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Online Brokerage and the Rise of Robinhood

Tyler Ventura, CFA

In the fall of 2019, the online brokerage industry eliminated retail trading commissions, marking a final salvo in the decades-long online brokerage war.

By the summer of 2020, the center of attention in the industry was on Robinhood, the red-hot trading app shaking up the industry. Robinhood has become a poster child for retail trading re-engagement, and a lightning rod for controversy. Since it launched in 2013, Robinhood has grown rapidly to become one of the most important fintech apps in the U.S., now boasting more than 13 million users. Raising over $600 million in its Series G funding round in September 2020, Robinhood sports a private market valuation upwards of $11 billion and currently has plans to go public in 2021.

Robinhood is a disruptive force in brokerage and wealth management. Here, we’ll explore how Robinhood rapidly entered the financial lives of millions and discuss recent competitive dynamics and ongoing trends in the industry.

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The views expressed are those of Diamond Hill as of January 2021 and are subject to change. These opinions are not intended to be a forecast of future events, a guarantee of results, or investment advice.

As of December 31, 2020, Diamond Hill owned shares of Charles Schwab Corp. and Morgan Stanley.

Online Brokerage Wars: A Race To Zero, Decades in the Making

The emergence of the modern self-directed investor and the genesis of online stock trading occurred in the mid-to-late 1990s as personal computers and laptops started to proliferate. It is probably hard for young investors today to comprehend the explicit cost to buy and sell stocks in recent history. In 1998, responding to competition from fellow low-cost brokers like E*Trade and Ameritrade, Schwab made a splash as it introduced a $29.95 flat-rate online trading commission. The move was intended to incentivize individuals to trade online versus over the phone or in person at a time when the average trading commission at Schwab was over $60 a trade. It was the latest in a series of pioneering moves for Schwab, founded in 1974, as it sought to disrupt full-service firms such as PaineWebber, Smith Barney and Merrill Lynch. As online retail investor engagement and trading volumes grew, competition intensified with each round of subsequent commission cuts. By the end of 2019, retail trading commissions were largely eliminated.

Robinhood’s growth from around 1 million account holders in 2016 to over 13 million in 2020 is remarkable considering the billions of dollars spent on advertising over the prior 25 years by the established discount brokers. While the 5.2 million self-directed accounts at E*Trade and 12 million brokerage accounts at Ameritrade are much larger and more profitable than Robinhood’s accounts, there is no doubt Robinhood is making its mark on a new generation of investors.

Robinhood: An Addicting Platform, Growing Pains and Controversy

Lower barriers to entry and ease of use are at the core of Robinhood’s app-based offering. Zero-dollar commissions, no account minimums and no order size minimums (the trading of fractional shares allows for small dollar investment amounts) make it easy for users to get started, and the app interface modernized the trading experience for newcomers. Robinhood did a good job creating a sense of community through education and information sharing, which also aided its viral growth, keeping its customer acquisition costs relatively low. Robinhood’s average user is younger than the traditional discount brokerage customer, they trade frequently and many are first-time traders who are attracted to the excitement and unique features of the app. A recent article in the Wall Street Journal titled, “I Started Trading Hot Stocks on Robinhood. Then I Couldn’t Stop,” starts off with the question, “Is the stock market a form of entertainment?”, touching on the aspects of gamification that makes Robinhood so popular, addicting and potentially dangerous.

Continuous investment in a robust technology backbone is imperative for any financial services company, and it is equally imperative to heed the industry’s regulatory overlay. Robinhood has dealt with trading outages and service glitches during high-volume periods. It also recently ran into regulatory scrutiny regarding investor protections, and the notion of gamification was called out in a complaint against the firm by the Massachusetts Securities Division. Consequently, Robinhood is working to improve safeguards, further educate its customers and increase system reliability. The company also agreed to pay a $65 million civil penalty in an SEC matter related to deceiving customers about its trade execution and order flow payment practices, its primary revenue source. Robinhood did not admit or deny the SEC’s findings, and Robinhood’s Chief Legal Officer noted, “The settlement relates to historical practices that do not reflect Robinhood today.”

Despite its recent success, Robinhood is not resting on its laurels. We believe the firm will continue to diversify its revenue sources and attempt to deepen its relationships with customers, but it’s anyone’s guess as to whether Robinhood ultimately succeeds in monetizing the lifetime value of its customer base beyond small dollar value trading accounts. Regardless of future outcomes, its impact on the competitive landscape in wealth management is certainly being felt today.

Wealth Management Trends

Competition in the wealth management industry is intense, as evidenced by the recent completion of two sizable transactions: the $26 billion purchase of TD Ameritrade by Schwab and the $13 billion purchase of E*Trade by Morgan Stanley. Increasing digitization is at the heart of both deals as industry leaders add meaningful scale, expand capabilities, enhance technology offerings and onboard new customers. Over the long term, we expect both firms to continue to grow, drive costs lower and achieve higher profitability.

The wealth management industry has largely embraced the importance of digitization, and we will likely see further consolidation as companies seek new growth avenues and look to gain market share. Delivering innovative, value-added solutions across the entire net-worth spectrum will also continue. One example is the proliferation of low cost, automated investing solutions from firms like Betterment and Wealthfront. Direct indexing technology is also a hot topic, as it offers advisors the ability to construct tailored portfolios in separately managed accounts based on custom indexes or factors, allowing for increased customization at a lower cost than ETFs. Relationship-driven business models will continue to evolve, but the immutable fact remains that people’s financial lives become more complicated with age and/or increased wealth. Individuals will increasingly begin their financial lives in a digital manner and will continue demanding great digital experiences. It is incumbent on the industry to continue to find ways to reach consumers and engage them in investing and financial planning, while serving their needs over time.

As of December 31, 2020, Diamond Hill owned shares of Charles Schwab Corp. and Morgan Stanley.

The views expressed are those of the research analyst as of January 2021, are subject to change, and may differ from the views of other research analysts, portfolio managers or the firm as a whole. These opinions are not intended to be a forecast of future events, a guarantee of future results, or investment advice.


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