In college, I distinctly remembered paying $7 per trade in my Scottrade account and thinking I made a great decision opening my first trading account with a discount broker. Despite making some poor trades when I first learned how to start investing money, I at least reasoned I didn’t overpay on my trading commissions.
Fast forward a few years and trading commissions dropped to the once unthinkable cost of nothing. How, you may ask? I, too, shared your skepticism, knowing brokerages made most of their money from these commissions collected from retail investors.
When a fintech startup named Robinhood came on the scene with $0 commissions, it made me wonder, “how does Robinhood make money?” and “why is Robinhood free?” The latter made sense: attract customers to the platform, though I did wonder for how long the company could maintain this strategy and still remain financially solvent. The former question made me curious to learn whether Robinhood is profitable enough to offer commission-free trades forever.
After investigating their various means for generating revenue (discussed in detail below), I’ve gained comfort knowing more about Robinhood’s business model and also answered my question about how Robinhood can afford to offer commission-free trades.
Many established companies in the industry likely shrugged them off until millions began joining the platform in mass with the appeal of free trades and fractional share purchasing. Now, many investing apps like Webull and Acorns must offer these free trades to customers or face the potential for losing customers to a company willing to forego this revenue stream. Instead, these services must find other avenues for monetizing their platforms.
This article examines how Robinhood makes money—a free stock trading app which has gained significant favor with Millennials and Gen-Z.
FinTech’s Impact on the Investment Industry
With the introduction of fintech, or the use of technology to enhance and automate certain financial transactions and processes, many previously costly transactions now come to consumers for dramatically reduced costs or even for free. This has led to many companies forming in the past decade which have provided low-cost access to once inaccessible alternative investment options, while others have sought to drive down the cost of doing business tremendously.
In the case of the best financial apps, they offer ways to do both and often for less initial and on-going funding commitments. Millennials have especially taken to these apps and services because they often do not find themselves flush with large amounts of cash to invest at once, and instead prefer to invest with small amounts of money spread out over longer periods of time.
Previously, trading commissions charged on each trade prevented many from investing in such small amounts. After over 200 years, investors needed to pay brokers for the ability to trade stocks and other securities between themselves. These fixed-rate commissions amounted to a significant cost for many, making retail brokerage access difficult to afford, costing hundreds of dollars per trade prior to the 1970s.
In a step in the right direction for the retail investor, the SEC ended that huge expense in 1975, resulting in brokerages offering trades closer to $70, a significant decline from the past. This reduction continued into the 1990s with sub-$20 trades becoming the norm and finally narrowing to $5 to $8 per trade with brokerages like Scottrade, TDAmeritrade, ETrade and more.
How Does Robinhood Work?
In 2014, two entrepreneurs saw trading commissions as too costly. They saw first hand how big Wall Street firms effectively paid nothing to trade stocks while retail investors paid for every buy and sell. Robinhood became the first company to push the commission trend to its theoretical limit: zero. This decision forced the hands of industry leaders and became standard fare for any new market entrant like Webull, Acorns, Firstrade or others.
After cutting off this valuable revenue stream brokerages enjoyed for hundreds of years, how did Robinhood’s decision affect brokers’ profitability? They had diversified businesses and earned money elsewhere, of course. And it seemed to work, albeit the decline in margin hit the publicly-traded brokerages’ stock prices.
In the fall of 2019, E-Trade, TD Ameritrade and Charles Schwab finally caved and began offering free stock trading to remain relevant to Millennials and other retail investors. While likely a major loss of high margin revenue, they had other ways to make money from their customers. Robinhood found a way to manage and seemingly turned the online discount brokerage industry on its head.
While Robinhood might have introduced the world to free trading, it now must contend with worthy rivals who have taken its commission-free trading model and begun monetizing several services, often offering more than Robinhood (e.g., investors cannot short stocks on Robinhood but can on Webull).
Let’s review how Robinhood makes money—and it isn’t from hidden fees paid by customers.
How Does Robinhood Make Money?
Given the proliferation of these no commission investing apps, you might wonder just how these companies make money without earning a fee each time you trade. Each offers slightly different services, so their revenue streams will vary slightly, but in effect, these companies all earn money through other avenues and services. And still manage to give away free stocks for creating an account (and depositing a qualifying amount of money in the case of Webull).
Robinhood has found a way to remove trading commissions for their users and can afford to do so in part by keeping their operational costs down by having no physical offices. Further, Robinhood makes money by:
→ 1. Offering Robinhood Gold subscriptions to members ($5/mo).
Robinhood Gold offers investors a number of additional functionality above the basic Robinhood investing app (Robinhood Instant).
First, it offers larger instant deposits. With Robinhood Gold, you can have higher daily instant deposit limits based on your account balance in the following amounts:
- $50,000 instant deposit when your portfolio has value above $50,000
- $25,000 when your portfolio has between $25,000 – $49,999
- $10,000 when your portfolio has between $10,000 – $24,999
- $5,000 when your portfolio has less than $10,000
Under the standard Robinhood Instant, you receive $1,000 in instant deposits, regardless of the value of your account. This provides for instant access to $1,000 per day, though the funds may take longer to settle in your account than one day.
