IS AD­VO­CAT­ING FOR DO­MES­TIC MAN­U­FAC­TUR­ING SELF-SERV­ING? AB­SO­LUTELY.

Forbes - - THE INVESTIGAT­ION -

Zekel­man In­dus­tries is a fam­ily of com­pa­nies, 100% do­mes­tic man­u­fac­tur­ers. We make struc­tural steel and pipe prod­ucts, and we are rev­o­lu­tion­iz­ing the off-site con­struc­tion in­dus­try with mod­u­lar build­ing in­no­va­tions for cre­at­ing multi-fam­ily hous­ing and fa­cil­i­ties for all kinds of com­pa­nies quickly and ef­fi­ciently. What we make lets the wa­ter flow, keeps the lights on, helps builders build—and yes, we em­ploy thou­sands. We like what we do, and we love where we do it. If there’s an in­vest­ment to be made that will yield a greater re­turn than com­mit­ting to build­ing com­mu­nity in the coun­try we do busi­ness in, well, we can’t think of what that might be.

the 2011 Oc­cupy Wall Street move­ment ma­te­ri­al­ized as a protest of bailouts on Wall Street and fore­clo­sures on Main Street, one of Tenev and Bhatt’s friends ac­cused them of prof­i­teer­ing from an un­equal sys­tem. Soul search­ing led the pair in 2012 to con­ceive Robin­hood, a trad­ing app with a name that was an ex­plicit ref­er­ence to lev­el­ing the play­ing field. The most ob­vi­ous—and dis­rup­tive—in­no­va­tion: no com­mis­sions and no min­i­mum bal­ances, at a time when even low-cost ri­vals like E-Trade and TD Amer­i­trade made bil­lions on such fees.

Ini­tially, Tenev and Bhatt used the al­lure of ex­clu­siv­ity to cap­ture in­ter­est. For their 2013 launch, they re­stricted ac­cess, build­ing up a 50,000-per­son wait­ing list. Then they turned the vel­vet rope into a game, telling prospec­tive users they could move up the wait­list by re­fer­ring friends. By the time they launched on Ap­ple’s App Store in 2014, Robin­hood had a wait­list of 1 mil­lion users. They had spent vir­tu­ally noth­ing on mar­ket­ing.

Bhatt fo­cused ma­ni­a­cally on app de­sign, try­ing to make Robin­hood “dead sim­ple” to use. iPhones flashed with an­i­ma­tions and vi­brated when users bought stocks. Ev­ery time Bhatt came up with a new fea­ture, he’d run across the street with staffers from Robin­hood’s Palo Alto of­fice to Stan­ford’s cam­pus, corner­ing ran­dom students, ask­ing for feed­back. The app won an Ap­ple De­sign award in 2015, a prize given to just 12 apps that year. Mil­len­nial cus­tomers started down­load­ing it in droves.

By the fall of 2019, Robin­hood had raised nearly $1 bil­lion in fund­ing and swelled to a $7.6 bil­lion val­u­a­tion, with 500 em­ploy­ees and 6 mil­lion users. Tenev and Bhatt, both mi­nor­ity own­ers of Robin­hood with es­ti­mated 10%-plus stakes, were rich.

Then, in Septem­ber 2019, Go­liath bowed low to David. Over a 48-hour span, E-Trade, Sch­wab and TD Amer­i­trade, in­dus­try gi­ants many times Robin­hood’s size, cut com­mis­sions to $0. A few months later, Mer­rill Lynch and Wells Fargo’s bro­ker­age unit fol­lowed suit. As this source of rev­enue evap­o­rated, bro­ker­age stocks plunged, and TD Amer­i­trade soon en­tered a shot­gun mar­riage with Sch­wab, while E-Trade ran into the arms of Mor­gan Stan­ley.

Two Mil­len­ni­als had done some­thing that dis­count gi­ants like Vanguard and Fi­delity could never ac­com­plish. They had dealt the fi­nal blow to the easy-money trad­ing com­mis­sions that had fed gen­er­a­tions of stock­bro­kers and formed the fi­nan­cial foun­da­tion of Wall Street bro­ker­age firms.

The se­cret sauce of Robin­hood’s suc­cess is some­thing its founders are loath to pub­li­cize: From the be­gin­ning, Robin­hood staked its prof­itabil­ity on some­thing known as “pay­ment for or­der flow,” or PFOF. In­stead of tak­ing fees on the front end in the form of com­mis­sions, Tenev and Bhatt would make money be­hind the scenes, sell­ing their trades to so-called mar­ket mak­ers— large, so­phis­ti­cated quan­ti­ta­tive-trad­ing firms like Citadel, Two Sigma, Susque­hanna In­ter­na­tional Group and Virtu Fi­nan­cial. The big firms would feed Robin­hood cus­tomer or­ders into their al­go­rithms and seek to profit ex­e­cut­ing the trades by shav­ing small frac­tions off bid and of­fer prices.

