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Robinhood: zero-commission brokerage that could open up the stock market

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Few startups have the real potential to produce macroeconomic changes out of the gate, but Robinhood is one of those rare fast-growing startups that, if successful, might have an impact on the bigger picture. That’s the most interesting thing about their vision — what would the possible impact of Robinhood on the stock market and economy be? The Palo Alto-based company, 44% of whose employees are from Stanford, is now defying Wall Street by offering a mobile-first, zero-commission stock brokerage. Don’t be fooled by their relatively small size (25 employees) — they have half a million people signed up and already raised $16 million (seed round and series A combined) from the likes of Andreessen-Horowitz, Snoop Dogg, Box’s Aaron Levie, and Google Ventures.

Before we can go into the bigger picture, we first need to understand the idea behind Robinhood and what makes it different from regular brokerage services. Robinhood is a zero-commission mobile stock brokerage service — in other words, their app allows anyone (whose account is approved) to buy and sell stocks from their phones without any fees, unlike traditional brokerages. For instance, I can use their app to buy Facebook stocks for $77 right now on my iPhone. What used to be an expensive operation reserved for those with the cash to burn on $7 commissions per trade is now made free and accessible through Robinhood.

The two co-founders, Baiju Bhatt (B.S. 2007 in Physics and M.S. 2008 in Mathematics) and Vlad Tenev (B.S. 2008 in Physics and Mathematics), were roommates at Stanford before they went on to work in Wall Street. They realized that the transaction costs for executing trades on the stock market were dramatically lower than what brokerages charged. Although there was virtually no cost for brokerages to initiate these trades, every retail investor was charged a seven- to ten-dollar commission. Bhatt and Tenev were confused that nobody their age at the time was engaged in trading. They decided to try to democratize stock trading and change the common idea that the stock market is daunting and confusing, which the 2008 crisis only reinforced. “The Occupy Wall Street movement had just started, and we sort of thought to ourselves, ‘What are we doing? Aren’t we a part of the problem?’ We thought there was something more we could do, especially after learning so much about the intricacies of the market and what it takes to execute trades,” says Bhatt.

The idea that mobile is important has become common sense. If you want to target Generation Y (or Z, born after 1993) customers, you need to focus on mobile. Since everything from banking to meeting new people happens on our phones, Robinhood chose to focus on mobile first, specifically iPhones for now. This puts them ahead of their Wall Street competitors, who started their services on Web and went to mobile by shrinking their services into mobile apps, which usually resulted in a pretty bad user experience.

Being mobile is important, but the zero-commission part is where Robinhood really stands out: It doesn’t charge its users for stock trading. Over the next year, they plan to become cross-platform (Android and Web), release their API and offer more securities. Since they lack the costs of banks and brokerages — storefront locations, thousands of employees — they can keep their costs to a minimum. They also believe in using high technology to operate with less overhead. “Commissions make up around 20-30% of traditional brokerages’ revenue. We believe that eliminating this revenue stream would cripple them, especially since they are publicly-traded companies,” explains a Robinhood spokesperson.

While zero-commission trades and the possibility of financial upside is exciting, it’s also important to think of the larger-scale impacts that Robinhood’s service could have. Mainly, I’d like to address their monetization strategy and the fact that they are putting a lot of power in the hands of millennials, who may not be the most informed investors.

Robinhood’s zero-commission strategy is daring and seems unsustainable. However, they do have a monetization plan. Part of this plan hinges on charging interest rates for margin trading. What is margin trading? Imagine you are gambling and you want to bet $20, but you only have $10. Your friend then offers to lend you the extra $10 so you can bet $20. While margin trading doesn’t necessarily carry the same risk as gambling, it is still a high-risk activity. Encouraging margin trading can have very negative effects. It’s worth keeping in mind that one of the contributing factors to the Great Depression was excessive margin trading at the cusp of a market correction. Of course, the Great Depression is an extreme case — firms would lend up to $9 for every $1 invested. Per regulation, Robinhood will ask suitability questions before allowing margin trading, including questions about their goals, age, income bracket and investment horizon.

The grand vision for Robinhood is to become a beneficial force in the marketplace by letting more young people become retail investors (everyday investors). According to their team, these new investors could act as a stabilizing force and help to normalize the market, leading to less volatility. “During Robinhood’s seven month beta program, and since our public launch, we’ve noticed interesting trading behavior among our customers. Instead of leaping into the markets with large initial deposits and risky investments, our younger customers tend to deposit smaller amounts at first, make a few trades, and test the waters. This is key. It reveals that our younger and less experienced investors on Robinhood are thinking strategically about their investment decisions, and learning as they go,” tells Tenev.

“While the trading behavior on Robinhood proves that people are not active, whimsical investors, we do believe that more retail investors will lead to less volatility in the market, since retail investors tend to be ‘buy-and-hold’ rather than quick sellers focused on quarterly earnings,” said Tenev.

However, it is completely possible that these new young retail customers will not be as wise as institutional investors and will cause greater volatility due to market tremors. It is questionable whether having a lot of investors with the ability to make quick, zero-commission trades at any time will truly bring more “long-term” investors, and not the short-term investors that Robinhood believes characterizes institutional investors. Even Generation Z (born 1993 and after) would be able to influence the market. The stock market, once accessible to only those investors who were serious enough to pay a premium per trade, is now open to anyone, regardless of how much they’ve thought about their investment.

Robinhood is democratizing the stock market and giving a voice to more potential investors, whether for better or for worse. There are a lot of interesting scenarios that could appear when a new force comes to the marketplace, but it’s very clear that Robinhood is an idea whose time has come.

Robinhood is currently in a limited-access early trial. To request access to try it out, sign up on their website at www.robinhood.com

 

Talk to Lawrence Lin Murata at lmurata ‘at’ stanford.edu