Robinhood IPO: Looking Under The HOOD

Summary

• Robinhood’s income is highly dependent on getting retail investors into the riskiest sorts of investments — options, crypto, short selling, and margin.
• As such, they are highly dependent on the casino-like atmosphere in markets in the last year-plus. Eventually, that will end, and it will not be good for Robinhood.
• Like all retail brokers, Robinhood sells their retail order flow to market makers. But uniquely, over 75% of Robinhood’s revenue comes from order flow payments.
• They have next level Risk Factors in their prospectus.

Justin Sullivan/Getty Images News

Welcome to the Casino

“[I]f we buy this thing it will go up, so let’s buy it; also it will be fun and Elon Musk tweeted about it.”

Look, I understand that I have gotten stupider by typing all of that, and you have gotten stupider by reading it, but it’s gonna get worse.

- Matt Levine, prophetically sizing up the retail investing landscape, February 8, 2021

I love tech prospectuses. Since the late 1990s, they are their own genre of literature, and I do mean fiction. For example, the Robinhood (NASDAQ:HOOD) IPO prospectus begins thusly:

Our mission is to democratize finance for all.

-Robinhood prospectus. Emphasis in original.

Over 75% of Robinhood’s revenue comes from selling their order book to market makers, a system that relies on trust and everyone observing their fiduciary responsibilities all the time. Robinhood has been very lax with their responsibilities. This is a definition of democracy with which I am unfamiliar.

“If you are not paying, then you are the product,” is now a cliche for a good reason.

There are almost always surprises, good and bad in these things. For example, we learned that Roblox had far more users than anyone imagined. We learned that monday.com is trapped in an endless cycle of increasing marketing spends. With Robinhood, we learned:

• Aside from the $70 million penalty they just were levied, they have also paid, or have put aside to pay, another $81 million in penalties since December 2019. Most of this is for ignoring their fiduciary responsibilities.
• There are multiple open regulatory inquiries and lawsuits underway, and CEO Vlad Tenev has had his phone subpoenaed and seized by the US Attorney.
• Their highest paid employee in 2020, who started in May, was their Chief Legal Officer, Daniel Gallagher. Gallagher scored almost $30 million in bonuses. Considering the first two bullets, this was probably a good idea.
• Though only 3% of assets under custody, 38% of their Q1 2021 revenue came from selling their options order book.
• 17% of their revenue came from selling their crypto order book in Q1 2021. Over a third of that was just Dogecoin. Dogecoin was still only $0.05 at the end of March.
• Over 12% of revenues came from lending fees to short sellers, and margin interest.
• Via payments for order flow from market makers, in Q1 Robinhood took home 9.7% of their “customers’s” options portfolios, 0.8% of their crypto portfolios, and 0.2% of their equities portfolios. That is one quarter. In the full year 2020, those numbers are 20.8%, 0.5% and 0.8% respectively.

Despite that incredible rate, and the casino-like atmosphere of Q1 2021, they still only managed to eke out a 9.1% profit margin, and that is after pulling out the $1.5 billion non-cash hit to their operating statement from the repricing of warrants and convertibles. Schwab (SCHW), who also gets paid for retail order flow, had a 31% profit margin that quarter.

What this points to is a brokerage that is dependent on, and in some ways responsible for, the current Monte Carlo atmosphere in markets. Even in that context, they still earn only a thin margin. All the things they make the most money on — options, crypto, margin, shorting — are the riskiest types of investments. Robinhood actively encourages this risk taking in the user interface, through dark patterns and gamifying the experience.

Should this casino-like atmosphere end, and I believe it must eventually, Robinhood’s revenue will go with it.

But Q2 is yet to report, and likely the Q2 Dogecoin income alone will make for a beat:

Data by YCharts

What Is PFOF?

