Is US trading app Robinhood too much of a gamble for investors?

Robinhood Markets, the US trading app that has ridden a craze for “meme” stocks and cryptocurrencies in recent times, is now looking for stock-market investors to take a punt on it, with valuations touted for its upcoming Nasdaq flotation running at up $40 billion.

The app, launched in 2013 by former Stanford University roommates Vlad Tenev and Baiju Bhatt and which brought in the likes of rapper Snoop Dog and actor Jared Leto as early investors, had a simple goal from the outset: to democratise finance.

Inspired by the 2011 Occupy Wall Street movement and French economist Thomas Piketty’s work on wealth inequality, Tenev and Bhatt brought commission-free trading to the masses.

But with customer lawsuits on the rise, some of the most-traded stocks and cryptocurrencies on the app under pressure, and regulators scrutinising its very customer model, is Robinhood too much of a gamble for investors?

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Amateur investors

Robinhood had become enough of a threat to more established, low-cost US online brokers – including Charles Schwab, E-Trade and TD Ameritrade – by late 2019 that they moved en masse to cut their own commissions to zero. But it wasn't until stock markets started to rebound last April after the Covid-19 shock that the app came into its owns, as droves of amateur millennial-types took to investing during lockdown.

In January of this year, the Robinhood mob, spurred by investment tips in chatrooms on the discussion website Reddit, went into overdrive, pushing out-of-sort stocks such as video games retailer GameStop, Bed Bath & Beyond, and cinema chain AMC Entertainment to crazy levels as they took on hedge funds that had been short-selling these so-called meme shares.

In the 12 months to the end of March, Robinhood’s active users more than doubled to 18 million. Some 5.5 million of these signed on in the first three months of 2021 alone.

Some 81 per cent of revenues in the first three months of the year came from routing customers’ trades to stock market intermediaries – known as market makers – that make their own money in the spread between prices at which they are willing to buy and sell securities.

Robinhood essentially gets legal kickbacks from these firms, called payments for order flow. This way of making money creates a natural conflict between a broker’s duty to get the “best execution” for clients and an obligation to maximise profits for shareholders.

Last month, the US Securities and Exchange Commission (SEC) said it was reviewing the practice of payments for order flow (PFOF), fuelling talk that it may be outright banned. Robinhood's IPO prospectus warns: "The practice of PFOF may be limited substantially by new or revised laws or regulations, which would materially decrease our transaction-based revenue, or banned entirely, which could require us to make significant changes to our revenue model, and such changes may not be successful."

Robinhood has already been in hot water. Last December, the SEC fined the company $65 million for misleading clients about how it makes money from their trades and for failing to satisfy its duty to seek the best reasonably available terms to execute customer orders. Six putative class actions have since been filed by clients.

December also saw Massachusetts market regulators file a complaint against Robinhood, alleging it uses "aggressive tactics to attract inexperienced investors" as well as "gamification strategies to manipulate customers".

On June 30th, a day before Robinhood confirmed plans to go public, it was charged almost $70 million by the US Financial Industry Regulatory Authority for giving customers false information about their investments, having systems outages in March 2020 and for approving thousands of customers to trade investment derivatives, called options, that were not appropriate for them.

Class actions

All told, the prospectus has an eye-popping six pages of pending lawsuit disclosures, including 50 class actions filed after Robinhood was forced to slap trading limits on GameStop and a number of other meme stocks amid January’s trading frenzy.

What’s to come of the various lines of litigation – or the outcome of the SEC review – is anyone’s guess.

But a big question mark must also hang over how investment banks underwriting the IPO – and investors – can value Robinhood’s customers. Most are novices and it’s anyone’s guess how sticky they’ll be, especially when some favourite trades are under pressure.

A basket of 37 meme stocks tracked by Bloomberg have fallen by almost 20 per cent from the early-June highs, leaving them on the cusp of sliding into bear-market territory. Elsewhere, bitcoin, the most traded cryptocurrency on Robinhood, has fallen by half from April peak.

Robinhood plans to allocate up to 35 per cent of the shares on offer in its upcoming IPO to its own customers. But while red flags abound, if Carlsberg did foolhardy mobs, it'd probably pick up a number from this lot.