Fintech Startups

Robinhood: Regulatory Risks Make This an Unattractive Offering

Robinhood Markets (NASDAQ: HOOD), the zero-commission investment app that has revolutionized the brokerage industry, has filed for an initial public offering (IPO). The IPO is set to be one of the most anticipated offerings of the year, given how the company has drawn in millions of retail investors. The company said it hopes to raise $100 million from the IPO, but that number will likely change as it is often used as a placeholder value in the filings. Nevertheless, the prospectus is the first honest look that investors have been able to have into the company’s finances. In this article, we will discuss the key numbers from the prospectus and whether or not you should invest in the business.

The Gamification of Retail Investing

As is typical of many IPOs, Robinhood’s revenue numbers are sensational. According to the company’s investment prospectus, revenues tripled from $278 million in 2019 to $959 million in 2020. Moreover, growth has continued on this explosive path: in the first quarter of 2021, it was $522 million, up 309% from the same period last year. Revenue growth is driven by the surge in the number of registered users and funded accounts. The company had 31 million registered users at the start of 2021, double its number in 2020. In addition, Robinhood grew the number of funded accounts by 151% from the end of 2020 to 18 million funded accounts in the first quarter of the year, up from 7.2 million accounts for the same period in 2020. The number of funded accounts in 2019 was 5.1 million.

The financial establishment has criticized the company’s success in ushering in so many retail investors. One regulator referred to the company’s “gamification” of investing, which was meant to use bonuses, push notifications, and other prompts, as well as rewards, to encourage a high frequency of trading. Strictly speaking, this is true: without commissions, Robinhood makes money from the spread between the bid and ask prices, and so, the greater the frequency of trading and the more retail investors invest in stocks with wide spreads, the more money Robinhood makes. The company has been tremendously successful in this regard. As a result, retail investors are committing more significant and larger amounts to the app, and many have focused on meme stocks, the kinds of stocks with a wide spread between the ask and bid price. The average revenue per customer currently stands at $137 for the first quarter. This is up 65% from the same period in 2020 when the average revenue per customer with a funded account was $83.

In 2020, investors put 45% of their money on the platform, making them the most lucrative cohort of investors since the company started.

Payment for Order Flow

The heart of Robinhood’s business is something known as “payment for order flow” (PFOF). This is an extremely controversial practice. We alluded to it above in explaining how Robinhood makes money. Essentially, the brokerage sells customer trades to Citadel Securities and other market makers, who then promise to execute the customer trades at prices that match or better current market prices. In 2020, PFOF amounted to 75% of its revenue, earning it $720 million. This rose to 81% in the first quarter of 2021. According to the Security and Exchange Commission, the practice is banned in Canada and the United Kingdom and is under review in the United States. According to the SEC chair, Gary Gensler, PFOF is not in the best interests of retail investors. Zero-commission trading exists because of the hidden fees and opportunity costs represented by PFOF, and it is more ethical for those needing ethics demystified. The SEC’s weariness over PFOF represents an immense risk to investors as any adverse change to regulations would seriously damage the company’s business model. This alone is enough to put off a conservative investor. TD Ameritrade and Charles Schwab offer zero-commission trading, but, crucially, PFOF revenue makes up under 10% of their revenue. This means Robinhood would suffer much more than its rivals from changes to the law.

Regulatory investigations 

The company’s prospectus was published a day after Finra (the Financial Industry Regulatory Authority) ordered record penalties of $70 million against the company for causing “widespread and significant harm” to its customers. The company was found to have several failings, including technical problems during high volatility periods.

Robinhood has been accused of an approach that can be likened to Silicon Valley’s “move fast and break things” approach to innovation. Unfortunately, the same attitude applied to investing has led the company to run afoul of regulators. According to its prospectus, seven regulators are under investigation at the state and federal levels. Some of the inquiries revealed in the prospectus were not previously known. Not only does Robinhood face an onslaught of regulatory challenges and future penalties, but it also faces nearly 50 class-action lawsuits and three individual customer actions for the restrictions the company imposed on investors on trading in GameStop and other “meme stocks” in January. This constellation of challenges is another reason I believe the risks of investing in Robinhood are far too high. At a time of geopolitical risk, an investment in gold is probably a smarter bet.

Hugh Grant

Hugh Grant is a technology researcher who is always staying up to date on the latest tech news, trends and innovations.

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Hugh Grant

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