"Retail Investors' Boxer Rebellion" Robinhood: Can "commission-free" really dominate the market?

The combination of the epidemic bonus and the "Buffalo" phenomenon has created a myth around Robinhood.US. As the trend of all Americans trading stocks and retail investors battling Wall Street reached its peak, Robinhood also went public amidst great fanfare. While it can be said that going public is a peak for now, Robinhood remains an indelible mark in the transformation of the American brokerage era - thanks to its pioneering business model of PFOF (Payment for Order Flow) + widespread commission-free trading.

However, competition never stops. When Robinhood, holding high the banner of "financial democracy," reached nearly 23.9 million cumulative users and customer acquisition almost stagnated, it also meant that "commission-free trading" was no longer an exclusive selling point. The first-mover advantage brought by "business model innovation" to Robinhood has faded, but at this point, Robinhood has only just started to become profitable. Therefore, the issue of business transformation naturally lies ahead for Robinhood.

But before discussing the future changes of Robinhood, let's first review the development history of Robinhood. As an internet brokerage heavily reliant on trading business, under what industry background did it first raise the flag of "commission-free trading," and how did it navigate the bull and bear markets through innovative business models? Is PFOF really beneficial and harmless?

In this article, we will focus on the development of the U.S. brokerage industry and Robinhood's brokerage business. The next article will delve into Robinhood's net interest income - the real money-making tool.

I. Wealth distribution in the U.S. over 35 years: "Bull market" matches "over-investment," a new "generational shift" for core users

As an online retail brokerage, the market and potential development space where Robinhood operates cannot be discussed without analyzing the wealth distribution of American residents. Looking back in history, it is found that in the past 20 years, the wealth distribution of American households has exhibited characteristics of "asset securitization" and "intergenerational transition of users."

1. From "private business" to "equity investment"

According to data from the Federal Reserve System of the United States, over the past 35 years from 1989 to the present, the distribution of assets among household residents has shown different trends in terms of real estate, company stocks and mutual funds (equity investments), pensions, and private businesses.

Among them, there has been a significant increase in the proportion of equity investments, especially since the 2008 financial crisis when the Federal Reserve initiated QE to rescue the market and cut interest rates to the lowest. Along with this wave of bull market in stocks, equity investments have been the main driver of wealth appreciation for residents

From 2009 to the present, the S&P 500 has increased by 496%, and the size of equity investments in U.S. households has grown by 529%, indicating that asset growth is not only driven by the appreciation of equity market assets, but also includes an increase in household investments in equities.

However, at the same time, the proportion of assets held by private businesses has been continuously declining (with a lower growth rate), dropping from 14% in 1989 to 10%. This is related to environmental changes such as economic recessions starting in the 1990s, technological changes, global competition, mergers and acquisitions of large and small companies, as well as changes in consumer brand preferences.

While the proportions of other major assets (real estate, pensions) have fluctuated, the changes compared to the 1990s and the present are not significant. However, the real estate market in the U.S. has not shown a continuous bullish trend. The housing market took a hit during the 2008 subprime mortgage crisis, and the average annual compound growth rate in the following years did not exceed 10%. This reflects that residents still have a tendency to invest significantly in real estate assets when allocating their assets.

In summary, changes in asset proportions reflect the long-term tendency of U.S. households to have an overweight allocation to "equity assets," which has been mutually beneficial with the long bull market in U.S. stocks: From 2008 to the present, the S&P 500 has accumulated a 496% increase, with the valuation PE-TTM rising from 17x to 27x. This means that 73% of the driving force behind the rise in the S&P 500 comes from the growth of listed companies' own EPS, while 27% comes from increased liquidity.

2. Lack of money is a drawback, "Millennials" are just starting to show their potential

After looking at the overall market, let's take a look at who is investing in the equity market, which includes core users of brokers like Robinhood.

According to data from the Federal Reserve System, U.S. residents can be divided into four generations: Silent (born before 1945), Baby Boom (born between 1946 and 1964), GenX (born between 1965 and 1980), and Millennial (born between 1980 and 1996).

Looking at the age groups of users investing in equities:

(1) The "Baby Boom" generation in the U.S. has taken the lead after 2000, especially after overcoming the 2008 financial crisis. At the same time, the "Silent" generation has gradually reduced their total asset allocation as they enter old age and pass away

(2) Although the "X generation" is now in their middle age, due to the relatively small total number of people and the shadow of the stock market collapse around 2000 caused by the burst of the technology bubble, their overall investment preference is generally average. During the stock market avalanche in 2008, they even almost "liquidated."

