, embarrassing the firm after pricing the deal at the low end of a marketing range. Shares quickly recovered, however, hitting as much as $85 a few days later (though they have since fallen to around $50) and surprising observers who said HOOD had become its own version of a meme stock, bound for further whipsawing until its future business case becomes clearer.

That’s pivotal. As Covid-19 abates and competition heats up, Robinhood must quickly develop its franchise or risk being left in the dust by fast-growing, direct rivals such as WeBull, CashApp, eToro or Sofi, as well as established players like Schwab, Fidelity and E-Trade, rushing to develop competing systems.

The U.S. retail market is booming with daily trading volumes hitting $14.7 billion so far this year, doubling from $7 billion in 2019 and accounting for roughly 10% of the Russell 3000, according to Josef Schuster, CEO and founder of Exchange Traded Fund (ETF) operator IPOX Schuster. Newbie transactions in the options market, meanwhile, doubled in the past year and are set to rise sharply in the near-term, as long as the bull market reaches new heights.

Robinhood has a lot of momentum and free-marketing dollars stemming from its listing that will likely encourage it to rapidly develop into a trading powerhouse, claimed Schuster, who owns shares in the company.

It’s HOOD time

“Now is the time to speak about Robinhood,” he said. "Their image is good and their platform works very well. They have a lot of money in the door (after raising $2.1 billion in their listing) and have a first mover advantage like Google had as the first search engine or Facebook with social media.”

Co-founders Vladimir Tenev and Baiju Bhatt, CEO and Chief Creative Officers respectively, who—unlike the 14^th Century English hero inspiring their entity’s trademark—have become billionaires, are working to raise capital in a secondary stock sale that could take place in 6 to 12 months, Schuster said.

Currently, the firm’s existing shareholders are moving to sell 98 million shares to pocket about $4.9 billion but the process is on hold amid an SEC probe into Robinhood’s PFOF activities that some say could prompt a ban or limit its scope. Even if it can’t raise fresh capital, Robinhood has enough currency to quickly grow its franchise in diverse ways and maintain its market lead, Schuster insisted.

Apart from making acquisitions (such as bagging Say Technologies last week), “they can expand their offering, add cryptocurrencies and increase assets under management (AUM) by offering more ETFS,” he said. “I am not talking about something boring like an S&P tracking index but something really innovative like Ark’s funds with higher margins.”

Selling pre-IPO companies could also be in the cards, Schuster noted, adding that NFTs or non-fungible tokens would also be a good opportunity. NFTs are a new breed of blockchain-tracked assets allowing people to own digital fractions of art, sports memorabilia or other assets. The market has soared 20-fold to $2.5 billion in the past 12 months.

Tenev told investors during the IPO’s roadshow that the company is working to diversify its product suite based on customer input and turn “first-time investors into long-term investors.” It will do this by widening its crypto and options trading selection as well as by streamlining its debit card and savings products. Crucially, the 34-year-old entrepreneur noted he will continue to defend its PFOF model as a way to deliver zero-trading fees to customers.

Fractions of a penny

PFOF has fueled Robinhood’s thriving business – worth just $1.3 billion in 2017, when it began offering free crypto trading – and allowed it to kill stock-trading commissions once ranging from $5 to $10 and relegating investing to the wealthy.

Robinhood’s PFOF customers may also fight regulatory restrictions. This is because Citatel and Virtu make huge profits by acting as market makers or middlemen on ‘millisecond’ trades that bring fractions of a cent in every transaction, adding to billions. Crypto market makers such as DRW Trading or Jump Trading make even more, Schuster claimed.

Others aren’t convinced Robinhood can become a trading and investing giant.

“I think they would like to but I am not sure they are the firm for it,” said Kim Forrest, CIO at Bokeh Capital Partners in Pittsburgh, adding that the Game Stop drama highlighted the firm’s vulnerability to market shocks. “We saw the company unprepared for a surge in meme stocks during the pandemic and the regulatory conditions they had to operate in,” notably the SEC-mandated two-day trade settlement period which meant securities rapidly bought and sold had not cleared. This prompted the National Securities Clearing Corporation (NSCC) to demand Robinhood pony up $3 billion in case trades went south, forcing the firm to halt trading for GME and AMC, which was also soaring simultaneously.

“The lack of seriousness in running the plumbing was exposed,” added Forrest. “Robinhood has a pretty small balance sheet against other brokers” which would have had the bandwidth to handle such volatility. Amid such challenges, “I doubt they will become a Wall Street juggernaut and that everyone will be trading on Robinhood."

Still, Forrest said Robinhood offers advantages other trading houses could mirror, such as a glitzy interface that makes mobile trading fun and much easier to execute than old-fashioned rivals. “They are an innovator and I think some of the existing brokers will mimic some of their good ideas such as the ease of trading,” Forrest noted, adding that a larger rival may move to acquire Robinhood or that it could seek to sell a stake in its business.

That may not be so simple, said Daniel Wiener, co-founder and chairman of Adviser Investments. “You have to ask yourself what are you buying?” he said. “Are you buying [Robinhood] for their trading interface and the confetti? I can go to Schwab and Fidelity and trade stocks and options to my heart’s content. Why not spend that money to enhance your own platform?”

Wiener envisages the investing world evolving to offer a hybrid experience blending free-trading and other tools for young investors with those offered by old-fashioned houses targeting professionals. “The big question is does a Schwab evolve to look more like Robinhood or does Robinhood evolve to become like a Schwab?”

Still, unless it can mount a credible strategy to shift away from amateur investing, Wiener expects Robinhood will appeal to a casual retail investor and not financial professionals.

“They will never get someone like me to trade through them,” he said. “We have clients that have real money, on average $1.5 million, with us. They are not interested in confetti.”

History on its side

But history and volatility could be on Robinhood’s side, said Charles Trzcinka, who teaches behavioral finance at Indiana University’s Kelly School of Business’s MBA program.

“When Internet brokerages such as TD Waterhouse and E-Trade first offered online trading in the 90s, fancy screens gave people the illusion of control [as they no longer had to call their broker and place a manual trade],” said Trzcinka. “People who switched to online trading didn’t do well but brokers did and are still here.”

Trzcinka agreed Robinhood must attract more serious investors to succeed. “They can’t continue just using cellphones,” he said. “They need to move the tech to the computer and bring more data and information. If you look at decent traders today, they have lots of screens they check all the time and even then, they only win 51% of the time. Trading is a coin flip.”

‘Arms race’

Savvy acquisitions may save the day, said Dan Ives, head of research at Wedbush Securities. “Right now, next-generation finance and trading is an arms race across the board,” he noted. “You are going to see more industry consolidation in the next 6 to 12 months and Robinhood will play a big role in it.”

For all its popularity on Wall Street Bets and other forums trumping stocks, Robinhood’s $140 million acquisition of Say Technologies shows it wants to lure more serious customers. Say Technologies gives investors software tools to vote on future company events and question management practices, which research says is a growing trend.

As homebound traders flock back to work and normal social activities resume, can Robinhood maintain its magic?

“During the pandemic, e-commerce, trading to other dynamics have not been operating in a normal environment,” Ives noted. “Investors are going to want to see how these trading systems and business models shape up in a more normalized world during the next 12 to 18 months.”

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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