Before we jump into how Robinhood makes money, we’ll give you a brief overview of who they are and the logistics of commission-free trading.
Who is Robinhood?
Robinhood Markets Inc. was founded by Vladimir Tenev and Baiju Bhatt in the early months of 2013 as a commission-free brokerage app. The app is available both on iOS & Android.
This Menlo Park, California-based company provides brokerage services to more than six million users and boasts a valuation of more than $7.5 billion. A large number of its users are from a younger millennial generation.
But the question of how Robinhood makes money has been lingering in the minds of many people. Especially since they don’t charge a commission for trades.
In order to answer this question well, let us first walk you through the ins and outs of commission free trading.
The logistics of commission-free trading
Traditionally, the primary purpose of brokerage firm is to handle transactions, buying and selling financial securities. The firms generate revenue through the services they provide to clients who buy or sell stocks, options, bonds, mutual funds, ETFs, etc.
These include commissions, trading fees, monthly maintenance fees, inactivity fees, account rebalancing charges, and more. The fees are debited directly from a clients’ account by the brokerage.
So, if a brokerage firm is not charging to execute trades, how is it able to make money? How does commission free trading really work?
Well, new entrants like Robinhood market themselves with low-cost investing and have found several ways to generate revenue from trades:
- They sell order-flow data
- Loan clients cash to buy stocks on margin
- Sweep interest off of available funds in a client’s account
- Lend out securities to short sellers to make money on drop in prices
- Some also profit by catering to investment advisers
Looking at this from an economic and business perspective, the client is the “product,” in this case since he/she is not incurring any costs when using the “services” offered by the broker. That said, let’s dig in deep to see how Robinhood makes money off of you.
How Robinhood makes money
As has been stated, Robinhood doesn’t actually charge any commissions for trading stocks, options, exchange traded funds (ETFs), and cryptocurrencies despite having millions of users on its platform. Instead, this market disruptor makes money through the following ways:
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Selling your orders to market makers
According to a report on Bloomberg, Robinhood generated more than 40% of its revenue in 2018 from selling its clients’ orders to market makers, or high-frequency trading firms such as Two Sigma Securities and Citadel Securities.
When an investor places an order to buy a stock, Robinhood often sends the orders to a market maker who then pays the brokerage a small fee to process them through their platforms. Although this is a controversial practice, still many brokerages use it.
Robinhood gains approximately $0.00026 in rebates per dollar traded, according to a statement released by Tenev in 2018. This means that the brokerage earns about $1.3 from for every $500 of stock bought by a client. The money that Robinhood makes from rebates allows the brokerage to cover its operating costs.
However, order flow revenues typically vary depending on the number of options contracts or stocks traded. For an illiquid security, the spread between bid and prices is usually wide.
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Interest from available cash deposits
Another way Robinhood makes money without charging commission is through interest earned from idle cash in a client’s account. This is much like how banks collect interest on cash deposits.
For instance, if a client has $500 in his trading account and Robinhood’s interest rates are 2%, the brokerage would make $5 off his money a year. Although this isn’t that much, it would amount to millions when multiplied by the more than 6 million accounts that Robinhood currently has.
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Premium subscriptions
Did you know that Robinhood offers a premium subscription known as a Robinhood Gold? This service allows clients to make large instant deposits, instead of having to wait for the standard 2-3-day verification period.
According to the brokerage, premium clients also have access to “Morningstar research reports, NASDAQ Level II Market Data, and margin investing.”
Clients can try Robinhood Gold for free for the first 30 days. Once the free trial ends, the firm charges $5 every 30 days. Robinhood Gold users are also allowed to trade during pre-market and after-market sessions.
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Margin lending
If you are a Robinhood Gold subscriber and have a $2,000 minimum balance in your account, the firm allows you trade on margin. What this means is that customers can borrow money from the brokerage itself to trade securities or meet short-term financial needs.
As with any loan, you of course have to pay back the funds you borrowed plus interest. The $5 per month fee that clients pay to access Robinhood Gold gives them up to $1,000 in margin. Clients who borrow more than $1,000 of margin pay 5% yearly interest.
However, margin trading is not recommended for beginner traders.
Final thoughts
Robinhood has done an amazing job of fulfilling its pledge of making it easier and cheaper to buy financial securities.
This free-trading app has shaken up the industry and even forced older, more established rivals to eliminate commissions. It remains to be seen how some brokerages that were so reliant on commissions will get by without them.
For most brokerage firms including Robinhood, the game is now about gathering more assets and hoping that those assets will be generate more revenues over time.
Robinhood is doing exactly that by regularly adding new features, including a service called Robinhood Crypto to attract cryptocurrency traders. The firm has also expanded its web version and rolled out an options trading service to keep up with competitors.