(3) The "millennial generation" who have successively become middle-aged still account for a relatively small proportion. However, a clear sign is that their equity assets have doubled every year since 2019 and 2020, from $306.2 billion in 2018, doubling to $737.9 billion in 2019, and then soaring to $1.5194 trillion in 2020.

If it is said that the global bull market in 2020 led to a wave of rise, it is obviously not the main reason. During the same period, the asset size of other age groups did not achieve similar growth rates, with "silent generation" growing by 19%, "baby boomers" by 17%, and "X generation" by 12%.

Dolphin's contemplation is that the increase in asset size is nothing more than 1) more money flowing in, that is, increased user penetration and user investment; 2) the assets held themselves appreciate, that is, the assets heavily held by the "millennial generation" appreciate faster.

Obviously, the above speculations can be supported by data. The point 2) above reflects the catalysis of the epidemic on the online economy, thereby driving the significant increase in the valuation of technology stocks. The reason behind point 1) is inseparable from the promotion of flexible and convenient online retail brokers such as Robinhood.

As of the second quarter of 2024, the equity asset size of the millennial generation is $3.189 trillion, which is 9 times higher than the $306.2 billion in 2018. Among them, of course, the drive of the EPS growth of technology companies themselves, but also because of the new money inflow, has driven the valuation from 20x in 2018 to the current 40x

Regardless of whether technology stocks can drive further appreciation of equity assets, from the logic of user penetration, the growth of total asset size has not yet been completed. If we simply compare the penetration rates of the baby boomer and GenX groups, the penetration rate of millennials has just reached the standard of the previous two generations, but there is still a lot of room for growth in asset size compared to the previous two generations. For GenZ born after 1997, the current penetration rate of 30% still has a lot of room for improvement.

Looking back at history, with each round of intergenerational transition, the mainstream brokerage firms favored by users will also undergo changes. "Millennials" and "GenZ" are groups of people who grew up in the era of the Internet, so this round of intergenerational transformation is also an opportunity for pure online brokers and commission-free brokers to grow.

II. Robinhood's Disruptive Competition

Looking back at the growth process of Robinhood's customer base, it is found that besides the rapid acquisition of customers in the early days of its establishment, 2017 and 2019 were both periods of significant growth rate spikes. So, what are the reasons behind this? Can Robinhood pave its way in the crowded brokerage market solely by offering commission-free trading?

1. Commission Price Wars Among U.S. Brokerages

Since Robinhood was the first to offer commission-free trading across all platforms and clearly benefited from customer acquisition, let's first briefly review the commission development history of U.S. brokerages.

Let's go back to the early 1970s when the U.S. SEC had just lifted commission controls, allowing brokerages to price commissions freely. To attract users, lowering commissions naturally became the first card played by various brokerages, leading to the emergence of "discount brokerages" known for their high commission discounts, such as Charles Schwab and Ameritrade (later merged with TD Waterhouse, a brokerage under TD Bank).

At the same time, with the innovation of Internet technology in the 1990s, Internet brokerages focusing on technology also joined the competition, such as E-Trade, Fidelity Brokerage, and Interactive Brokerage.

By then, the U.S. securities trading market had developed relatively maturely, with the main brokerage trading institutions divided into three types based on the services they provided: full-service brokerages, discount brokerages, and online brokerages. Each rose to prominence based on their respective advantages: providing comprehensive investment services, low commission fees, and online trading

In the 1990s, investors mainly traded on traditional full-service brokerage platforms, especially institutional users. Individual investors would only choose discount brokers, which officially rose as institutions after the SEC lifted commission controls in 1975. Online brokers gradually became the mainstream trading method for a new generation of individual investors with the improvement of internet technology.

However, Dolphin believes that internet brokers are essentially a technological innovation that is not limited to specific brokers. In fact, discount brokers, because they focus more on product feature updates and the optimization of operating costs through internet technology, are often the first to try online trading in the later stages. Conversely, brokers that started purely with internet technology can join the competition with more favorable commissions due to reduced costs from online operations.

Therefore, the boundary between discount brokers and internet brokers is now blurred, but the undeniable fact is that market competition never stops.

According to CS First Boston's statistics, the average commission rate of the top 10 internet brokers in the United States has rapidly decreased from 1990 to the present. After 2000, the overall market's commission income growth has stagnated.

