Robinhood has been blowing up more than the ‘laurel vs yanny’ debate in the last few months. Everyone and their mother is making a brokerage account on Robinhood, and it has firmly established itself as the go-to platform for many millennials and ‘zoomers’ alike. While everyone’s rushing to put their money into Robinhood, has anyone stopped to think how reliable the company is? With zero commissions and fees, how does Robinhood make money?
I was curious, so I did a little research to find out.
What is Robinhood?
Founded in 2013, Robinhood’s mission was to provide a commission free stock trading environment. According to founders Vladimir Tenev and Baiju Bhatt, who were coworkers at a high-frequency trading firm before Robinhood, the goal of the company was to “provide everyone with access to the financial markets, not just the wealthy.” They are FINRA regulated and registered with the SEC.
Lately, Robinhood’s popularity has absolutely exploded. From 2016 to 2020, Robinhood has grown from 1 million to 10 million users. And it’s easy to see why. The system is easy to use with a great design. You sign up for a free account, put your money in, and suddenly you’re able to buy stocks with zero fees or commissions. After only a few minutes, you start feeling like the Wolf of Wall Street.
Since 2018, Robinhood has also added options and cryptocurrencies to its wheelhouse.
How Does Robinhood Make Money?
There’s no fees or commissions when you trade, and most accounts are free. So how does Robinhood make money? While there’s seemingly no direct cost to the investor, Robinhood has plenty of avenues for income.
1) Payment for Order Flow
The biggest way Robinhood makes money is by taking a little off each trade. When looking at a stock, there are really 3 prices at any given time. The market (the price you see), the bid (the price to sell), and the ask (the cost to buy). This is the case for all brokerages, not just Robinhood.
The bid is the smallest value, the ask is the largest, and the market price is in the middle. Every time you buy a stock, you pay the highest amount. Every time you sell a stock, you pay the lowest amount.
By tacking on a little more to the bid and ask prices, Robinhood gets to make a couple pennies on each transaction. This whole process is called payment for order flow. Think of it like a processing fee that’s rolled up into the price.
Fortune had this to say about payment order flow (PFOF):
[Payment for order flow] describes the fees Robinhood and others receive from electronic market makers for passing on customer orders. For example, when you buy a share of Tesla on your phone, Robinhood sends that order to a trading giant like Citadel Securities and receives a few pennies in return—the PFOF. Citadel, meanwhile, completes your trade and makes a few pennies itself.
2) Investing Your Cash
The good news is that all of that unused cash sitting in your Robinhood account is accruing interest. The bad news is you don’t get any of it. By taking the cash you aren’t using and investing it, Robinhood essentially has the ability to play with free money.
Since the founders worked at a high-frequency trading firm for years before Robinhood, they know how to invest money quickly and efficiently. When cash is just sitting in your account, Robinhood is finding a way to profit from it.
3) Subscription Fees
That’s right. Robinhood, the low cost cowboy, actually has a subscription service. Who woulda thunk it? For $5 per month, you get access to additional research, bigger instant deposits, and the ability to trade on margin (borrowing money to buy stocks).
Trading on margin is another way Robinhood makes money. The first $1,000 of margin trading is free with the subscription. After that, Robinhood will charge you 5% interest on what you borrow.
How Does This Compare to Other Brokerages?
As sketchy as this all sounds, it’s actually not that different from how other brokerages make money. In late 2019, nearly all brokerages switched to a commission-free strategy. With this switch, many of the businesses had to figure out different sources of income.
Payment for order flow is one of Robinhood’s most hotly debated income sources. It feels weird knowing that they are essentially taking a fee for themselves for simply being a middle man.
But as it turns out, Charles Schwab, TDAmeritrade, and eTrade also make money this way–shown as ‘trading revenue’, ‘transaction fees and commissions’, and ‘fees and service charges’ respectively. None of these brokerages have the infrastructure to directly access the markets, they have to use a service, like Citadel, to make trades for them.
What about investing your cash reserves? Yep, turns out the big guys do that, too. In fact, this is the largest source of income for Schwab and eTrade–shown as ‘net interest’ in the above links. Granted, some of these brokerages will continue to pay you a small amount of interest. Speaking from experience, Schwab is one of the brokerages that does this.
The other brokers also offer a subscription service. Well, kinda. The subscription that Schwab, TD, and eTrade offer are managed portfolios–meaning someone will make investments for you. You pay a fee, and you don’t have to worry about doing your own research on stocks anymore. Not exactly the same, but not that different.
What Does This Mean for the Investor?
If they’re all the same, then why does it matter who you pick?
Well, they’re not exactly the same. In fact, even though Robinhood hangs its hat on its free options, you may actually end up paying more if you use it. Data from SEC filings shows that you may be paying 10 times as much for Robinhood compared to eTrade.
If you’re not paying for the product, you are the product.
Reliability is a big concern with the Robinhood system as well. Outages and glitches have become commonplace on the app. One student even committed suicide after allegedly seeing a glitch on the system.
The fact that Robinhood is a private company also gives me pause. Schwab, TD, and eTrade are all public. This gives investors insight into how the company operates and how financially stable they are.
While you may be protected with SIPC if Robinhood went bankrupt, you may not be fully covered. SIPC coverage is limited to $500,000 per customer. Anyone trading with more than that on Robinhood is playing with fire.
The moral of the story is to do your research! If you like to use Robinhood because of its usability and convenience, that’s perfectly fine. If you are using it because it offers the cheapest way to trade stocks, you might want to reconsider. Schwab, TDAmeritrade, and eTrade are all great brokerage options as well. Whichever brokerage you choose, make sure you do your research beforehand.
You should also be aware the Robinhood has this going on. Stay educated!
DISCLAIMER: Investing is an inherently risky operation. Past performance is not a guarantee of future returns. All information presented is for educational purposes only and should not be taken as investing advice.