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[CB Insights Report]: How Robinhood Makes Money

CB Insights | Dec 2, 2020

Robinhood app going IPO soon - [CB Insights Report]:  How Robinhood Makes Money

Robinhood has made investing accessible for even the most inexperienced first-time investors. But while it has attracted millions of users with its no-fee, gamified approach, critics argue that the company's business model is not without risk.  Almost overnight, Robinhood gave millions of first-time investors easy access to the stock markets by making trading simple and, perhaps more importantly, free. Since it launched in 2013, Robinhood has become one of the most popular and influential fintech apps in the world, growing to more than 13M users. With a valuation of over $11B, the company makes much of its revenue from razor-thin margins on vast volumes of individual trades — a business model that is as lucrative as it is potentially precarious.

How Robinhood Works

Robinhood’s primary means of driving revenue is making very small amounts of money on individual trades at scale.  It does this by attracting large numbers of users using incentives such as “free” stocks and commission-free trading, retaining those users and encouraging trading activity via behavioral triggers in the app, and earning razor-thin margins on those trades through a process known as payment for order flow (PFOF).

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Prior to Robinhood’s launch, getting started with investing could be difficult and time-consuming. With much of its revenue dependent on attracting large numbers of users, Robinhood had to lower the traditional barriers to entry in investing — and did so by challenging the status quo of the entire brokerage industry.

Pre-Robinhood: Rise of the free trading investment platform

Brokerages typically fall into one of two categories: discount and full service.  Discount brokerages are able to charge their customers less for services provided by reducing overheads such as physical locations. They usually charge lower commissions than full-service brokerages, but they don’t conduct market analysis on behalf of their clients or offer investment advice. Because of this, discount brokerages are often synonymous with online brokerages.  Full-service brokerages typically charge higher commission fees, but offer a wider range of services including market research and investment advice. Many full-service brokerages have nationwide chains of brick-and-mortar locations, allowing customers to discuss their investment goals with an adviser in person.

Until fairly recently, investing was out of reach for many people. Choosing a brokerage required at least some knowledge of the markets, and commission fees made investing a potentially costly endeavor.  That changed in the wake of the financial crisis of 2008, when the first digital brokerages began to emerge, offering clients a new, lower-cost way to invest. These platforms quickly became a popular alternative to full-service brokerages.

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Emerging in 2013, Robinhood has lowered the barriers that were once common to investing. The product’s commission-free value proposition makes it easier for lower-income first-time investors to begin trading, and there are no minimum account requirements. Users can also trade fractional shares — fractions of a single share in a company, as opposed to a whole share. This makes investing in high-performance stocks, such as Apple, more accessible.

Further, Robinhood’s app interface is designed to avoid overwhelming beginner investors with information.  This accessibility expands the platform’s total addressable market (TAM) considerably by moving beyond typically older, wealthier individuals — who have at least some knowledge of investing — to younger and less experienced ones. The average Robinhood customer, for example, is 31 years old, while the average Charles Schwab customer is around 50.

How trading on Robinhood works

Before a user can begin trading on Robinhood, they must apply for an account. The Securities and Exchange Commission (SEC) requires all brokerages operating in the US to collect and verify the personal information of individuals trading on their platforms, including net worth and Social Security number.

The process can take up to a week, though most applications tend to be processed faster. Users must also connect a bank account so that funds can be transferred to and from their Robinhood brokerage accounts.

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The Robinhood app differs from most online brokerage tools in 2 key ways:

  • It provides the user with only the most relevant information in an effort to reduce complexity.
  • It encourages frequent use with behavioral triggers that reward certain actions.

Rather than risk overwhelming users by presenting them with the range of data offered by some professional trading tools, Robinhood keeps its information as streamlined as possible. For example, individual stock performance over time is displayed as a simple line graph. Users can find information on specific stocks with a typical search field.  But simplicity is only half of the equation. The other half is Robinhood’s use of behavioral triggers and rewards.

The gamified elements begin as soon as customers start interacting with the app. One of Robinhood’s promises is that new accounts receive a free stock — a single share of a company determined at random. While new users could receive a share in a company like Apple or Tesla, Robinhood acknowledges that it’s unlikely. New users have a 98% chance of receiving a stock valued at between $2.50 and $10 — but the incentive is still there.

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Much of Robinhood’s user experience is rooted in positive reinforcement and short-term reward structures. When account holders make their first deposit, they receive a congratulatory message saying that funds have been made available immediately so they can start trading. Free stocks serve as a referral engine to drive other people to the product. Robinhood also sends push notifications to alert users of movements in their positions, bringing them back to the app.

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