The direct impact of competition from existing players is elimination, with the number of brokers registered with FINRA (the Financial Industry Regulatory Authority in the United States, mainly regulating broker-dealer over-the-counter trading activities) declining year by year.

To gain more user penetration, it means that price wars must continue. However, simply offering discounts can damage company profits. Therefore, most retail brokers have chosen to explore additional value for users, such as wealth management, banking services, and investment advice, in simple terms, gradually moving from a single brokerage to traditional full-service brokerage

For example:

In the early 2000s, Jiaxin extended its wealth management services by acquiring a trust company in the United States to provide trust and private banking services to high-net-worth clients;

Yichuang also opened a banking business, E-Trade bank, in 2001, bridging bank accounts and securities accounts;

Yameili, after being acquired by the securities company under TD Bank, collaborated with TD Bank in 2006 to transition from a brokerage firm to financial management, mainly selling fund products.

Therefore, since the deregulation of commissions, the decline in commission rates and the development of diversified finance have ultimately led to a continuous decline in the proportion of commission income in total revenue for U.S. brokerages.

Transitioning from a single focus to diversification is a business development strategy that is a win-win for revenue generation and risk control. The dual structure of trading and margin financing will lead to homogenized competition, while diversified financial services can not only attract more users and establish economies of scale, but also reduce friction costs between businesses and improve overall operational efficiency. Moreover, when risks come to a single business, diversified finance can maintain a more stable income scale.

However, as the predecessors all followed the same path of becoming full-service brokerages, venturing into wealth management, consulting, banking, and other businesses to compete with traditional top investment banks. Inspired by the "Occupy Wall Street" movement in the United States in 2011, the founder of Robinhood saw the power of the common people. Instead, they focused on trading revenue, which the predecessors had paid less attention to, and innovated the business model by not charging commissions to users from the start.

The birth of Robinhood officially kicked off the 3.0 version of the commission price war (1.0 pure discount commission, 2.0 internet broker)— ushering in the era of widespread zero-commission.

Why is it called "widespread"? This is because before the birth of Robinhood (2013), some retail brokerages had already implemented zero commissions on a small number of ETF products and mutual funds. However, for more widespread stock and options trading, commissions were still charged.

From 2013 to 2018, traditional full-service brokerages and retail brokerages continuously experimented with widespread zero commissions, such as JP Morgan, which launched the "You Invest" commission-free app, but also added some thresholds and restrictions for eligible users. For example, Firstrade, as an early full-service brokerage that transitioned to the internet, announced a widespread zero-commission system in August 2018, including stocks, options, mutual funds, ETFs, and other assets.

It wasn't until the largest two retail brokerages in the United States— Fidelity Investments in August 2018 and Jiaxin Wealth Management in October 2019 announced widespread commission-free trading, that the trend of zero commissions reached its peak. Soon after, TD Yameili, Yichuang, and Fidelity also successively announced commission-free trading within a week

For the retail brokerage giants, why did they wait 5 to 6 years to launch widespread commission-free trading? Dolphin believes that it may be related to their concerns about the short-term impact on performance after implementing commission-free trading. After all, Jiaxin, Yameili, Yichuang, and Fidelity were all listed companies at the time. If trading revenue accounts for a large proportion, the impact on overall performance would not be insignificant.

Dolphin found that when Jiaxin announced commission-free trading, the commission income from 2017 to 2018 accounted for only a little over 5% of total revenue, the lowest level in history. Therefore, launching commission-free trading at this time may also be to minimize the short-term impact on the company's performance.

However, despite the fierce competition, the introduction of commission-free trading by the retail giants has allowed Robinhood, still a small and micro institution, to gain some popularity by being the first brokerage to raise the "widespread commission-free" flag. Coupled with the cryptocurrency market, from 2017 to the eve of the epidemic in 2019, Robinhood's user growth CAGR exceeded 90%. After 2020, due to the epidemic, there was a dividend from the bull market and the online stay-at-home economy, leading to a doubling of the user base. However, after 2021, as the stock market entered a period of stagnation, under competitive pressure, Robinhood's customer acquisition rate quickly slowed down.

2. Jiaxin focuses on "depth" vs. Robinhood focuses on "breadth"

Next, Dolphin compares Jiaxin to discuss the differences in development strategies between Jiaxin and Robinhood.

