What does the average person associate with the stock market? Probably some guys in suits speaking an incomprehensible language and making money out of thin air.
About ten years ago, this perception was compounded by highly inconvenient brokerage applications. Thus, stock trading was the domain of the most dedicated and financially savvy, leaving a huge audience of potential investors untapped.
Then, in 2013, the Robinhood app was launched in the USA. The founders' goal was to provide access to financial markets to everyone, not just the wealthy.
Instead of a professional interface, Robinhood appealed to the young audience with colorful and simple design, and they promoted it with the help of celebrities like Jared Leto and Snoop Dogg.
Three years after its launch, Robinhood was the most popular investment app in the US (see chart at the end of the post), with the average age of its clients being 31 – one of the most financially capable audiences, for whom Robinhood opened the door to financial markets.
However, Robinhood’s killer feature wasn’t in its UX/UI, but in the absence of trading commissions. How is that possible, you ask? After all, brokerage businesses are built on commissions! How does Robinhood survive and thrive?
The company’s main income doesn’t come from user commissions but from market makers. Robinhood makes money by selling information about its clients' trades to those who process these trades. Confused? Let me explain.
Suppose you want to buy one share and place an order on Robinhood. At that moment, there are two offers to sell the share – for $99 and $100. In an ideal world, the broker would throw this order onto the exchange, and various sellers would compete for it. But Robinhood ensures you buy the share a bit more expensively, even if no one bought the share for $99.
This happens because Robinhood sells the right to execute your order to major market participants. And having bought this right, the market maker will sell you the share at their price – not for $99, but for $100.
So, Robinhood clients don’t pay a commission, but they overpay for the asset. Just like in Islamic banking or zero-interest mortgages.
This practice in the brokerage business is called PFOF (payment for order flow), and it generates 80% of Robinhood’s revenues, which is 4-15 times more than its competitors.
The secret to success is that Robinhood clients, like many Apple users, are willing to overpay for functionality and convenience without delving into the technical details. However, on financial markets, such carelessness can severely hurt your wallet.
As a result, Robinhood clients use riskier instruments more often compared to clients of other brokers, and before COVID-19, the platform didn’t even have educational content explaining the risks of various instruments.
All this means that most Robinhood users are not investors but real amateur speculators, which makes the app creators very happy.
What do you think about it? Is it better to have commissions or to use the system similar to Robinhood?
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