Robinhood And The Band Of Merry Traders: A Closer Look At The Zero-Commission Brokerage Model

When Stanford roommates Vladimir Tenev and Baiju Bhatt finished grad school and went to work on Wall Street developing high-tech trading platforms, they became disenchanted with a stark shortfall that was rampant in the industry. They wondered why small retail investors were made to pay several dollars for executing trades that cost no more than a fraction of a dollar to their brokerages.

They quickly realized that this was standard practice – people had been inculcated with the notion that smaller investors had to pay commissions that ranged from $7 to upwards of $12 a trade, regardless of the size of the transactions. They looked at institutional investors and high-frequency traders, who often paid cents for their trades, and wondered: how do we find a way around this inefficient system that burdens low-volume traders with hefty fees?

In early 2013, they launched a mobile application, “Robinhood,� declaring the need for the democratization of stock predictions in a highly social platform. But there was still a need to address the mismatch in the brokerage model for retail investors, a need for more transparent access to trading. From that emerged the novel idea to create not just an intuitive stock-tracking app, but also to enable the buying and selling of equities, options, and corporate bonds – all with a few swipes of the finger or clicks of the mouse.

The latest version of the Robinhood app is based on the value proposition of zero-commission trades for the demographic that typically pays hefty fees for even the smallest orders. It is able to do this by cutting out the bloated cost structures of the traditional online brokerage: manual task management, retail locations, marketing expenses. Instead, the startup is focused on on using advanced technology and cleverly programmed trading systems to reduce costs and offer low-latency trading to the average user.

The company – which is based in Redwood City, California – is backed by several big name venture capital firms such as Google Ventures, Index Ventures, and Andreessen Horowitz, and also angel investor and StockTwits’ CEO Howard Lindzon. RobinHood has raised just over $3 million thus far in seed funding and is driving its proposition forward with an attractive design for the application, touting its ease of use and cost savings. The mobile application’s primary interface adopts a black or white theme depending on whether the markets are closed or open.

According to its co-founders, the RobinHood app’s user interface (UI) has been designed so that users can execute trades within a timeframe of around 30 seconds, in order for trading to seamlessly coalesce with their daily lives. Imagine standing in line at a fast-casual restaurant with a few moments to spare, and being able to pull out a smartphone and buy a particular stock, all with just a few swipes.

The case for a revamped trading model for retail investors is solid. In the last quarter of 2013, average trading volumes at discount brokerages like Charles Schwab Corp. (SCHW) and TD Ameritrade (AMTD) were up in the high-teen percentages as small investors begain to believe in the economic recovery and put their money on stocks.

The co-founders seem to have the right idea – giving low-cost universal access to the markets for all. The company plans to appeal to the new generation of investors, who are increasingly turning to mobile and social platforms for an understanding of the markets. The Robinhood app will be available for the public in the next few weeks, for which email signups have opened up since late last year. The response has been completely overwhelming, even for the founders themselves. As of the first week of June, the wait list for an invitation to join the Robinhood platform exceeds 360,000 individuals.

Skeptics Abound
But the increasingly disruptive question of whether Robinhood presents a threat to existing brokerages has invited a range of skeptics to question how exactly Robinhood will make money.

The company’s answer is that it will initially make money by charging for the third-party use of its application programming interface (API), which lets developers and traders create automated logic-based trading systems and in-depth market data to provide stock trading services on their website through the Robinhood platform.

But many say that revenue generated by charging for API access doesn’t come close to what the startup would need to scale operations for millions of trades – data centers, back-end programming, marketing, and office space. There are also many online brokerages that currently let users access their APIs for a small fee. TD Ameritrade, for example, allows free access to their API if a customer has equity positions worth around $25,000 in his/her account and has a good standing.

Other firms, like TradeKing and Interactive Brokers (IBKR), also enable API downloads for their customers with similar terms, but they compensate for the forgone revenues by charging a hefty commission on clients’ trade orders. RealTick EMS, the trading services arm of Boston-based Eze Software Group, which serves many large hedge funds, also has its own consumer-facing API that offers low-latency market data.

The advanced API, which allows access to data as well as high-quality market execution, costs around $100 a month. There is an additional software fee set at $250, which is refundable if the customer trades more than 200,000 shares a month.

Robinhood could offer similar rates for access to its APIs to let users take advantage of real-time, in-depth market data and clearing services as it builds upon its expertise in analytics and programming solutions.

Another segment of trading that Robinhood plans to capitalize on is margin trading, which is typically offered to users with credible histories who pass certain minimum capital requirements. In a recent interview with Bloomberg, the company’s co-founders noted that margin trading catered to young 20-somethings with few savings and capital, and will invite a new wave of investors who had previously never had this kind of easy access to leveraged accounts.

Other avenues for revenues include the introduction of premium services for more active traders, and even greater access to global equities and over-the-counter (OTC) stocks, which Robinhood has indicated is something it will probably do. It makes sense to limit a user’s monthly trades given the zero-commission model, which could open the system to abuse from excessive bot trading and high-frequency traders using automated trading algorithms.

But with per-trade commissions excluded, critics stress that revenues from selling APIs and margin trading may not be enough to cover the costs of operating the Robinhood platform. As the company expands its user base, it will need to invest in the high-tech back-end systems required to facilitate high-volume trading and focus on speedy order executions, paying fees to service providers like securities exchanges and clearing agencies.

And it still leaves many questioning whether eager traders would actually switch from some of the premium services offered by existing online brokers, such as Charles Schwab and E*Trade. These brokerages offer a whole range of specialized services like financial advice, block trading and advanced portfolio tools – things that Robinhood cannot offer, at least initially, due to its lean operating structure.

RobinHood could also, of course, use many other strategies used in the brokerage space to drive revenues, such as netting on rapid order flow, where trades can be routed to occur directly between buyers and sellers in the event of matching orders.

Tenev and Bhatt have defended their business model, arguing that high-frequency traders already pay very low fees, and that there is no good reason why retail users should incur predatory charges. They say that the cost of executing electronic orders is very low, and certainly does not reflect the hefty premiums being charged to the retail client.

Several startups with the same or similar ideas have by now tried and failed, but Robinhood says the markets are primed for democratization. If it is successful, Robinhood has the opportunity to turn the standard retail brokerage model on its head.

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