PFOF is payment for order flow. A broker takes your market buy order for 100 shares of Acme, Inc., aggregates it with all the other small Acme buy orders, and sells that to a market maker, who fills the order. The market maker pays your broker for the volume. That’s an oversimplification, but that’s the basic flow — trading volume to the market maker and cash to the broker. It’s how “free” trades are possible, and every retail broker with free trading uses it, to my knowledge.

PFOF was invented by Bernie Madoff. I can tell, you’re already excited about it. Here’s pre-scandal Madoff, the market maker, in a 2000 interview with CNN Financial:

CNNfn.com: Your company is one of the biggest payers of order flow, paying brokerages to ship trades your way. Why?

Madoff: Payment for order flow was only an issue as it related to best execution. Does inducing someone to send an order to you present a problem as far as getting the right price goes? Quite honestly that depends on the firm. You're all fiduciaries. As long as you operate in the proper fiduciary capacity, and you're dealing with a reputable firm, it wasn't a problem...

No one tells a firm how they can advertise. If I want to hire salesmen to generate order flow, no one is going to object. I don't have them. So if I want to use Fidelity's salesmen and pay part of my trading profits in the form of a rebate, why shouldn't I be allowed to do it? It was characterized as this bribe and kickback and something sinister, which was very easy to do. But if your girlfriend goes to buy stockings at a supermarket, the racks that display those stockings are usually paid for by the company that manufactured the stockings. Order flow is an issue that attracted a lot of attention but is grossly overrated.

CNNfn.com: Don't traders get a lot of valuable information by amassing order-flow volume, though, like when limit orders provide a good picture of demand?

Madoff: Whoever holds limit orders has an information advantage. But there are very strict rules that I would assume most firms comply with… But we guarantee any of the 500 brokerage firms that give us their limit orders, that they are going to get as fast an execution as if they put that somewhere else. The person who sees that order gets certain information. It's just part of the marketplace.

[Emphasis added]

Let’s try and sort through some of the irony in those paragraphs. In the telling of the inventor of PFOF and noted securities law violator, this is a system based on trust:

• Trust that the broker is going to get the client the best deal available.
• Trust that the market maker will present the tightest bid-ask spreads available, getting better deals for both buyers and sellers.
• Trust that the market makers will not use the information from order flow for their own trading.

Madoff drops “fiduciary” twice. The Investopedia definition is as good as any:

A fiduciary is a person or organization that acts on behalf of another person or persons, putting their clients' interest ahead of their own, with a duty to preserve good faith and trust.

Good faith and trust. You trust your broker; your broker trusts the market maker. But the incentives to both the broker and market maker go against their fiduciary duties, which is why we have to discuss them in the first place.

• Brokers’ rebates are paid as a percentage of the bid-ask spread. This encourages them to take the highest spread, not the lowest spread.
• Market makers have a full view of supply and demand for individual stocks, and there are many ways for them to profit off that, both legal and illegal. That profit comes from individual investors, who pay a higher price to buy, or lower price to sell.

Let’s start with the market makers. The illegal thing is front-running the trade. As a simple example, this means the market maker sees a buy order for a stock, buys it first, then sells it to the retail investor for a penny more. In 2020, 45% of Robinhood’s order flow went to Citadel Securities, a market maker. Citadel, a separate hedge fund, has about $30-$35 billion under management in its funds.

To be clear, I am making no claims regarding Citadel entities. I have zero information about that. I am merely using them as an example because they are Robinhood’s largest market maker, and please do not infer otherwise.

But legally, market makers can still pad their profits at the expense of investors, just by using the asymmetric information they have. For example, suppose a market maker sees an overnight buildup of retail market buy orders for Acme, Inc. They can go to the overnight ECNs like Island/Instinet and buy a lot of Acme shares. When the market opens, the market maker can put in a higher bid price, gradually raising it as they fill market orders. This is called “walking up the price.” Retail investors pay that extra, especially the ones at the back of the line at the open.

This is just one simple example; there are many more of varying complexity. But the more technical an investment vehicle is, or the thinner the market depth, this asymmetry of information becomes even more important.