Although both rely on price wars and technology to start, there are significant differences in the development path and profit model between Jiaxin and Robinhood. Of course, this is also related to the differences in the era of the rise of the two brokerages and their target positioning.

Jiaxin's ability to develop into the largest retail brokerage in the United States actually seized three waves of change: discount commissions, internet technology revolution, wealth management, and ultimately achieved business transformation.

Under these three waves of change, Jiaxin broke through different categories of users:

Discount commissions attracted small and medium-sized users who are not highly demanding of advisory services but are more sensitive to commissions, internet revolution attracted young users, and wealth management attracted relatively wealthy middle-aged and young new elites.

Of course, users attracted by discount commissions will also be retained in the long term because Jiaxin provides more trading varieties, iterative optimization of internet trading, and the introduction of wealth management services Compared to brokerage businesses that need to continuously reduce commissions to maintain a competitive advantage, the future of wealth management business seems more promising. Therefore, in the next 30 years, that is, before the introduction of commission-free policies in 2019, Jiaxin has always been pursuing attracting high-net-worth clients for long-term stable investments, hoping to achieve a stable client base and more asset management value-added fees. This can be seen from Jiaxin's early launch of proprietary funds with a relatively high minimum investment size and investment advisory services, indicating Jiaxin's aspiration to transition from a seller to a buyer.

On the other hand, Robinhood focuses on penetrating more small and medium investors. The characteristics of these users include relatively low capital size, for example, the individual client capital size of Robinhood is much smaller than other retail brokers like Jiaxin.

On the other hand, in terms of quantity, this group of users is not small (as mentioned earlier, the penetration rate of GenX group in stock investment is 30%), it's just that traditional brokers have not included this group with limited funds and investment knowledge in their accessible user lists.

Therefore, after the establishment of Robinhood, the development strategy is not to attract high-net-worth individuals like Jiaxin, but to focus on the characteristics of these users (low capital size, frequent trading, love to share and communicate), and through various marketing methods and customized services, to achieve "user penetration" and "high stickiness" for this group. This series of operations indeed somewhat align with the founder's pursuit of "Democratize Finance."

a. Social media hype & incentive marketing: Attracting young investors through social platforms, utilizing incentive games and word-of-mouth influence for promotion.

In the early stages, customer acquisition mainly relied on the promotion of "commission-free" on social media. After harvesting the first wave of users, the platform gradually set permissions for services beyond basic stock trading such as options, cryptocurrencies, Gold, etc., and users needed to wait for approval. Robinhood intentionally designed a referral incentive game:

While users are on the waiting list, their ranking is displayed (often towards the end), and if they refer friends to join Robinhood, their ranking moves forward.

Whether it's options or cryptocurrencies, they are popular trades among Robinhood's core users. Therefore, under this incentive game, the motivation for existing users to refer new users to join is relatively strong. However, in reality, this is more like a form of "starvation marketing" completely controlled by the platform Later, Robinhood also likes to use event hype marketing. The most typical case is the battle between GME retail investors and Wall Street. Before restricting GME trading, Robinhood gained a large number of radical and active trading users through this wave of hype.

b. Lowering the Threshold: Since the goal is to promote financial democracy, lowering the threshold is necessary.

On one hand, Robinhood simplifies the platform UI, with the trading page only showing price trends and prominent buy/sell buttons, using eye-catching red and green colors to reflect price changes in real time. Instead of presenting a large amount of complex information to users, various popular stock lists like "Top Movers" are used to influence user decisions, making users think that investing is as simple and fun as a game.

However, Robinhood also provides some investment learning courses, institutional reports (Morningstar), and a community for novice users to supplement their investment knowledge.

On the other hand, to address the issue of low user capital, in order to increase trading activity for more users, Robinhood introduced fractional share trading in 2019. This significantly lowered the investment threshold, especially for retail investors who prefer tech giants.

For example, before the stock split, Amazon's stock price was over $3000 per share. Based on Robinhood's average customer capital of $4000 in 2020, without using leverage, they could only buy or sell 1 share at most. However, after the introduction of fractional shares, users can participate in purchases at 1/15 of the price.

Additionally, Robinhood also offers lower margin rates (the only major retail broker that can compete with it is Interactive Brokers), allowing retail investors to trade stocks with higher leverage at a lower cost.

c. Multi-Market Trading: In terms of the richness of equity products, Robinhood may not necessarily surpass traditional leading institutions. However, when it comes to cryptocurrency trading, Robinhood is the only retail broker that not only introduced the market early but also implemented a zero-commission policy.

