Online Brokers and Robinhood
A stock brokerage firm facilitates the buying and selling of tradable financial assets. The present blog entry introduces the various forms of brokerages and explores the opportunities and threats posed by online brokerage firms—especially Robinhood—to the brokerage world.
Background
A stock brokerage firm facilitates the buying and selling of tradable financial assets, including stocks, bonds, mutual funds, exchange-traded funds (“ETF”), and other investment products. The present blog entry introduces the various forms of brokerages and explores the opportunities and threats posed by online brokerage firms—especially Robinhood—to the brokerage world.
Traditional Full-Service Stock Brokerage
A traditional full-service brokerage firm offers services and products (e.g., financial and retirement planning, investment advice, tax advice, and portfolio updates) and, in general, generates revenue by charging fees proportional to assets under management. Because investors using traditional full-service brokers receive personalized services and recommendations in accordance with their risk appetite, the fees charged tend to be higher than those of other forms of brokerage firms. As a rule of thumb, traditional full-service brokers charge between 1 to 5% on the assets under management, with declining fees as the assets under management increases. Many of these brokers also require a minimum maintenance fee charged on a per annum basis.
- Pros:
- Personalized attention from experienced financial advisors
- No need to spend time researching and adjusting portfolio holdings
- Cons:
- High fees
- Lack of control over portfolio holdings
Online Stock Brokerage
The Internet revolutionized the way people traded financial instruments and dramatically increased trading volumes and liquidity, all the while slashing the amount of fees that could be imposed by “the middleman.” Many investors today care not so much about the analysis and recommendations provided by traditional brokerage firms as they do about the ease of executing a trade. Accordingly, online brokerage firms—including Charles Schwab, E*Trade, Fidelity, and Interactive Brokers—have moved away from imposing annual fees based on assets under management and started imposing fees on a per transaction basis.
Because the business model here is tied to the number of transactions made by investors, online brokerage firms tend to spend much on customer acquisition and provide perks for opening an account. Promotions range from free trades for a period of time to getting some amount of trading credit. For instance, E*Trade allows new registrants to trade for free for up to 60 days and gives $600 to those who deposit $250,000 or more.
As online stock brokerage firms merely provide a platform for investors to trade, product differentiation—and therefore barrier to entry—is arguably quite low. Various websites, in addition to providing signup perks, therefore attempt to differentiate themselves by providing heavy discounts in a particular product. eOption, for example, charges only $3 per option trade and 15¢ per option contract.
- Pros:
- Lower fees compared to traditional full-service stock brokerages
- Able to execute trades almost instantaneously, thereby having complete control over portfolio holdings
- Cons:
- Lack of a professional feedback loop and requires time for research
- Software delays can lead to delays in price quotes and information on order status
Robinhood
2013 came Robinhood, a stock brokerage application that, according to its founders, “democratizes access to the financial markets.” Providing only a simplistic, yet elegant, mobile platform to trade, Robinhood prides itself on enabling its customers to buy and sell stocks and ETFs with zero commission. With the launch of Robinhood Gold (a premium tier that charges monthly fees), Robinhood now positions itself as a freemium business. Robinhood Gold enables customers to trade on margin without paying interest and provides access to pre-market and post-market trading sessions, which have only been accessible to institutional investors. In addition to collecting membership fees, Robinhood also generates revenue by accruing interests from customers’ uninvested cash balance.
- Pros:
- Free to use
- Access to pre- and post-market trading sessions
- Simple and intuitive user interface
- Provides investors with complete control over their portfolio holdings
- Cons:
- Encourages day trading
- Lack of a professional feedback loop and requires time for research
Next Steps
The act of placing a trade is a commodity; thus, unlike Li & Fung for example, the middleman in this case does not provide much value-add. All of these translate to high price elasticity, with customers rushing to platforms that charge minimal to no transaction fees. Going forward, it is likely that Robinhood will roll out other features (e.g., currency trading, options trading, etc.) that further slash fees for the middleman. To survive, the entire stock brokerage industry needs to rethink its business model. Will we see an end to online brokerage firms? Should the industry as a whole move into a subscription based model (as is Robinhood Gold)? What other sources of revenue are there to be reaped if not transaction fees?
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As a brief user of the platform, one thing about Robinhood that I did not enjoy was the limited offering of trade types. Robinhood, at least as of last year, did not allow users to execute options trading or trading of mutual funds and ETFs. Because of this, I was reluctant to engage in single stock picks through Robinhood, especially because the platform did not provide comprehensive research capability.
I think these are examples of why Robinhood’s value proposition needs refining. The no-commission model probably is exciting for novice savers looking to begin trading at a low cost. However, combining the research and product offerings with the modest commissions offered by other services may be cheaper in totality than uninformed decisions made through Robinhood. As with any freemium model, providing the a high quality service is a challenge and I would expect that as competitors enter into this space, Robinhood will be challenged with developing robust trading information and products to stay competitive.
Great summary — appreciate you sharing on this topic.
Seeing that this is a new company with little track record of a sustainable business model, how viable do you think this business model is? Given that they seem to only make money off of interest from un-invested cash and monthly premiums, albeit only for gold members, what happens if customers do minimize their trades and stay in the free segment of their business? Does this premium model have enough product differentiation to merit the price increase from free, and is there enough profit per customer for them to be profitable and grow in a low barrier to entry market?
Also as a brief user of Robinhood, I agree that the value prop needs some fine-tuning, especially with their premium Gold tier. Furthermore, it costs Robinhood extra money to input each trade, so the company is bleeding cash right now unless they figure out a way to monetize their platform. One added-value I can see is perhaps moving toward a robo-advisor type model much like Wealthfront, which is an online management service that provides users investment advise using algorithmic models and financial data based on that person’s risk appetite.
Thanks for writing! Couple of thoughts:
– How will Robinhood differentiate itself against more established brokerages that have more value-added services? For example, TD Ameritrade has a thinkorswim platform that allows its clients to do more advanced stock analysis to generate investing ideas. My brief experience with Robinhood left me with the impression that the platform is relatively basic and useful only to execute trades, which is hard from a unit economics perspective for the business (as people have mentioned before, it’s likely burning through lots of cash).
– Agree with CYou’s comment on robo advisors – I see those as far more pertinent threats to the traditional online brokerage model, or even the actively managed / passively managed mutual fund market. Wealthfront and Betterment have reached, in a short amount of time, significant assets under management. These companies charge low fees while providing active trading capabilities and constant portfolio optimization / rebalancing.