So it is up to the brokers, in their fiduciary responsibilities to their customers, to keep the market makers honest. If they always chose the lowest spread and fastest execution without regard for their own profits, these pennies that market makers skim from retail investors are harder to come by.

So far Robinhood has not been that great at holding up their fiduciary duties in this respect.

• A FINRA fine of $1.25 million in December 2019 “in connection with alleged noncompliance with best execution rules during the 2016 to 2017 timeframe.” (Quote from Robinhood prospectus.)
• In December 2020, Robinhood paid a $65 million fine, with the SEC alleging "we did not conduct a regular and rigorous review of our execution quality, resulting in certain customers experiencing lower execution quality, and that we made certain materially misleading statements regarding our sources of revenue, which may have misled investors about the extent of our PFOF practices.” (Quote from Robinhood prospectus.) That last part was Robinhood initially lying about using PFOF.
• Just this past week, the largest FINRA penalty ever, with a $57 million fine and almost $13 million in customer restitution. FINRA: "In determining the appropriate sanctions, FINRA considered the widespread and significant harm suffered by customers, including millions of customers who received false or misleading information from the firm, millions of customers affected by the firm’s systems outages in March 2020, and thousands of customers the firm approved to trade options even when it was not appropriate for the customers to do so.”
• Numerous customer class action suits in progress with regard to Robinhood's fiduciary duties.
• Another $15 million put aside for a money-laundering case.

There are open investigations with the US Attorney’s Office in Northern California, the Department of Justice Antitrust Division, the SEC, FINRA, regulators in New York and Massachusetts, as well as "other state attorneys general offices and a number of state securities regulators.” (Quote from Robinhood prospectus).

This is a wild west company that can only flourish in a wild west atmosphere.

The Wild West

When we break down how Robinhood makes money, we see that two-thirds of it comes from the riskiest investments they offer: options, crypto, margin interest, and short sale interest.

Only 26% of their income comes from plain-vanilla equities trading. In Q1, almost 17% came just from their crypto PFOF. Until it began attracting attention from regulators, Robinhood used dark patterns to encourage options trading, but they have backed off some of their more onerous practices, like coaching investors through the questionnaire so unqualified investors would be eligible for options trading.

There is a good reason they want to push people into trading options instead of common shares. If we divide Robinhood’s segmented revenues by their segmented assets under custody, we can see that options trading is by far their most profitable business.

In 2021 Q1, Robinhood had a little over $2 billion in options under custody, but made $198 million off them. Annualized out, that’s almost 40%.

It is tempting to joke that Robinhood is a Dogecoin brokerage, but it isn’t. Economically, Robinhood is an options brokerage. Robinhood’s main business is convincing people to trade options, and then having options market makers pay to take the other side of those trades.

- Matt Levine, putting it better than I can, July 2, 2020

As you can see, plain-vanilla equities trading is their least profitable PFOF, because it has the most liquid markets, and spreads only get very wide in extraordinary circumstances. Q1 saw some of those extraordinary circumstances with popular Reddit stocks like GameStop (GME) having giant spreads approaching a dollar on the highest volume days. On January 22, almost 200 million shares traded, about 3.5 times the float. Robinhood can only maintain this sort of growth in this sort of environment.

If you are wondering what happened in Q1 2021, that was a huge amount of options and crypto trading driving it, as well as increased interest revenue from margin and short sales. It being the IPO quarter there was also a tripling of the marketing spend.

Marketing went from 10% of revenues in Q4 2020 to 20% in Q1 2021.

Next-Level Risk Factors

I want to focus this article on casino-like environment on which Robinhood’s revenue is dependent. In the long term, this is the most important thing. Any change in that environment, and a calming of the retail landscape will not be good for Robinhood. There are other red flags, like the capital structure, but there is something else that deserves highlighting.