Robin­hood didn’t in­vent this sell­ing of or­ders—E-Trade, for ex­am­ple, earned about $200 mil­lion in 2019 through the prac­tice. Un­like most of its com­peti­tors, though, Robin­hood charges the quants a per­cent­age of the spread on each trade it sells, ver­sus a fixed amount. So when there is a large gap be­tween the bid and asked price, ev­ery­one wins—ex­cept the cus­tomer. More­over, since Robin­hood’s cus­tomers tend to trade small quan­ti­ties of stocks, they are less likely to move mar­kets and are thus lower-risk for the big quants run­ning their mod­els. In the first quar­ter of 2020, 70% of the firm’s $130 mil­lion in rev­enue was de­rived from sell­ing its or­der flow. In the sec­ond quar­ter, Robin­hood’s PFOF dou­bled to $180 mil­lion.

Given Tenev and Bhatt’s his­tory in the high-fre­quency trad­ing busi­ness, it’s no sur­prise that they clev­erly built their firm around at­tract­ing the type of ac­count that would be most de­sir­able to their Wall Street trad­ing-firm clients. What kind of traders make the most saleable chum for gi­ant sharks? Those who chase volatile mo­men­tum stocks, car­ing lit­tle about the size of spreads, and those who spec­u­late with op­tions. So Robin­hood’s app was de­signed to ap­peal to the video-game gen­er­a­tion of young, in­ex­pe­ri­enced in­vestors.

Be­sides be­ing given one share of a low­priced stock to start you on your in­vest­ing jour­ney, one of the first things you no­tice when you be­gin trad­ing stocks on Robin­hood and are au­tho­rized to trade op­tions is that the bright orange but­ton right above BUY on your phone screen says TRADE OP­TIONS.

Op­tions trades also hap­pen to be prime steak for Robin­hood’s real cus­tomers, the al­go­rith­mic quant traders. Ac­cord­ing to a re­cent re­port by Piper San­dler, Robin­hood gets paid—by the quants—58 cents per 100 shares for op­tions con­tracts ver­sus only 17 cents per 100 for equities. Op­tions are less liq­uid than stocks and tend to trade at higher spreads. Sell­ing op­tions trades ac­counted for 62% of Robin­hood’s or­der-flow rev­enues in the first half of 2020.

The most de­lec­ta­ble of these op­tions trades, ac­cord­ing to Paul Rowady of Al­pha­cu­tion, may very well be so-called “Stop Loss Limit Or­ders,” which give buy­ers the op­por­tu­nity to set au­to­matic price trig­gers that close their po­si­tions in an ef­fort ei­ther to pro­tect prof­its or limit losses. In Oc­to­ber 2019, Robin­hood glee­fully an­nounced to its cus­tomers, “Op­tions Stop Limit Or­ders Are Here,” a nifty fea­ture which es­sen­tially puts trad­ing on au­topi­lot.

“That [stop limit] or­der is im­me­di­ately sold to a high­speed trader who now knows where your in­ten­tion is, where you would sell,” says one former high-speed trader. “It’s like you’re writ­ing a se­cret on a piece of paper and hand­ing it to

OP­TIONS TRADES ARE PRIME STEAK FOR ROBIN­HOOD’S REAL CUS­TOMERS, THE AL­GO­RITH­MIC QUANT TRADERS.

your bro­ker, who sells it to some­one who has an in­ter­est to trade against you.”

Robin­hood re­futes the no­tion that its model preys on in­ex­pe­ri­enced in­vestors. “Re­ceipt of pay­ment for or­der flow is a com­mon, le­gal and reg­u­lated in­dus­try busi­ness prac­tice,” says a Robin­hood spokesper­son who in­sists the firm’s trade ex­e­cu­tions saved cus­tomers $1 bil­lion this year. “We are fo­cused on pro­vid­ing a plat­form that makes fi­nance ac­ces­si­ble and ap­proach­able and where peo­ple can make thought­ful, in­formed in­vest­ing de­ci­sions.”

Bil­lion­aire com­peti­tor Thomas Peterffy, the founder of In­ter­ac­tive Bro­kers, says stop limit or­ders are the most valu­able or­ders a so­phis­ti­cated trader can buy. “If peo­ple send you or­ders, you see what they are. You can plot them up along a price axis and see how many buy and sell or­ders you have at each of those prices,” he says.

