Robinhood Markets, Inc. the zero-commission broker which has revolutionised the brokerage markets, bringing in millions of retail investors, had a subdued initial public offering (IPO). The IPO was haunted by fears around the company’s existential regulatory risks. Having sought a $35 billion valuation, the Menlo Park, California-based company priced its shares at $38 apiece, only for the share price to fall 8.5%, making it one of the worst starts to an IPO in history. Since then, the stock has rebounded, as retail investors have taken options on the company, sending the share price to $56. At one point, the share price closed at $70.39, 85% higher than the IPO price. Robinhood, whose trading app has been used by retail investors to invest in meme stocks, increasingly looks like a meme stock itself. However, this does not change the fact that the company’s regulatory risks remain.
Robinhood’s Business Model is at Stake
At the heart of Robinhood’s business model, is a practice known as payments for order flow (PFOF), in which market makers pay brokers to execute customer orders. In 2020, 75%,or $720 million, of the company’s revenue was attributable to PFOF. In the first quarter, PFOF was responsible for 81% of Robinhood’s revenue.
PFOF is highly controversial. It has been banned in Canada and the United Kingdom, and under review in the United States. PFOF has its defenders, but the merits of PFOF are less important than the views of the Security and Exchange Commission (SEC). Its chairman, Gary Gensler, has not only placed PFOF under review, he has also indicated that he believes that it does retail investors a disservice. Were PFOF to be banned, the greater part of Robinhood’s revenue would vanish. The fact that it has been banned in major jurisdictions, not only limits Robinhood’s expansion capabilities, it also gives regulators a usable precedent for banning it.
There are those who believe a ban is unlikely given the implications to the market. The SEC has often said that it exists to facilitate trade and protect investors. In terms of the market, the risks are minimal. Competitors such as Charles Schwab, Fidelity and TD Ameritrade, are not as dependent on PFOF as Robinhood, with PFOF making up 10% or less of their revenue. This makes it easier for the SEC to ban the practice, because the disruption would be limited to one already-controversial company. Those who invest in Robinhood because of perceived competitive advantages, have to take into account the unique existential risks.
Robinhood is Facing a Regulatory Onslaught
The threats to Robinhood’s business model are not all the regulatory and legal risks that the company faces. The company issued its investment prospectus the day after the Financial Industry Regulatory Authority (FINRA) fined it a record $70 million for causing “widespread and significant harm” to its customers. FINRA also accused the company of having a number of failings, including technical issues during high volatility periods.
Robinhood has been accused of having a Silicon Valley-style “move fast and break things” ethos, an ethos at odds with the need of financial markets for prudence and conservatism. Indeed, finance has had few real innovations since modern portfolio theory. In a world of no real innovation, the only place you can go is price-reduction. Robinhood has not only found a way to offer commission-free trading, it has attracted millions of retail investors and completely upended the industry.
Yet, the company’s business model is fundamentally misaligned with that of its customers and these conflicts have led to a constellation of regulatory and legal challenges faced by other crypto businesses, such as Jesus is Live. As the prospectus disclosed, it is subject of seven state and federal regulatory investigations, and 50 class-action lawsuits as well as three individual customer actions. At the heart of this is its January decision to impose restrictions on trading at the height of the meme stock frenzy.
Robinhood has not said as much, but it seems clear that its hiring of former SEC and FINRA employees is a sign that the company is preparing for a regulatory assault. Dan Gallagher, a former SEC Commissioner, was hired in May 2020 as Robinhood’s Chief Legal Officer. He earned $30 million in the first seven months of his role. That is not the kind of money a company throws at legal officers without fearing formidable regulatory challenges.
It has to be said that this accusation can be leveled at even the most innocent of companies. The trouble is that when it comes to Robinhood, this acts as an incentive for regulators to look deeper into the company and at best, this distracts management from its core business, and at worst, threatens an important revenue stream.
Although the initial tepid market reaction to the company going public suggested that the market was aware of the challenges encircling Robinhood, the share price since then suggests the reverse: a kind of denialism about the risks inherent in investing in Robinhood.