Signals: How Robinhood is preparing for life after PFOF

Last July, the European Union imposed a general ban on payment for order flow in a move which has reignited long-lived discussions around the practice. And while Robinhood insists that the practice is here to stay, it hasn’t been without opposition: In 2022, the SEC proposed a series of rules which Robinhood said would “crimp payment for order flow” and continue to rouse regulators in Washington.

These new rules would be very bad for brokers. Robinhood, in particular, made $785 million in transaction revenue last year. If the SEC’s proposed rules were implemented, they would threaten what has historically been Robinhood’s largest source of operating revenue. As a result, it’s starting to plan for a world without PFOF.

In the early days of stay-at-home orders, Robinhood became a centerpiece of pandemic pop culture, capitalizing on a new wave of retail investors who wanted to turn their stimulus checks into shares of high-flying growth stocks. For a period of time that was enormously lucrative: in the five quarters from Q2 2020 to Q2 2021, Robinhood made nearly $1.5 billion from transaction revenues (namely, payment for order flow).

Robinhood’s boom times went bust when it became a convenient pariah in the eyes of users and the media for the GameStock stock fiasco. In Q1 2021, the company froze trading on a number of popular stocks, like GameStop and AMC Entertainment, citing volatility that arose from a retail short squeeze. Soon, users charged that Robinhood was colluding with “the suits” to sell out its users — and while that alone didn’t cause the debacle, it had actually somewhat been the case for a while.

The GameStop episode sparked a larger exploration of payment for order flow. Robinhood and other brokerage apps reason that the practice of selling users’ orders to third-party trade houses is what makes commission-free trades viable. However, there is a downside: Selling these trades means customers don’t necessarily get the best deal — and in some cases, the order flow data is used by trade houses to bet against customers, as happened during the GameStock short squeeze. In mid-2020, Robinhood was discovered to be earning 4 to 15 times more PFOF on trades than institutional competitors like Schwab, as trading houses place a premium on order flow from “dumb money”.

PFOF became the target of discussion in popular investing culture, the halls of Congress, and among regulators, who suggested that its inherent conflict of interest was reason enough to ban it. However, Robinhood would soon have bigger problems to deal with than reputational risk as flighty investors learned that everybody is a genius in a bull market. In 2022 high-flying growth stocks started to suffer, Robinhood investors lost money, and Robinhood’s trading volumes began to fall soon thereafter.

Robinhood’s monthly active users have fallen over 50% from their peak, and transaction revenue has dropped accordingly since then. Rather than continue to rely on PFOF revenue, Robinhood is betting its future on something bigger and better…

In late 2022, Robinhood began rolling out its Retirement product, allowing users to open a Traditional or Roth IRA on the platform for the first time. Robinhood Retirement came with one kicker for savers: IRA Match, which promised to match up to 1% of contributions– and later rollovers– to a retirement account at Robinhood.

This feature got a big update last summer: Robinhood announced it would match up to 3% of contributions for its more than 1 million Robinhood Gold subscribers, who pay $5/mo for access to higher cash sweep (5.25% as of 3/7/24), lower margin rates (8% instead of 12% for standard users), and other research features. 

Of course, there’s a catch to that money: Customers have to keep paying for Robinhood’s subscription for at least five years to keep their IRA Match. But that hasn’t been a deterrent for users so far, as Gold subscribers have grown 25% since the company launched its Retirement product in Q4 2022.

Many of Robinhood Gold’s new subscribers are, unsurprisingly, paying to take advantage of the 3% IRA Match. The hard part for Robinhood will be finding a way to make its money back.

Robinhood now counts 13% of its monthly active users as Gold subscribers. At the end of Q4 2023, there were 1.42 million Gold subscribers — which would generate $85.2 million worth of recurring revenue in the next twelve months at the current $5/mo cost. 

That revenue isn’t going anywhere… and nor are the affluent investors that are moving their money to the brokerage. CEO Vlad Tenev says that the company has seen more growth in the first half of the first quarter than it has in each of the last eight quarters. Furthermore, the average inbound transfer is averaging about $100,000 — which Robinhood is paying $3,000 to retain for 5 years.

Why is Robinhood spending $3,000 in CAC per Gold user?

Historically, Robinhood has made the bulk of its revenues from routing high-volume order flow to market makers like Citadel. With Gold, Robinhood is refocusing towards a new revenue source: Interest on investors’ assets.

The brokerage’s assets under custody (AUC) rose above $100 billion in Q4 2023 for the first time since Q2 2021. Robinhood capitalized on these assets, driving net interest revenues up 41% to $236 million — surpassing PFOF to now account for the majority of Robinhood’s revenues. Net interest may become an existentially important revenue source for Robinhood if the SEC clamps down on PFOF this year, so Robinhood is using Gold to strategically build up several forms of interest-generating AUC:

Robinhood’s margin interest revenues represented $66 million in Q4 2023 and $243 million for all of FY 2023, making it second to only the revenue that Robinhood generated on its own corporate treasury. Higher rates have helped push up margin rates, but more users could also translate to greater borrowing — especially during periods of market excitement (like now). Robinhood’s aforementioned discounts on margin loans to Gold users show its commitment to doubling down here.

Robinhood made $54 million in interest on segregated cash and cash equivalents and deposits, which includes the company’s cash debit card. Robinhood has generated a high degree of margin from the interest-free deposits it generates from offering two-day early direct deposit, a mainstay among many neobanks and financial institutions.

In total, customers held over $17 billion worth of cash in the broker-dealer at the end of Q4 2023 — with Gold subscribers earning 5.25% and non-paying users earning 1.5%. Robinhood generated $37 million in spread on the money that its users held in Q4 2023 — and made more than $123 million in FY 2023 for being home to their cash.

Securities lending is another exciting opportunity for Robinhood, with margins highest on accounts with long-term, substantial holdings (like retirement accounts). As Robinhood builds an even larger portfolio of blue-chip stocks, highly-liquid exchange-traded funds, and bonds, the opportunity for securities lending in its revenue could expand.

However, in Q4 2023, nobody wanted to bet against markets — which reduced the demand for securities lending significantly. In the quarter, Robinhood generated just $9 million in net lending revenues from securities (for contrast, the average securities lending revenues in the last eight quarters for Robinhood was $21 million.) 

Many of Robinhood’s subscribers will come for the Retirement bonus and stick around because it’s the only way to keep it. However, Robinhood is spending a lot of time making other aspects of the Gold subscription even more appealing to customers. 

In 2023, Robinhood rolled out a 24-hour market and made significant hires to re-(re-)launch a UK business, plus a media business which could add rich features to the Gold suite. The company has also teased advisory products on earnings calls, which could eventually speak to the more affluent audience that Robinhood is now engaging.

Before the quarter ends, Robinhood is also expected to roll out a credit card exclusive to its Gold subscribers which could confer additional features or industry-beating cash back. The Robinhood Gold Credit Card would be the first significant product launch since the company bought X1 for $95 million last year.

That would also give the company more pricing power with Gold, which it might start charging more for in the coming weeks. The company recently updated its fee schedule, reflecting its plans to increase the price of Gold to $7/mo — which would produce at least $34 million in next 12 months revenue based on the company’s quarter-end subscriber count.

However, for now, Robinhood is building Gold into a feature rich financial subscription which could pick up the slack in the absence of payment for order flow… if it ever goes away, that is.