Other competitors of Robinhood, also popular online retail brokers, such as Charles Schwab and E-Trade, did not introduce cryptocurrency markets due to asset risk control considerations. While some institutions like Webull have introduced cryptocurrency, they have not implemented a commission-free system like the equity market.

III. PFOF, the Essence of Zero Commission

Because Charles Schwab and Robinhood target different user groups, their business models also have fundamental differences.

For Charles Schwab, whether attracting trading users through discounted commissions or product features, they will gradually lead users to value-added wealth management services (such as purchasing funds on the OneSource platform, investment advisory services). Additionally, Charles Schwab Bank, established in 2003, can attract users' idle funds after transferring assets to the Charles Schwab platform for unified management, and then lend out these funds to earn interest differentials Therefore, the revenue scale of the latter two businesses, asset management revenue, interest income, is the main source of income for Jiaxin, while the contribution of trading commission income has been squeezed due to competition until Jiaxin also introduced zero commission (stocks, ETFs, options), which then increased its proportion.

However, for Robinhood, the business model is different:

On one hand, since it is zero commission, naturally, they cannot earn anything from users, but instead earn fees by selling order flow to market makers, which is the PFOF (Pay For Order Flow) mechanism.

On the other hand, the greater value comes from the series of services Robinhood has launched around "trading brokerage," such as margin financing, stock borrowing and lending, credit loans that can generate interest income, and the Gold membership subscriptions that grow with the number of users.

Therefore, for Robinhood, the trading income from market maker commissions and the interest income from financing and securities lending are currently the main sources of revenue. Compared to Jiaxin's intention to guide users towards wealth management, Robinhood is more willing to have users frequently engage in high-leverage financing and securities lending transactions. Under this approach, naturally, young investors with a small capital base but a higher risk appetite are more suitable to become Robinhood's core users.

Due to space constraints, this article mainly introduces Robinhood's business model in the brokerage business. Regarding the interest income mentioned above, Robinhood has implemented many strategies. The specific business operations and business model will be discussed in detail in the next chapter by Dolphin.

1. The Market Maker System is the Basis for the Existence of PFOF

The PFOF business model under zero commission was first adopted by Robinhood in 2014. The basis for the operation of PFOF lies in the market maker system. Market makers are a type of "alternative investor" that mainly profit from buying and selling at high frequencies in the market.

For brokerage firms, they can send the order flow from investors to public exchanges for matching, or they can send it to market makers for matching. However, the minimum price unit for stock quotes on exchanges is 1 cent, which is 0.01 dollars, while market makers can quote as low as 0.1 cent, which is 0.001 dollars.

Therefore, the following situation may arise: for example, for a stock, the best bid and ask prices on the exchange are 100.64 dollars and 100.65 dollars, respectively, meaning the bid-ask spread is 0.01 dollars. But if given to a market maker, they can accept buying the stock at 100.645 dollars and then sell it at the same 100.65 dollars As a result, for investors who want to sell stocks, the stocks that could only be sold for $100.64 before can now be sold for an additional $0.005 per share, thus obtaining a "Price Improvement" of $0.005 per share. For market makers, they can earn the spread income of $0.005 by selling at $100.65 and buying at $100.645, and then pay a compensation fee to the broker, such as Robinhood, which generally charges $0.001 to $0.002 per share. The remaining $0.03 income is the market maker's true net profit. (As shown in the simulated figure below)

The presence of market makers generally has a positive impact on market liquidity. However, for some high-risk assets, market makers may increase the spread due to the need to add some risk compensation space for themselves, such as in some options trading.

For market makers, the key reason for being able to earn the spread is to match enough counterparties to facilitate transactions. Otherwise, if their sell orders cannot be executed in the short term while they take the buy orders, it will greatly affect their profits.

This also means that market makers are willing to pay a certain cost to obtain order flow. The majority of order flow owners are retail brokers. Therefore, Robinhood, which needs to monetize through other means while offering commission-free trading to users, naturally cooperates with market makers.

2. The Inevitable Issue of PFOF

In the market maker system, brokers providing platform intermediary services need to maintain independence. However, under the PFOF system, where brokers unilaterally benefit, the lack of independence inevitably leads to an unfair situation for the paying party.

