Robinhood Markets, the commission-free equity investing and trading service, has been in the news in recent years, for both good and bad reasons. While the app has helped introduce many newbie investors to the financial markets, it has also come under intense scrutiny.
As the company prepares to go public, here’s what investors need to know.
The economic model
Robinhood’s mission is to “democratize finance for all”. Since the company’s initial launch, Robinhood has stood out from its financial peers and challenged the traditional money-brokerage service path. By eliminating commissions and allowing its users to buy and sell securities for free, Robinhood has been able to lower barriers to entry into the financial markets and attract many new investors.
While Robinhood doesn’t charge an upfront transaction fee, that doesn’t mean the company isn’t making money. Robinhood generates the majority of its revenue through a system called Pay for Order Flow. This means that when Robinhood users enter trade orders on securities such as stocks, options, or cryptocurrencies, those orders are routed to other companies for execution. These other companies named in Robinhood’s S-1 as “market makers” then pay Robinhood for trades based on a range of characteristics, including order size and security type.
While this system may seem complicated, it pretty much boils down to the volume of transactions. The more transactions processed on the Robinhood service, the more money Robinhood earns.
Robinhood in numbers
The past 12 months have helped Robinhood achieve exceptional financial growth. Fueled by government stimulus measures and lockdowns amid the pandemic, many individual investors have poured an unprecedented amount of money into the market. For Robinhood, that meant more deals.
Driven by a doubling of the number of monthly active users and an annual growth rate of 321% of assets in custody (fair value of securities held in all accounts receivable excluding margin balances), Robinhood generated $ 522 million in revenue in the first quarter of 2021 alone – 309% more than the previous year. While this growth is certainly striking, it has come at a cost.
Due to the rapid acceleration of users partly driven by the Gamestop (NYSE: GME) craze in March, Robinhood was forced to raise more than $ 3 billion in convertible notes to help defray costs associated with the increased volume of transactions. This resulted in a 158% annual increase in the company’s operating expenses in the first quarter.
Don’t overlook the risks
While the overall growth is undoubtedly exciting, Robinhood’s business also carries some serious risks that are worth considering by investors.
According to its own S-1, Robinhood currently has several pending legal proceedings that could lead to potential losses for the company. While many of these disputes may not produce anything of significance, they are still something investors should be aware of.
Some of those legal proceedings include around 50 putative class actions that have been filed against the company in various states, 1,600 jointly represented individuals who could pursue arbitration and $ 70 million in penalties recently imposed by regulators.
Besides legal risks, there are also business model issues. For example, about 6% of the company’s overall first quarter revenue came from Dogecoin transactions. While the real merits and value of Dogecoin are hotly debated, a drop in sentiment for this cryptocurrency could lead to a significant decrease in trading volume and, in turn, a dramatic reduction in Robinhood’s income.
While it is certainly possible that Robinhood will continue to grow and be immensely profitable in the future, the risks I just mentioned could lead to significant losses for investors as well, and for me that is enough to stay. apart.
This article represents the opinion of the author, who may disagree with the “official” recommendation position of a premium Motley Fool consulting service. We are heterogeneous! Questioning an investment thesis – even one of our own – helps us all to think critically about investing and make decisions that help us become smarter, happier, and richer.