Robinhood (NASDAQ: HOOD), the revolutionary zero-commission investment app that has shaken up the brokerage industry, filed for an initial public offering (IPO). The company’s approach has drawn in millions of new retail investors, making it the king of retail brokers. According to the company’s investment prospectus, Robinhood plans on raising $100 million from the IPO. This is usually a placeholder value, so we should expect the real terms to emerge with amendments to the prospectus. Though the company has ushered in millions of retail investors, it has until now been very opaque about its financial prospectus. The release of the prospectus will give investors an opportunity to consider the merits of the offering. In this article, we will discuss a few findings from the prospectus that I believe is of concern to investors.
The company released its prospectus the day after the Financial Industry Regulatory Authority (FINRA) fined them $70 million, the highest penalty that FINRA has ever levied. According to FINRA, the company is guilty of causing “widespread and significant harm” to its customers. Robinhood was also found to have various failings, such as technical problems in periods of high volatility. Ordinarily, these are small beans, but the FINRA case is part of a broader pattern.
According to its detractors, the company wrongfully pursues a Silicon Valley-style policy of “move fast and break things”. Unlike innovation, finance is highly conservative and such an approach threatens the funds of its customers. The prospectus revealed that the company is being investigated by seven state and federal regulators. Some of these investigations were not previously known. The legal issues do not end there. The company is the subject of 50 class-action lawsuits and three individual customer actions. These are related to the company’s restrictions imposed on its customers in January, at the height of the GameStop frenzy.
Payment for Order Flow
Many people wonder how a brokerage firm makes money without charging any commission. Robinhood employs a very controversial practice, “payment for order flow” (PFOF), to earn the bulk of its revenues. PFOF is a practice in which a broker such as Robinhood sells customer trades to a market maker (Robinhood is particularly enamored of Citadel Securities) in exchange for which that moneymaker promises to execute the trade at a price equal to or greater than the current market price.
In 2020, PFOF was 75% of the company’s revenue, or $720 million. By the first quarter of 2021, that had risen to 81%. PFOF is so controversial that it is banned in Canada and the United Kingdom. Crucially, the practice is under review by the U.S Security and Exchange Commission (SEC). The SEC chair, Gary Gensler believes that the practice does a disservice to retail investors. The SEC’s stance presents a challenge to Robinhood. It is not an overstatement to say that the end of PFOF would lead to an existential crisis on the part of Robinhood. The challenge would not affect TD Ameritrade and Charles Schwab in the same way: only 10% of their revenue is derived from PFOF. They can survive the end of PFOF, Robinhood cannot.
At present, these risks are hypothetical, however, as I glance through the offerings at Creative Cabinets and Fine Finishes, I cannot help but think that they are too much for any sensible investor.