In particular, if brokers send all orders to a small number of market makers, users can only trade with market makers who may not offer the best quotes. For example, in the above case, if a market maker chooses to offer a buying price not at $100.645 but at a lower price of $100.630 compared to the exchange, investors who are eager to sell will have to trade at the cost of sacrificing $0.01 per share.

This clearly violates the "Order Protection Rule" of the U.S. NBBO (off-exchange quotes must be equal to or better than exchange quotes). To address potential unfair risks, the U.S. SEC has considered banning PFOF.

Although PFOF was eventually allowed to continue, brokers are required to disclose information related to PFOF transactions to investors and the relationship between brokers and market makers. Market makers are also required to regularly disclose whether their actual quotes comply with the Order Protection Rule.

In theory, the most direct way to avoid unfair trading or violations of the best quote principle is to keep brokers strictly independent or have market makers provide sufficient quotes

1) Brokers are strictly independent: Brokers do not charge PFOF fees

2) Market makers provide sufficient quotes: Introducing a large number of market makers to participate in quoting, or maintaining both on-exchange and off-exchange trading.

However, the above theoretical methods are not easy to implement in practice:

Only a few brokers that do not rely on trading revenue can achieve this;

Due to the scale effect in the financial industry, the development of a relatively mature market maker market tends to be an oligopoly market.

As shown in the figure below, off-exchange trading accounts for 43% of the total trading volume, with 10% of dark pool trading within brokerage firms, and the remaining 34% is completed by market makers. Among this 34%, Citadel dominates, followed by Virtu with a significant share. The top 3 alone account for the vast majority of the market maker market.

Therefore, while theoretically introducing more market makers can reduce unfair risks, the actual effect may be discounted.

After all, the quotes provided by market makers may all meet the "order protection principle" (better than exchange quotes), but there are differences in quotes among market makers. Brokers may choose a market maker with a higher commission rate but less favorable buying and selling quotes for users.

As shown in the figure below, Robinhood and E*TRADE, which profit from PFOF, have significantly higher EFQ (effective spread/total bid-ask spread) than brokers that do not charge fees, but Robinhood's PFOF fee rate is relatively high.

Taking everything into consideration, it is reasonable to suspect that Robinhood, for PFOF revenue, sells users' order flow to market makers that can afford high fees but offer inferior quotes.

As for on-exchange trading, in a situation where one pays and the other does not, it is another choice that brokers need to resist the temptation of income. Currently, in the U.S. stock trading market (S&P 500 targets), among brokers involved in market maker systems due to relatively sufficient liquidity, only Interactive Brokers maintains the vast majority of on-exchange trading, followed by Fidelity (mainly because they charge lower PFOF fees, thus can independently provide users with fairer quotes).

On the other hand, Robinhood, TD Ameritrade, and Charles Schwab are almost all off-exchange trading (market makers), meaning that in the absence of user specifications, order flow is entirely given to market makers to match transactions

Therefore, considering these unavoidable unfairness, the vast majority of countries and regions around the world have strictly prohibited PFOF. Currently, it is only completely legal in the United States, and in addition, some markets in Canada and Australia can adopt it, but regulatory agencies are cautious and require strict scrutiny.

For the Hong Kong region of China, there is a market maker system, but the Securities and Futures Commission (SFC) of Hong Kong explicitly stated that PFOF is strictly prohibited.

3. The business model is not a real barrier

Robinhood's innovative business model allows its commission-free game to be launched and continued, but soon more and more peers also chose commission-free and PFOF.

As of the second quarter of 2024, the total stock trading volume in the U.S. market is approximately 1 trillion shares, with over-the-counter trading accounting for about 45%. Among them, PFOF traded 192 billion shares in the second quarter, accounting for about 19% of the total trading volume. The total options trading volume in the second quarter is about 4 billion contracts, with PFOF trading 1.3 billion, accounting for about 33% of the total trading volume.

Since not all brokers using the PFOF system will charge fees to market makers, it is necessary to look at market share. Dolphin Jun chooses to restore the number of shares and options contracts contained in the order flow as a unit of measurement to see the market share of various retail brokers.

Looking at the above charts together, Dolphin Jun found:

(1) Brokerage firms using the PFOF mechanism are not only discount brokers or internet brokers, but also the presence of Full-service broker Morgan Stanley, thanks to its acquisition of another top retail brokerage firm E-Trade in 2020.