To track your daily instant deposit limit, review the Instant Deposit Health section of the Account Overview.
Second, Robinhood Gold provides access to more powerful investing tools and research. A Gold subscription gives you Morningstar Research reports to improve your investing research as well as NASDAQ Level II Market Data for a better view into available bids and asks on the exchange.
Third, Robinhood Gold offers margin investing, something unavailable to a basic Robinhood Instant account. When you choose to buy on margin, you borrow funds from Robinhood Securities and pay an annualized percentage rate (APR) on funds after borrowing your first $1,000.
Be aware, shorting stocks on Robinhood requires using inverse ETFs or options because you cannot directly short stocks, even with a margin account.
→ 2. Monetizing their order flow (rebates from market makers and trading venues).
In the ordinary business of buying and selling stocks, options and index funds on Robinhood, Robinhood sends orders to market makers for execution.
Market makers act as individual market participants or member firms of an exchange to buy and sell securities for its own account.
They do so at the prices displayed on the exchanges’ trading systems with the goal of profiting from the difference between bids and asks (bid-ask spread).
Effectively, the quoted price differs from the ultimate settle price, with the difference going to the market maker for providing market liquidity.
This bid-ask spread capture allows market makers to receive compensation for holding assets in the event they deviate significantly in value over time.
In other words, if they must hold a substantial position in the security to create liquidity for the market, they must have some form of compensation to offset the risk of a significant decline in the security’s value, thereby causing a substantial loss on their books.
When you trade securities in your brokerage account, these orders route through a market maker for execution.
In order for market makers to compete with exchanges, they must offer rebates or discounts to brokers to use their service and not the exchange. This discount goes to Robinhood while you pay the quoted amount.
In order to maintain this profit opportunity, Robinhood Securities maintains relationships with numerous market makers and sends your order to the one they believe will have the best likelihood to execute your trade at optimum price.
Robinhood states it does not consider rebates when routing your brokerage orders and merely profits from the difference after the fact.
Likewise with Robinhood Crypto, the cryptocurrency platform maintained by Robinhood for trading cryptocurrencies. The broker routes your orders through various trading venues to receive competitive prices and does not consider volume rebates when routing orders.
→ 3. Lending out securities and cash held by their investors.
Much how you would place any uninvested cash in a high-yield savings account with someone like CIT Bank, Robinhood also takes any idle cash sitting in your brokerage account and deposits this into an interest-bearing account.
This generates interest income for Robinhood, who benefits from your cash sitting unused in your Robinhood account.
→ 4. Interchange fees from purchases made with their Cash Management debit card and fees from member banks.
When you deposit money in Robinhood’s Cash Management account, their equivalent to a high-yield savings account, though covered through SIPC Fund coverage and not the customary $250,000 of FDIC coverage you would receive for a depository account, you will have a debit card issued against your account.
Sutton Bank, which issues the Robinhood debit card pursuant to license by Mastercard® International Incorporated, receives an interchange fee which then gets passed to Robinhood as a fee.
Depending on the type of network and transaction, Robinhood could have earned between $0.22 and $0.54 per debit card transaction in 2018 based on the average interchange fees seen in the industry.
These interchange fees come as revenue to cover the costs incurred from transaction processing and fraud loss. However, any unused funds count toward Robinhood’s bottom line.
Finally, Robinhood also receives fees from Cash Management program banks for sweeping funds to them.
→ 5. Earning interest income earned from investors who use margin loans to leverage their investment returns.
For now, the final revenue stream available to Robinhood comes from offering investors margin loans in the Robinhood Gold accounts. As stated above, for amounts about $1,000, Robinhood charges interest on borrowed funds.
Further, Robinhood can also earn income from lending stocks held in investors’ accounts when purchased on margin to counterparties.
In other words, if an investor from another brokerage wishes to short a stock and needs shares of the underlying security, Robinhood can lend shares from its investor(s) to fill this order. The interest paid on these loaned shares can result in profit to Robinhood.
When the initiating investor closes the short position, the shares return to the Robinhood investor(s)’ accounts while Robinhood nets the interest income. Webull offers a similar service but it offers to share some of the income earned with the account holder.
Is Robinhood Profitable?
While Robinhood introduced commission-free trading and now rely on other revenue streams, it doesn’t look like they have finished disrupting the industry. This means they have some idea that profit awaits from their first-mover advantage and will lead them in the right direction.
But they might need to get moving sooner than later after raising $200m in capital during this health pandemic. Especially after Robinhood outages came at some very untimely days during heavy market volatility.
Of further concern, however, is that Robinhood might actually fall into a less-vaunted tech category: masquerading as a high-margin tech company while in fact grinding out razor thin margins.
According to data shown on Fortune about one of Robinhood’s best alternatives, the company has earned between $600-$650 million over its existence.
Further, the company earns 20-25% of its income from interest on customer accounts and the majority from from order flow—rebates given to brokerages from market makers and other major trading entities.
In order for Robinhood to compete, it will need to turn a profit and stand on its own. For now, it appears able to rely on its first-mover advantage and name recognition to gain new customers, but it will need to continue innovating to stay ahead.