Transforming the Financial Brokerage Industry

The commission-free, mobile-only firm Robinhood is digitalizing and disrupting the discount brokerage industry.

The discount brokerage industry, with incumbents such as Fidelity and ETrades, has been under-serving a growing population of retail investors.

Consider the financial services firm that handles your 401k. It is designed around the notion of passive investment in the long horizon. By investing in a market-tracking index fund, they claim, one can significantly grow their retirement savings because the US stock market will always trend up in the long run. What if you want to actively invest in the stock market? You will need to figure out the complications of converting your passive investment into an IRA, from there on all the future trades you make will be executed by your brokerage firm on a commission basis.

Let’s zoom out a bit and look carefully at the whole picture. The traditional discount brokerage firm uses commission fees and account transfer fees to “hook” individual investors onto the platform through what Richard Thaler calls “the sunk cost fallacy.” The brokerage firm rarely provides high-quality investment advisory services to the customers. As customers make more and more indecisive and ill-informed trades, they feel compelled to rectify their investment blunders with follow-up remedial trades, surrendering more commission fees to the brokerage firm.

Then came Robinhood, a commission-free, mobile-only tech firm based in Palo Alto at the heart of the Silicon Valley. The founders of Robinhood are former financial industry professionals, and they observed that the actual electronic execution of a regular buy/sell action costs nearly zero per trade to the brokerage firm. Then comes the insights: traditional brokerage firms are charging commission fee only because (1) their competitors are doing the same and (2) they need to use the commission-based revenue to cover the overhead cost of business operations. Instead of following suit, Robinhood adopts a radically new business model: fulfilling stock trades with zero commission fees while making money from the interest rate of customer deposits (i.e., “the float”) as well as from a subscription-based premium service where customers can execute trades with leverage. In lieu of the paper-based (or at most desktop-based) user experience offered by industry incumbents, Robinhood offers an intuitive, delightful mobile user experience where users can access realtime market information and execute trades through simple tapping and swiping gestures. Their referral program (“refer Robinhood to a friend and get a free share of a random stock”) further added elements of virality and gamification to the user journey.

Who are the users of Robinhood exactly? Many articles have been written about the so called “Robinhood Generation” with a variety of behavioral and sociological insights. One recurring theme seems to be that the “Robinhood Generation” is steering retail investing toward greater social responsibility. For example, we have Environmental, Social, and Governance (ESG) criteria that socially conscious investors use to screen potential investments. The Robinhood Generation is increasingly relying on ESG guidelines and specialized business databases such as GREENR/GALE to inform their stock market investment decisions. The recent Reddit vs. Wall Street episode around Gamestop is another case in point, where millennial investors, many of them on Rohinhood, staged a noteworthy “battle” against institutions that had seemingly short-sold the GME stock too aggressively while creating little values for the society.

It’s also worth mentioning that there is a more developer-friendly version of Robinhood called Alpaca. Instead of placing trade orders via a mobile app, Alpaca enables a user to execute trades programmatically via an API. Having a programming interface also opens up a myriad of possibilities for Alpaca to integrate with other software and hardware applications. The trading API can also be complemented by financial statistics APIs or relevant databases along the full user journey of equity research, trading strategy development, and trade order placement, all done programmatically. The future might not be too distant where a retail investor can simply speak to their Alpaca-integrated virtual assistant (e.g., Alexa, Google Home): “buy me 3 shares of Apple stocks” and some pre-configured computational processes will take care of the rest.

Robinhood is now a “unicorn” (i.e., a high-growth company with $1 billion or higher post-money valuation) with millions of engaged retail investors onboard (or, rather, “jumped ship” from industry incumbent to Robinhood) and a healthy profit margin. Robinhood has also added trading support for cryptocurrencies in response to its growing user population eager for alternative assets. While an early-stage digital winner in the space of financial brokerage industry seems to have emerged, it remains to be seen where Robinhood’s next pillar of growth may be, as both traditional brokerage firms and API-first upstarts join the “commission-free trading” brawl.


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Student comments on Transforming the Financial Brokerage Industry

  1. Very cool post! Interesting business model and decision to go mobile only. It will be fascinating to see how the incumbents respond. Also will be interesting to see how Robinhood’s success ultimately compares to robo-advisors such as Betterment and Wealthfront. It seems like most millennials have been partial to passive investing but the opportunity to try active investing without incurring fees on every trade will certainly be enticing to many.

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