To put it plainly, I’ve never seen a Risk Factors section like this. It is 75 pages long and over 52,000 words. For comparison, I just covered the monday.com listing, a company with many forward risks, and theirs is more than 20,000 words shorter. Chief Legal Officer Daniel Gallagher earned a large part of that $30 million bonus just writing this thing. To his credit, it is thorough.

6,800 of those words are related to legal, regulatory and PFOF risk. Here are some subheadings, so you can get a taste of it:

• Risks Related to our Business Relationships with Market Makers
• Risks Related to Regulation of PFOF
• Risks Related to Negative Publicity Associated with PFOF or our Market Makers
• Proposed legislation that would impose taxes on certain financial transactions could have a material adverse effect on our business, financial condition and results of operations.
• We have been subject to regulatory investigations, actions and settlements and we expect to continue to be subject to such proceedings in the future.
• Recent statements by lawmakers, regulators and other public officials have signaled an increased focus on new or additional regulations that could impact our business and require us to make significant changes to our business model and practices.
• As a result of our recent settlement with the SEC, we are currently considered an “ineligible issuer,” which limits our ability to use certain free writing prospectuses in securities offerings and will delay our ability to qualify as a “well-known seasoned issuer” in the future.
• We are involved in numerous litigation matters that are expensive and time consuming, and, if resolved adversely, could harm our reputation, business, financial condition or results of operations.

It’s not every day you read that the CEO and founder had his phone seized by the US Attorney’s office. Daniel Gallagher and his team will remain busy.

But, Q2

It doesn’t take much imagination to believe Robinhood with report a blowout Q2 shortly after listing. The casino atmosphere extended into Q2, April and May especially. Dogecoin closed Q1 at $0.05, but by early May it reached $0.74. Robinhood booked $30 million from Doge in Q1, so it stands to reason that the Doge frenzy of April and May netted Robinhood several multiples of that. Likely a reduced options take will offset that a little.

In any event, depending on the exact timing of the Q2 report relative to the listing, I think it’s reasonable to think the stock will go up after IPO, before reality sets in.

All Parties End

Let’s go back to that May 2000 interview with Bernie Madoff. Keep in mind the context. May 2000 was just as the dot com bubble was about to be popped.

The crash began in August and September, and continued for two years through September 2002, aided by the 9/11 attacks. The market did not start recovering until early 2003. This interview was during the calm before the storm.

CNNfn.com: As a lifelong trader, do you think that many investors fancy themselves, or fancied themselves, as traders?

Madoff: Yeah. It's a bull-market phenomenon. The market has been very hospitable to day traders. The last couple of months changed a lot of that. It's a sunny day, temperatures are balmy, everybody goes to the beach. It's cloudy, it rains, people go to the movies. The environment will change.

CNNfn.com: Will volume come back?

Madoff: The day-trading volume will decrease in a bear market -- if and when we get one. Clearly the great preponderance of day traders are a bull-market scenario. I think volume will come back depending on the market. Tell me what the market is going to do, I'll tell you what volume is going to do.

Madoff may have thought that providing financial services is akin to selling hosiery, but he was not stupid. He understood that at some point the casino-like atmosphere of 1999-2000 had to end, and when that end came, it would not be good for market makers. I lived through that period, and I never thought I would see a wilder one, but here we are.

Robinhood is the poster child for our current moment. They are a beneficiary of this Monte Carlo atmosphere, but in some ways they are also the cause of it. They began free trading for retail customers, forcing all the brokers to follow, and be even more dependent on PFOF than they were before. They have gamified the investing experience, and subtly pushed inexperienced investors into the riskiest sorts of securities.

“It’s cloudy, it rains, people go to the movies. The environment will change.” When it does, it will not be good for Robinhood.

Corrections: After publication, Citadel complained that my wording inferred illegal actions on their part. I intended no such thing, but I could see their point, and I have added a clarification, so there will be no such inference.

Disclosure: I/we have a beneficial long position in the shares of VIRT either through stock ownership, options, or other derivatives. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.