September 1, 2021

Breakingviews: Robinhood is vulnerable to disruption

by Breakingviews.

Before Robinhood Markets came along, the retail investor complex controlled by firms like Fidelity, Wellington, Charles Schwab and E*Trade was sitting pretty. But the online trading platform run by Vlad Tenev has upended that, and like any good disruptor, made its fair share of enemies along the way. That’s come in the form of mountains of lawsuits, regulatory scrutiny, and distracting Washington gadflies that promise to reshape Robinhood. The backlash may be enough to leave the disruptor vulnerable to some disruption of its own.The company co-founded by Tenev filled a need in the centuries-old trading business. Until Robinhood burst onto the scene in 2019, E*Trade and Schwab made up more than 40% of the total industry’s online revenue, according to IBISWorld. But Robinhood has attracted more than 21 million monthly active users, doubling in a year. It now surpasses Schwab’s market share based on online brokerage revenue last year.Creating new demand, an important aspect for any upstart tech business, helped. African-American investors represented 9% of Robinhood’s customer base, compared with just 3% at incumbent firms, and Hispanic users made up 16%, compared with 7% elsewhere, according to filings ahead of the company’s initial public offering in July. For a business dominated by white, aging investors, it’s an important aspect that not only appeals to socially conscious companies; it is enough to tempt those companies to recreate what Robinhood has done.

Still, some of what made Robinhood great for new users has worried regulators. Trades are free, but the firm has to make money somehow. So around 80% of Robinhood’s revenue in the second quarter came from the practice of brokerages sending user orders to market makers in exchange for payments, known as payment for order flow, and a similar practice for its cryptocurrency unit, called transaction rebates. The U.S. Securities and Exchange Commission watchdog chief Gary Gensler told Barron’s in an article published on Monday that banning so-called payment for order flow is under consideration, sending Robinhood’s stock down as much as 8%.

The firm also accrued users with practices casually known as gamification, or using congratulatory tactics like raining digital confetti when a user made a first trade. On Friday, the SEC asked for public comment about such behavioral prompts and other tools that spur users to trade more often, which could hurt investors. Robinhood got rid of that feature several months before it went public in August.

But there are other aspects to the pile-on, from Tenev’s cellphone being confiscated as a result of an investigation being done by a U.S. Attorney’s Office to the 63 class action lawsuits and 1,600 potential arbitration claims it is fighting, according to an SEC filing.

The litigation and regulatory pushback is at best a distraction for the people who founded Robinhood, recently took it public, and now, with a $37 billion market capitalization, have investors expecting it to grow at a breakneck pace. At worst, the detractors could make Robinhood an educational test case, spurring Gensler and others to back rules based on what makes them uncomfortable about Robinhood’s business model.

That regulatory pushback helps level the playing field for challengers, which could take what Robinhood has done and start to do it better themselves. They wouldn’t have the headache of being the test case for watchdogs and would be starting without a spat of lawsuits. Some copycatters are already sprouting up. Earlier this year, Fidelity launched brokerage accounts for teenagers that don’t charge commissions. On Monday, CNBC reported PayPal is exploring a stock trading platform.

First movers have the advantage of creating a market that didn’t exist, so it’s possible that Robinhood users who are on the platform decide to stay. But that won’t be the case if others start to execute trades better, for example, and a financial firm that is accustomed to making regulators more comfortable will hit fewer snags.

Investors who own Robinhood’s own shares may start to wonder whether Robinhood is a Google, the search disruptor that has crushed others, or a MySpace, the early social media company that was displaced by Mark Zuckerberg’s Facebook. Commanding a new market can have extraordinary value. Keeping it in the face of immense pushback isn’t quite as easy.

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