Business Breakdowns
· Arthur Olson, Matt Reustle
[00:00:00] S1: The way it works is I buy $100 of Apple. That order gets executed, and it gets routed either to a market maker or to an exchange. The market maker—let's use a name like Citadel that people know. I mean, it is crazy. By the way, I just saw this stat the other day. I think Citadel trades is responsible for over 20% of total US market trading on a daily basis. So they are just massive in scale. But the concept is that the market maker values retail order flow. Their business model is buying and then reselling and turning over their book very, very rapidly. And their goal is to make an infinitesimally small profit. We're talking tenths of cents per share. But when you magnify that and multiply that across so many trades, obviously in aggregate, that is very meaningful. [00:00:00] S0: 20% of the volume. That's a big number.
· Arthur Olson
[00:00:00] S1: Exactly. It's massive. So it's this dynamic where retail is getting filled at a good price, and yet the market makers are able to make a significant profit. This was a point of a lot of contention and controversy about three years ago. Gary Gensler made it very much a mission to go after payment for order flow. I've looked into it. I think the reality of the matter is, you look at a lot of the studies in academic literature, and it's kind of a push. Half would say it can very, very slightly impact negatively execution quality. Half would say it has no impact. What's interesting and what is really unequivocal is that it is a way better deal for Robinhood-specific customers. So payment for order flow is much more efficient for small-dollar trades. If you think about the old model, you were paying, let's call it roughly $10 commission to buy and then $10 to sell. Robinhood's average account today is $10,000. Back in 2021 even, it was like $5,000. So these were very small accounts. If you're making a $100 trade and you're paying $20 in transaction fees, you've got to earn a 20% return just to be even. And then if you take that a step higher, let's say $1,000 trade, okay, now it's a 2% hurdle. So 200 basis points of your return is chewed up in transaction fees. When you look at payment for order flow, generally speaking, I think the academic research would show that the effect on liquid names is about 1 to 2 basis points. So in that $1,000 trade example, you're talking about 200 basis points of transaction cost lowered to 1 to 2 basis points for payment for order flow. And if you think about the coin of equivalency—it's more a rule of thumb, it's actually different for every stock. Even the volatility that day, there's a lot of different moving parts—like around $50 or $100,000 trade is the point of equivalency where, over that, so trades that are larger than that, actually are more expensive using payment for order flow for the customer, and then trades under that are going to be cheaper. And obviously Robinhood is overwhelmingly under that.
· Matt Reustle
[00:00:00] S0: It makes a lot of sense, particularly with that piece of the market. And there's this discussion of increasing TAM of any type of market. And theoretically, anyone with a logical brain might see that $20 commission that they're going to have to pay on a $100 trade and know this is a bad situation, whereas that payment for order flow model with zero commissions is going to be net better, and that might bring in new customers on top of everything else that they're offering. I'm curious, is there still the double dipping in terms of payment for order flow with the commission trades? I know pretty much everybody has free commissions now, so maybe it's not as relevant. But how dominant is that across the brokerage market?
· Arthur Olson
[00:00:00] S1: That is the power, really. The industry has voted with their feet, and now everybody's payment for order flow, with the exception of Interactive Brokers and partners. That is because they've got a different customer base—small hedge funds, prop traders. But no, it's very interesting. So yes, the whole market has moved to payment for order flow. And in that way, commission-free trading is no longer a competitive advantage on a relative basis for Robinhood. If you go back in history, so Robinhood was founded in 2013, hit the market in 2015. Within five years, had flipped the entire industry. So in 2019, Schwab made the decision they were going commission-free, and then literally within weeks, every other player in the space made the same decision. This ultimately crippled, for instance, TD Ameritrade, E*Trade. Both of those ultimately got subsumed by Schwab in the one case and Morgan Stanley in the other. But it was a point in time where many people said, "Okay, Robinhood is dead. That is their whole differentiation, is commission-free trading. The bar is now leveled." And what we saw is that they went on over the next year and a half to like 5x their customer base. So the whole industry has moved to this model. But those that thought that it would kill Robinhood misunderstood what is the real competitive advantage here. Innovating on economics was one, but the other is the mobile experience and also the brand. The product velocity that Robinhood has been demonstrating over the last, really, three years since 2022 is incredibly impressive. It's just a stroke of genius. I don't know if our listeners have watched some of their product summits. I highly suggest the most recent one, the Active Trader Summit. And it's just a masterclass in sales and brand building—going to your customers, showing them all the new product that you've built for them, and then saying, "What else do you guys want us to build for you?" That's not something Schwab, Fidelity, any of those guys are showing that kind of attention to the customer. This is in Vlad's DNA. This is what the VC investor said: "We've never seen a CEO that's more in touch with his customer than Vlad." The initial flywheel or the initial wedge, a decent chunk of that was payment for order flow, but now that is standard across the board.
· Matt Reustle
[00:00:00] S0: On the customer base, you mentioned the average size of an account, and that's gone up meaningfully. Is there any way to capture the quality of the account versus Interactive Brokers has many institutional or institutional-like investors sitting on its platform? Then you start to move into the high net worth. What does the quality of the Robinhood customer base look like?
· Arthur Olson
[00:00:00] S1: This was probably the biggest unlock, and when I knew we had a real differentiated view, because I think it's fair to say the perception of Robinhood, frankly as a company, but also their customer base, is not that great to the average person. Both of those are misleading. So I would say people expect Robinhood to be day traders, to be unsophisticated bad investors, effectively. So there's 250 roughly trading days in the year. I think most people that I talked to at the time assumed Robinhood customers were trading at least once a day, maybe twice a day. So their number of trades per year would be 200, 300, 400. The real number is 40. They're placing 40 trades a year, or about one a week. It's not the picture of this hyperactive day trader that you would think. Schwab's average customer, the self-directed customer, trades 40 times a year. It's very, very similar. And then, okay, if you look a level deeper, you say, okay, what's the mix of those trades? Maybe it's all just crazy options and crypto. Again, I think that's the perception. When you look at it, no, two-thirds are vanilla equity, about one-fourth are options, and then about a tenth are crypto. If you look at equity, it's overwhelmingly skews to large cap, high quality companies. Lastly, if you think about outcomes, we know roughly 85% of day traders ultimately fail. So if that was Robinhood's base, you would expect to see one, a lot of churn, and then average account balances flat or probably down. And the reality is we see the opposite. Churn for the last two years, almost three years at this point, has been about 5%. We're talking about 95% retention, and that's before any net new adds. So we're talking about enterprise SaaS levels of retention. By the way, those numbers are 2 to 3 points higher than Schwab's. Average account size is 5x from the lows three years ago. And even from that crypto meme stock era, it's still double that level. The takeaway ultimately that we had is that functionally, Robinhood users are really no different than a Schwab user or Fidelity user in terms of the risk appetite. There's a generational thing we see in terms of younger people are obviously starting to invest earlier and they also are a little bit more active. So we would expect them to be a little bit more active over time, but that's not a bad thing.