Business Breakdowns
· Matt Reustle
[00:00:00] S0: This is Matt Reustle, and today we are breaking down Robinhood. My guest is Arthur Olson, founding partner at Ravenswood Partners, and Arthur educates me throughout this conversation on how Robinhood has evolved as a business away from the pure payment for order flow model and diversified its revenue streams, how product velocity is really the foundation behind everything in that continued penetration, and how new talent coming into the organization has made a material difference in terms of what they would be potentially exposed to during cycles. Now please enjoy this breakdown of Robinhood. All right, Arthur, we have a topical name today in Robinhood. It's a name that's topical from a stock perspective, from what they represent to the market. I'm excited to cover it with you. To kick us off, maybe you can level set the conversation with the simplest explanation of what Robinhood is. I think we all have an idea in our head, but how would you describe it to basically lay a foundation for the rest of the conversation?
· Arthur Olson
[00:00:00] S1: Thanks, Matt, for having me on. Robinhood is a really interesting business. The core of the business and the way to understand it is that it is a digital broker. So that means that it exists to allow its customers to buy, sell, and hold different securities. The breadth of those securities and even the account types have expanded over time as the company, I think, has improved and matured. But think about that broadly as equities, as options, as crypto. What is striking about Robinhood is just how much customers love the product. It has very much been a product-led growth story, scaled incredibly quickly. Today it has 26 million funded accounts, making it the third largest brokerage firm in the US based on accounts behind Fidelity, behind Schwab. It has achieved that in just over a decade, so basically one-fifth of the time that it took Schwab to achieve a similar number. Our view is that Robinhood is really the broker of the future, of the next generation, and it has significant both technological and also demographic tailwinds. And we see it as the logical industry share taker in brokerage and associated financial services over the next 20 to 30 years.
· Matt Reustle
[00:00:00] S0: You laid out a lot there, and normally I would get to some of the key people involved later in the conversation, but I think Vlad is key to the Robinhood story. Can we get into his journey to founding the business? I know he had somewhat of a trading background, but what went into the origin story of a digital brokerage, which didn't feel entirely new to me? We had digital brokerages in the past, so it wasn't entirely a new concept. But anything that you could tap into there in terms of the origin story and particularly Vlad would be interesting to hear.
· Arthur Olson
[00:00:00] S1: We could probably spend a whole hour just talking about this. Even Vlad's childhood is fascinating. So his family immigrates from Bulgaria. He's left behind for a year or two when he's in kindergarten. It develops this rock-hard determination and grit that you see pop up at multiple times throughout Robinhood's both founding, then also their trajectory of growth as a public company. I don't think it's really well understood. They've had to do a lot of really hard things. Being a tech company innovating in financial services, which is heavily regulated, is difficult. But if we fast forward to when he and his co-founder Baiju both meet, they're both at Stanford undergrad studying mathematics and physics, both gifted. They have the misfortune of graduating, I believe, in 2009. So the employment market is really bad. Baiju succeeds in getting a job at a high-frequency trading firm. Vlad tries to do the same, basically as an options trader, is not successful, so goes back to Stanford to pursue a PhD in mathematics. Within the first year, he becomes very disillusioned with what he sees in academia. There's this real piece of pure and noble desire to rethink and come up with first principle solutions to problems and a desire to touch a lot of people with those solutions. He talks about looking out to these famous mathematicians, Gauss, and studying their works and being very impressed by the idea of multiple generations working and basically learning from the insights of that one person. He wanted to do something similarly. Punchline is he wasn't getting that fulfillment in academia. So Baiju calls him up and says, "Hey, listen, my fund is doing well, but actually the technology is really old, and I think we could start our own firm, basically mimic what they're doing, use some modern technology, and be successful." They take a risk. They start their own high-frequency trading firm, they move to New York. I think by both guys' admittance, it's pretty much a failure. They very quickly, within the first year, pivot not to trading themselves but to selling the software that they've been building to bigger hedge funds and banks. But both of them ultimately find that somewhat unfulfilling as well. So within a year, they start thinking about Robinhood. They hit it at a very interesting time. So you have three secular trends that are happening.
· Arthur Olson
First of all, you have the rise of electronic trading. You also have the rise of mobile. This is about 2013 is when they're coming up with the product. The iPhone is still new, and it sounds crazy to us today, but the thought of trying to trade stocks, even paying bills on your phone, was crazy at the time. So they were very early to see that mobile would be the next compute iteration and where our lives would be mediated. And I think the third thing that really made the business possible in a way that others had tried commission-free trading in the past and hadn't been successful—part one of that is that they didn't have a really compelling app. But also there was this ripe environment post-GFC where you had Occupy Wall Street. There was a huge erosion in trust in these legacy financial services companies, and that brand equity was kind of at an all-time low, and it created space for these new challenger brands, Robinhood one of them and several others. That was the context. Their specific insight was when they were running the high-frequency trading firm, they saw that we're trading, and firms like us are trading every day, thousands of times a day, millions in aggregate, and we're not paying anything, or effectively we're not being charged, certainly not the $10 per trade commission that the retail investor is being charged. And that doesn't really make a lot of sense that the smallest investor should be charged the highest amount, and that really this is rent-seeking behavior that should be disrupted. The business model that facilitated that is known as payment for order flow. The broker receives a small rebate from a market maker in exchange for the right to execute that trade. Market makers like retail order flow because it's seen as non-toxic, it's uncorrelated, so they pay a small rebate. This is a business model that goes back to the '80s. When Robinhood was coming about, Schwab, for instance, made a significant amount of money on payment for order flow. It was just that they double-dipped. They got the rebate, and then they charged the $10 commission. Robinhood's core conceit was they surveyed the field and saw that traditional brokerages at the time made about 30% of their revenue from commission. And the thinking was, okay, what if we can start with a clean sheet of paper and build a modern brokerage using modern technology?
· Arthur Olson
We run it more efficiently. We don't have a brick-and-mortar network, not old workflows held over from the '80s, smaller headcount, and basically harvest those expense savings in order to offset basically sacrificing this 30% revenue from commissions. We'll make up the difference by volume of new customers that we acquire using that value proposition, but then also using these traditional brokerage revenue lines of net interest income, income on cash balances, margin lending, and also on subscription. The other really important half of this was having a really compelling product experience. So that was one of the big insights as well, is we need to make this product way less complex. Even if you look at the legacy broker apps today, they still very clearly are ports from web-based platforms. It's grid-based, a lot of dropdown menus, very clunky, and you can force your way through it. But if you're a digital native customer that grew up in the era of a smartphone, you're going to naturally gravitate to Robinhood's app.