E-Trade took a similar path as Charles Schwab, extending from trading to wealth management and asset management. Before the acquisition, E-Trade had 6 million retail clients and 2 million institutional clients in 2020. Therefore, E-Trade also relies mainly on interest income, with 60% of its total revenue of 3 billion coming from interest income, the second largest income being advisory service fees, accounting for 26%, while commission income directly related to trading accounts for only 12% However, for Morgan Stanley, which has mainly focused on institutional clients in the past, E-Trade's influence in the retail sector can help MS fill the gap in its retail business.

(2) Looking at the frequency of payment of order flow rebates from market makers to various brokers, Robinhood is currently still in the lead, but Jiaxin is catching up at a faster pace, especially by the end of 2023.

Although there are cases where multiple orders are combined and paid for at once, the trend shows that the higher the payment frequency, the more orders brokers send to market makers.

(3) When it comes to actual shares/options traded, Robinhood is relatively ahead in PFOF options trading, but significantly behind Jiaxin and TD Ameritrade in PFOF stock trading. After acquiring E-Trade, Morgan Stanley is rapidly catching up and is now on par with Robinhood in terms of scale.

Considering <1-3>, in reality, Robinhood's market share in PFOF is not as dominant as expected.

After the peak of commission-free trading in the second half of 2019, within less than a year, traditional retail brokers with a larger user base (number of accounts, average client assets under custody) quickly caught up in terms of PFOF scale (including cases where these retail brokers did not fully pass on order flow to market makers).

Even during periods of underperformance in the U.S. stock market, TD Ameritrade, leveraging the user stickiness of traditional retail brokers, surpassed Robinhood in PFOF scale; while the rising Jiaxin and the traditional brokerage firm Morgan Stanley, which now owns E-Trade, are also eyeing the situation.

Of course, you could argue that Robinhood's users are younger, more active in the community, trade more frequently, and as they age, the average account funds can continue to rise. However, at least in the brokerage business, Dolphin believes that Robinhood cannot escape the path taken by its retail predecessors. Simply looking at the competitive barriers in the trading business, they are not as high as imagined:

Undeniably, PFOF remains the most prominent part of Robinhood's development history, and it is precisely because of this business model innovation that Robinhood had the confidence to launch the "commission-free" era and gained a customer acquisition advantage in the following 6-7 years. But as commission-free trading becomes mainstream for retail brokers, relying solely on commission-free trading will no longer be Robinhood's low-cost customer acquisition weapon.

(1) In 2021, Robinhood's trading revenue slowed significantly during the bull market, indicating a notable impact from competition.

(2) Dolphin's calculation of average customer acquisition cost, after the commission-free era in 2020, was still relatively low due to the bull market and the pandemic, but it has been unable to resist the subsequent upward trend

In addition, the unfairness of PFOF, as long as Robinhood accepts payment for order flow from market makers, is difficult to fundamentally resolve (market makers pass on this cost through quotes to users). Although it is not a major issue at the moment, we believe it is still a ticking time bomb.

1) There is a potential issue of user interests being harmed (non-optimal quotes, high effective spreads), which will become more apparent as competition intensifies. Some users may express their rejection by either mandating orders to be sent to exchanges or flowing directly to competitors. However, traffic (both users and trading activity) is the core foundation supporting the smooth operation of the PFOF business model.

2) PFOF is not permitted in most regions. If Robinhood continues to rely on the PFOF business model, it will affect Robinhood's global development.

It can be foreseen that Robinhood may eventually need to transition from a single to a diversified development path to reduce the impact of stock market revenue fluctuations and increase user stickiness. The trend is already faintly visible through Robinhood's attempts with Robinhood Gold to venture into electronic consumer payments, credit cards, retirement investment, and financial planning services.

Despite all the changes, as mentioned by Dolphin in the first part regarding intergenerational user changes and changes in the brokerage competition structure, the core barrier for Robinhood still lies with the users themselves. Robinhood is a financial app that has grown with Gen Z users. Past successful experiences indicate that only by starting from the needs of these core users and extending and iterating corresponding functions and services early on can one maintain long-term relative advantages.

As PFOF is increasingly imitated by peers and the first-mover advantage is rapidly eroded, the growth of market maker commission income is also affected, especially during the market doldrums from the second half of 2022 to the first half of 2023. So, how does Robinhood innovate its business model to offset some of the gaps brought by trading revenue with interest income, which is also affected by market fluctuations? Dolphin will provide a detailed explanation in the next article, so stay tuned.

Risk disclosure and statement of this article: Dolphin Research Disclaimer and General Disclosure