A closer look at Robinhood’s public debut
Robinhood’s recent initial public offering (IPO) has put the online trading platform back in the limelight. The company, launched in 2013, is an app that allows users to trade individual stocks, Exchange Traded Funds (ETFs), crypto assets or options without paying a transaction fee.
For years, investors paid up when they bought or sold a stock. The first company to break down the trading barriers for ordinary investors was Chares Schwab, the San Francisco-based firm that believed that individuals with small amounts of money should participate in the investment world, too. Over the past 40 years since Schwab introduced low-cost trading, fees have been trending lower.
Enter Robinhood, the first company to offer customers commission-free trading. Other big online brokers, including Schwab, E-Trade and TD Ameritrade, quickly followed suit, but it was Robinhood that broke through to become the favorite trading app among young investors.
The strange circumstances of the pandemic, where millions were at home and many were flush with excess savings, helped Robinhood flourish. With more than 22 million customers, up from just 500,000 in 2015, the company turned a profit of
$7.3 million in 2020 and its IPO valued the company at around $29 billion.
That’s a rich value for a company that doesn’t charge transaction fees, so how does Robinhood do it? Like online behemoths Facebook, Amazon and Google, who sell your personal data to advertisers to generate profits, Robinhood makes money in a less obvious but lucrative way: It sends customer orders to high-frequency traders in exchange for cash. This legal practice is called “Payment for Order Flow” (PFOF).
If you use Robinhood, you won’t see a line item for PFOF, but you will likely receive a slightly worse price (we’re talking a few pennies) for your transactions than another potential broker might get for you. Although a few pennies might not seem too bad, they add up for the company when volume soars.
The SEC fined Robinhood $65 million for not being clear with investors about how it makes its money. Separately, the Financial Industry Regulatory Authority (FINRA) announced a $70 million slap to resolve various alleged customer care and suitability violations. Robinhood also makes a lot of money from its “Robinhood Gold” account, which costs $5 per month. The gold account allows customers to participate in margin trading, which is a way to borrow money from the firm to trade. Margin has been around for a long time — it is essentially a way to supersize your investment returns, but it can also supersize losses.
Finally, like big investment companies and banks, Robinhood also makes money off cash you keep in your account and charges $75 to move the account to another brokerage firm.
If this all sounds just fine, you might wonder why people like me, who want to encourage people to invest, have been concerned about Robinhood. Trading with a few taps is great, but luring inexperienced users with video game and online betting gimmicks can be problematic. This type of “gamification” was seen in Robinhood’s early practice of rewarding investors’ winning trades with confetti animation (now removed from the platform) and digital nudges, like making the screen turn green when you’re up and red when you’re down, which encourages a lot of trading.
Adding to the concern is Robinhood’s practice of marketing trading tactics, like margin and options, without providing enough investor education. If you want to learn more about trading with borrowed money and about options, head to the FINRA and SEC websites. And, of course, like any risky investment, limit your exposure to 5% of your total investment portfolio.