For in­stance, if a buyer sees sell or­ders bunched up around a cer­tain price, it means that if the stock or op­tion hits that price, the mar­ket is go­ing to fall hard. “If you are a trader, it’s good for you if you can trig­ger the stop—you can go short and trig­ger the stop, and then cover much lower,” Peterffy says. “It’s an old tech­nique.”

In a sense, Covid-19 has been both a bless­ing and a curse for Robin­hood.

The pan­demic forced mil­lions of fu­ture Robin­hood cus­tomers home to shel­ter in place, free from di­ver­sions like sports and armed with fast in­ter­net con­nec­tions and free money from the gov­ern­ment. The stock mar­ket, mean­while, pro­vided edge-of-your-seat ex­cite­ment as it plunged and then soared, pro­pel­ling su­per­stars like Ama­zon and re­viv­ing walk­ingdead stocks like Ch­e­sa­peake En­ergy. The re­sult was un­prece­dented growth for the up­start bro­ker­age. Robin­hood now has more than 13 mil­lion reg­is­tered cus­tomer ac­counts, nearly as many as ven­er­a­ble Charles Sch­wab, which af­ter 49 years has 14 mil­lion funded ac­counts, and more than twice as many as E-Trade, with 6 mil­lion ac­counts.

The com­pany has also been a game changer for some of its clients. Tay­lor Hamil­ton, 23, an IT worker who grad­u­ated from the University of Penn­syl­va­nia in 2018, opened a Robin­hood ac­count and be­gan trad­ing in March. He be­gan buy­ing put op­tions against plum­met­ing travel-in­dus­try stocks like Delta and Uber, and later bought calls on Boe­ing and other beaten-down com­pa­nies, cor­rectly fig­ur­ing that they would ben­e­fit from the gov­ern­ment’s de facto bailout via the bond mar­ket.

Af­ter four months and 300 trades, Hamil­ton has net­ted nearly $100,000 and paid down his $15,000 in stu­dent loans. “It felt like a once-in-a-life­time op­por­tu­nity,” says Hamil­ton, who re­ports that he has trans­ferred most of his prof­its to his bank ac­count to elim­i­nate the temp­ta­tion to trade away his gains.

The pan­demic has also ex­posed Robin­hood’s warts. Dur­ing the mar­ket’s 5% one-day swoon and sub­se­quent re­bound in early March, Robin­hood’s cus­tomers were com­pletely shut off from their ac­counts for nearly two days as the bro­ker­age firm’s tech­nol­ogy sys­tems crum­pled un­der the weight of a ten­fold jump in or­der vol­ume. An­gry cus­tomers lashed out against Robin­hood on so­cial me­dia, and more than a dozen law­suits were filed against the com­pany.

In the last few months, Robin­hood has qui­etly been re­struc­tur­ing. Tenev says it’s mak­ing ma­jor tech­nol­ogy in­vest­ments to in­crease ca­pac­ity and add re­dun­dancy. A siz­able chunk of its $800 mil­lion in fresh ven­ture cap­i­tal is go­ing to­ward up­grades and adding engi­neers to the 300 al­ready on staff.

In the wake of the Kearns tragedy, Robin­hood’s op­tion­strad­ing in­ter­face is also be­ing over­hauled. The com­pany has pledged to help ed­u­cate its cus­tomers on the highly spec­u­la­tive na­ture of the trades. That in­cludes hir­ing an “Op­tions Ed­u­ca­tion Spe­cial­ist” and “rolling out im­prove­ments to in-app mes­sages and emails” that it sends to cus­tomers about their com­plex op­tions trades. In Au­gust, the bro­ker­age app said it would hire hundreds of new cus­tomer-ser­vice rep­re­sen­ta­tives in its Texas and Ari­zona of­fices by the end of 2020.

Ac­cord­ing to in­sid­ers, there’s a sense of ur­gency at the com­pany these days. For two years, Robin­hood has been speak­ing pub­licly about an IPO. With in­ter­est rates near zero and the stock mar­ket roar­ing, the public-of­fer­ing win­dow is wide open, but it won’t be for­ever.

A better op­tion—es­pe­cially con­sid­er­ing Robin­hood’s cur­rent prob­lems—might be a quick sale to a full-ser­vice firm such as Gold­man Sachs, UBS or Mer­rill Lynch. Such a sale would surely pro­vide bil­lion­dol­lar wind­falls for its young founders, Tenev and Bhatt. And as any good trader knows, it’s much better to sell when you can than when you have to.

No one loves Robin­hood trades more than Wall Street’s bil­lion­aire quants. Citadel, owned by Ken Grif­fin (above), No. 34 on The Forbes 400, is the big­gest buyer. Bil­lion­aires in Sher­wood For­est

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